Clauses in a Shareholders Agreement

by | Dec 6, 2021

A shareholders agreement legalizes the transaction and relationship between the shareholders(investors) and the startup or company(investee) in which the investment is made. Thus it becomes extremely important for both of them to know the contents of such a legal document. In this blog, an attempt has been made to make the readers, entrepreneurs, angel investors, funding investors, any investor wanting to invest or fund a startup, and even for the startups who are seeking funding or investment, understand the clauses that form part of a shareholders agreement. This will help them to play a more proactive role while drafting and negotiating the terms and clauses in a shareholders agreement and ultimately safeguard their interests.

 Clauses in a shareholders agreement:

Instrument – This clause determines the type of investment that the shareholder is going to make. Whether he is opting for equity or preference share or debentures or hybrid securities.

Capital Structuring

This clause provides details as to the capital structure of the startup or company, the timeline of payment, and the subscription of shares for the shareholders. Structuring of the share capital helps to represent the ownership of the shareholders.

Consent of Shareholders

This clause provides details as to the situations in which the consent of the shareholders might be required in majority matters. Consent can be taken in situations like whenever there is the dismissal of any member of the supervisory board, drafting of a financial statement, distribution of dividend, amendment of articles of association, amalgamation or filing for bankruptcy, dissolution of startup or company.

 Pre-empti`on rights

This clause provides existing shareholders or those shareholders to which the right is granted, the right of subscribing to any new or additional shares issued by the company and protecting their ownership percentage from being diluted. Such a right also prevents the startup or company from issuing its new or additional shares to any third party without first offering such shares to the existing shareholders.

Vesting Clause

This clause ensures that the shareholders stay invested in the company or startup for a particular period before getting benefits from their investment. A pre-agreed percentage of shares will be vested with the shareholders after the fulfillment of conditions relating to the vesting period. If such conditions are not fulfilled then the startup or company can buy back the shares.

Reverse vesting Clause

This clause is favorable for the investors and is against founders as it prevents or restricts the founders from leaving the startup or company with their shares and saves the investor’s investment. It forces the founders to give up their rights over their shares and earn those shares again and then such shares will vest back in the founders as per the vesting schedule. It makes the founder work for his own investment in the startup or company.

Tag along with clause

This clause is beneficial for the minority shareholders. The minority shareholders can tag along when the majority shareholders transfer their shares to the incoming investors. This binds the majority shareholders or the selling shareholders to allow the minority shareholders to sell their shares along with them on the same terms and conditions including a pre-determined agreed price of shares.

Board Representation

This clause provides the investors or the shareholders with the right to choose their representative to the board of directors of the startup or company.

Affirmative Voting Rights

This clause provides the rights to the investors or shareholders to vote in reserved matters. Shareholders have the right to vote in direct proportion to their shareholding.

Information or Inspection Right

This clause helps a shareholder in getting information about the company regarding its balance sheet, cash flow statements, marketing plans, etc. at regular intervals. It also includes the right to inspect the books of accounts and other important documents of the startup or company.

Non – compete for clause

This clause seeks to prevent the existing shareholders from engaging in any business that is similar to the company.

Confidentiality Clause

The shareholders as well the promoters or founders should not disclose confidential information about the startup or company. They need to take the prior written consent or approval of the other shareholders of the startup or company. If any such information is leaked without consent then it would amount to breach and the same would have to be compensated either through costs or termination.

Representation, Warranties, and indemnities

This clause is actually a statement of factual matters whereby parties to a shareholders agreement represents and states to the other party that a given state of facts is true and correct as of a given time. It provides details regarding the current status of the startup or company, its work, and the utilization of funds received from the investors. In case of breach of warranty, investors can ask to indemnify through collateral or a penalty interest or any amount for such breach. The parties to a shareholder agreement take important decisions based on the representation and warranties of each other. If in any case such representation and warranties are false or there is a breach with respect to them then the indemnity clause protects the financial interest of the other party.

Liquidation Preference

Liquidation is the process of bringing a business to an end and distributing its assets to claimants. As company operations end, the remaining assets are used to pay creditors and shareholders, based on the priority of their claims. So this clause provides details as to which type of shareholder will be preferred in case of liquidation of startup or company. In such cases, mostly the angel investors or the venture capitalists are preferred in both cases wherein the startup or company is either sold at a profit or a loss.

Termination

This clause provides details as to under what circumstances a shareholders agreement might get terminated. A termination clause is applied wherein the agreement gets terminated on the occurrence of any specific event which can be non-contribution of share towards the capital by the parties or insolvency of parties wherein the parties had represented to be solvent earlier. This can result in termination of a shareholders agreement upon written notice to the defaulting party.

Dispute Resolution

This clause provides details as to the procedure that will be adopted to resolve any disputes which might arise between the shareholders and the startup or company during the functioning of the startup or company. The disputes can be over seeking additional funding for the company, dividends, an increase or reduction of shares, or acquisition of the company. The startup or company has to be prepared for such events. Resolution of such disputes can be done by out-of-court settlement by means of arbitration or conciliation between the shareholders and the startup or company.

Conclusion:

So in this blog, an attempt has been made to cover the maximum number of important clauses that form part of the shareholder’s agreement. This will help the readers to get a basic understanding of the shareholder’s agreement. It will help them to know the intention and purpose behind various clauses that form part of a shareholders agreement. A shareholders agreement needs to be drafted in such a way that creates a balance between shareholder interests and the interests of the startup or company. 

Every entrepreneur who wishes to start his own startup or company and every angel investor or funding investor wanting to invest in a startup should focus on a well-drafted shareholders agreement. He should consult a startup lawyer for the drafting of the same. A startup lawyer can ensure that all the required legal compliances with respect to startups have been adhered to. Such a startup lawyer can not only help you in drafting and vetting of legal documents(contracts and agreements) but he can also be helpful in various stages like getting investors in your startups, startup finances, getting angel investors or angel investment companies providing angel capital or angel money, crowdfunding or other funding opportunities for startups. So if you are an entrepreneur with a startup plan, or an angel investor or funding investor looking to invest then seeking the consultation of a Startup Lawyer who has all-around knowledge with respect to startups, is a must.

Written By Pooja Terwad

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