All About Shareholders Agreements

By Adv. Apurva Chodanker

Introduction

A company is a legal entity created or formed to carry on business activities. It may be formed by an individual, or by a group of people. A company may be a public or private company, hence, once a company is formed or established it has to be registered, shares are to be equally distributed amongst the partners, Articles of association, Memorandum of association, registration clause, liabilities clause, prospectus etc. have to be incorporated.

Share refers to a unit of ownership in the share capital of the company. These shares can be subscribed to by paying their current market value. A shareholder is a person who has subscribed to the shares of the company.

When a company is formed, they determine their share capital in the company and their respective duties towards it. Based on the terms decided, the Articles of association of the company is drafted. Usually, the Article of association covers major terms with respect to capital and shares, mode of share transfer, director’s rights and duties, meetings, proceedings of the boards.

Shareholder agreement is a display between the company’s shareholder describing as to how a company should be operated as well as the rights and obligations of shareholders. 

For any company, be it private or public, it is a difficult task to maintain and manage its internal and external affairs. Shareholder agreement is beneficial when it comes to shareholders or co-investors who are not familiar with each other personally.

Purpose of Shareholders’ Agreement

The purpose of shareholders’ agreement includes: 

1. To safeguard the shareholders’ investment in the company
2. To have fair relationship between the shareholders
3. To run the company successfully and efficiently.

Importance of Shareholders’ Agreement

The importance of shareholders’ agreement is that it acts like a guide on how a company is operated, rights and obligations of the shareholders, the company’s relationship with its shareholder etc. The whole purpose of shareholders’ agreement is to ensure that the shareholders are treated properly, fairly and their rights are protected. 

The agreement makes it possible for the shareholders to make decisions regarding third parties who may become shareholders in the near future. The shareholders’ agreement is designed in such a manner that it protects the shareholders, but more importantly, it protects the minority shareholders. The main aim of this agreement is that the majority shareholders are obliged to protect minority shareholders from abuse and to give them a voice in making key decisions.

Furthermore, the shareholders’ agreement protects the interest of the shareholder incase there is any kind of abuse by the future management. When the company or the entity is taken over, or acquired by another entity, or a new management comes into picture, the agreement will protect the decisions pertaining to the dividend distribution, issuing of new stock, debts etc.

How Shareholder Agreements protect Minority Shareholders

When there is no shareholders agreement in existence, the minority shareholders lack voting power in the company. This is disadvantageous to the minority shareholder since these shareholders end up exercising minimal influence in the company’s operation. 

As we know that more than 50% of the shareholders of the company participate in the decision-making of the company, whereas the minority of the shareholders’ decisions or key management decisions will not be considered.

Though Articles of association protect the minority owner, there is always a possibility of the provisions being altered by a special resolution that is approved by the majority shareholders. Such flaws are addressed by the shareholders’ agreement by seeking approval of all shareholders in the company’s key decisions, irrespective of their voting power. The benefit of shareholders’ agreement is that such rules limit the capacity of the majority shareholders’ decision to override minority shareholders’ decisions, like new shares, taking new debt, appointments, removal of directors, etc. 

How Shareholders’ Agreements protect Majority Shareholders 

This agreement protects the majority shareholders in situations where the minority shareholders are not cooperative.

For example– The shareholders’ agreement enables the majority shareholders to include the ‘drag-along’ provision which allows them to sell part of all of the shares at a specific time and place even though the minority shareholder is not ready to agree on the transaction. The shareholders’ agreement includes a clause that forbids the minority shareholder from transferring their share to the enemy competitors or other party that the majority shareholder does not wish to get involved.

How to Draft a Shareholders’ Agreement

This agreement is a contract between the shareholders of the company and their corporation. The agreement helps in forming a clear understanding of the goals, rights, and expectations of the shareholders. The agreement also clearly mentions who is responsible for what when there is a conflict of interest between individual shareholders, the price of each share, the shareholder’s entitlement to his share in the company’s capital etc.

Components of Shareholders’ Agreement

The contents of the shareholders’ agreement may vary for every company. The following is a list of the standardized content that a company must incorporate in its shareholders’ agreement.

1. Parties: The shareholders’ agreement must recognize the corporation as one party in the first section of the agreement, which is different from the shareholder.

2. Board of Directors & Board Meeting

• The agreement recognizes and describes the role of the board of directors in the company.
• It mentions that the decision should be approved by the majority.
• It talks about the number of times meetings of the board of directors should hold as well as the mechanism for selection or replacement of directors.

3. Reserved Matters

• The shareholders’ agreement allows the company to set out issues that need approval from all signatories and not just the majority support. A list of reserved matters must be included in the agreement so that all the shareholders are given a fair chance to evaluate transactions in order to decide and determine if any disadvantageous investment is being carried out. 
• Reserved matters include changing share capital, acquiring or disposing of certain assets, borrowing new debts, paying dividends, and changing articles of association or memorandum of association.

4. Shareholders’ Information and Meetings

• The agreement states that the shareholders are required to be updated regarding the company’s performance through quarterly and yearly reports.
• It must mention a specific period as to when the report is to be sent out to the shareholders.
• It also mentions information regarding the shareholders’ meeting to be held, including the date, time, and venue of the meeting.

5. Share Capital and Share Transfer

• The agreement should record the corporation’s share capital on the date at which it is signed.
• The directors are not allowed to issue new shares or change existing shares to a new shares class without the signatories approving of the changes (changing share capital is considered to be a reserved matter).
• Provisions with regard to share capital are also mentioned in the agreement. The agreement prevents the transferring of share capital to an unwanted party or to a new party.
• It also discusses what is to be done if a director or shareholder dies with matters related to drag-along and tag-along provisions.

6. Amendment and Termination

• The process of amendment and termination is to be provided in the agreement.
• Example– The agreement must describe the termination on grounds of:

 i) dissolution of the company

ii) upon a written agreement

iii) after a specific number of years from the date of the agreement.

Important Clauses in Shareholders’ Agreement 

• Responsibilities of Shareholder

The role and duties of the parties to the agreement are well-defined in the shareholders’ agreement. The composition of the board is also specified in the agreement.

The process for monitoring the relationship between majority and minority shareholders and the board, and other shareholders is to be mentioned. 

• Special Rights 

This clause gives a higher level of desperation for venture capital. It may also be done via an additional seat on the board, preferential rights, etc. 

• Address Questions 

Many things can happen in a company that is not expected to happen in general such as, some shareholders may leave, or documents may not be in order or be invalid. Such situations are to be considered in this agreement.

• Constraints on Transfer

Certain restrictions may be applied on the transfer of shares in the shareholders’ agreement. First right to offer and first right to refusal are two standard clauses that must be included in the agreement. Buy-back rights are also defined in the shareholder agreement.

•  Assigning Period

The agreement states the benefit period for each shareholder. It talks about what happens to the share when the directors need to hand over the sale to the company or to another shareholder.

• Detail Warranties

Usually, investors expect all the detailed assets and liabilities of the company to be revealed to them, thus directors grant warranties to the investors up to a certain amount.

• Remuneration

The shareholders’ agreement mentions the specific sum of amounts to be paid to the shareholder.

• Confidentiality 

The shareholders’ agreement contains provisions regarding the company’s confidential information that is to be kept secret with respect to shareholders, along with the information that is provided by the shareholders.

Benefits of having Shareholders’ Agreement

1. Different authority- In the shareholders’ agreement, the distinct rights and liabilities of the shareholder are highlighted. Authority is properly defined in this agreement.

2. Amendable- The agreement may be amended as per the needs of the shareholders. Special resolution is required to be passed by the shareholders via majority votes in order for the amendment to be made. 

3. Protection to minority- There is a distinction between majority and minority shareholders. Hence their rights and liabilities are also separated such that the minority shareholders are protected from any kind of abuse.

4. Control over the company– Shareholders’ agreement establishes some kind of control over the involvement that happens within the company.

5. Provides basic restriction- The shareholders’ agreement deals with specific provisions related to the transfer of shares.

6. Care for the position- The shareholders’ agreement protects the position or role of shareholders within the company.

Main Points to be included in the Shareholders’ Agreement

1. Sale of shares

This is one of the important provisions to be considered in the shareholders’ agreement. Sales and transfer of shares can only happen with the consent of the parties.

2. Requirements of the business

Any requirement relating to the business should be discussed in and considered in the shareholders’ agreement, such as financial requirements of the business, the future funding of the business, etc.

3. Requirement of meetings

Meetings include two types of meetings: (1) Board meetings (2) General meetings. Quorum of these meetings must be in accordance with the Companies Act of 2013. Respective shareholders’ consent is to be taken into consideration to conducting the meeting.

4. Evaluation of shares

The evaluation rule depends on the mode of evaluation of shares of the company. The value of the company shares differs as per the market since the market and its components are subject to constant change. The method of valuing a company’s shares indicates the significance of the evaluation of shares.

5. Liabilities of the shareholders

When it comes to a private limited company, the liability is limited to unpaid share capital in the shares of the company. In the case of a private and public limited company, the liability is limited and the principle of liability comes from the separate entity of the firm.

6. Minority shareholders rights

Minority shareholders have less share-holding when compared to majority shareholders. Following are the rights of the minority shareholders.

•  To apply to the board for relief of Oppression and Mismanagement Related to the affairs of the company
• To bring out action against the auditors and directors of the company.
• To ask the majority shareholder to sell the shareholdings. 

Conclusion 

India is a very diverse country, every day new companies, entities, and entrepreneurs are established. To keep in place the internal as well as external affairs of the company intact, it is important to enter into agreements. The shareholders’ agreement is for the benefit of all the shareholders of the company. The agreement sets certain goals and ambitions which the members can achieve. It also gives a sense of responsibility and acts as a guide as to how one can achieve these established goals and help the company reach new heights.