Prefatory Note
Now that we have decoded the term sheet, it is time to move from the preliminary sketches to the detailed playbook – the shareholders' agreement (‘SHA’). If the term sheet is the visionary blueprint, the SHA is the definitive agreement that brings that vision to life, ensuring every shareholder is on the same page. It is the ultimate playbook for a company, with its primary role being to govern the relationship between shareholders and the company. It is the internal rulebook that everyone agrees to follow, ensuring harmony and clarity as the company grows and evolves.
Executed simultaneously with share purchase agreements (‘SPA’) or share subscription agreements (‘SSA’), the SHA serves a distinct and crucial purpose. While the SPA deals with the sale and purchase of shares and the SSA focuses on the subscription of shares, the SHA is the comprehensive legal document that delineates the rights and obligations of shareholders within the company and in relation to one another. Its comprehensive nature ensures that no aspect of shareholder rights and obligations is left unaddressed, providing a profound sense of security and reassurance in the document's coverage.
By providing a robust framework for governance and addressing specific areas of potential conflict, SHAs play a pivotal role in promoting transparency, stability, and effective management within the company. This guiding authority helps prevent misunderstandings and disputes, ensuring everyone is on the same page and working towards common goals. This instills a profound sense of confidence and ease in the legal framework, providing a reassuring sense of security.
Once the blueprint is decided through a term sheet between the promoters and the investors, the process culminates in the definitive SHA. This is where the real magic happens: investors officially come on board as shareholders. Unlike the generally non-binding term sheet, the SHA is binding and captures the broader understanding and detailed documentation of all the negotiations between the investors and the promoters.
However, even though the agreement involves all shareholders, the SHA often reflects the tug-of-war between investors and promoters, outlining the rights and protections each party will have. This delicate balance of power is carefully penned down in the SHA, making it arguably the most important document governing the company’s internal workings.
So, in the second insight on the ‘Decoding Startups series,’ get ready to dive deep into the nitty-gritty of the SHA – the cornerstone of any well-governed company. We will explore its essential elements, how it mediates the interests of diverse stakeholders, and why the clauses enshrined in the SHA are crucial for fostering a collaborative and transparent business environment.
Key Aspects
At the heart of the SHA are shareholder rights, which define who gets to do what and how much say each shareholder has in the company’s operations. These rights balance power between founders and investors, ensuring that decisions are made fairly and transparently. Whether it is voting on major company decisions or determining how profits are distributed, they are all enshrined in the shareholder rights.
The SHA also outlines the company's management structure, specifying how the board of directors is composed, the appointment and removal of directors, and the roles and responsibilities of key management personnel.
The SHA sets out the procedures for transferring shares, whether voluntarily or involuntarily, and includes provisions such as the popular right of first offer (‘ROFO’), right to first refusal (‘ROFR’), and tag-along and drag-along rights.
Minority shareholder protections are another critical aspect of the SHA safeguarding the interests of smaller shareholders. They ensure that their voices are heard and that majority shareholders' actions do not unfairly disadvantage them. This includes rights such as access to information, veto powers on certain decisions, and fair treatment in the event of share sales or company dissolution.
Confidentiality is paramount in any business; the SHA addresses this with rigorous clauses. These provisions protect sensitive information about the company’s operations, strategies, and finances from unauthorized disclosure.
Dispute resolution mechanisms are also vital to the company's strong functioning. Given the potential for conflicts in a dynamic business environment, having a clear and agreed-upon method for resolving disputes is essential. Whether through arbitration or mediation, the SHA outlines the steps to be taken in the event of a disagreement, ensuring that conflicts are resolved efficiently and amicably.
Exit strategies are another crucial element detailed in the SHA, defining the terms and conditions under which shareholders can exit the company, whether through buyouts, IPOs, or other means.
Thus, the SHA is a multifaceted document that includes various provisions tailored to the specific needs of the company and its investors. It is a crucial tool that transforms the strategic visions of the term sheet into actionable, enforceable commitments, paving the way for a successful and collaborative journey ahead.
Clash Between AoA and SHA
In the dynamic world of corporate governance, one of the most intriguing battles is the clash between two foundational documents: the SHA and the articles of association (‘AoA’). Understanding this tussle is crucial for anyone involved in a company’s lifecycle, from incorporation to scaling up.
The AoA is essentially the company’s constitution, a charter document that every company must have in place at the time of its incorporation. It outlines the company’s organizational structure, operational procedures, governance framework, and the rights and responsibilities of shareholders and stakeholders. It provides the legal framework for the company’s internal affairs, detailing everything from its name and objectives to its share capital structure, rules for conducting meetings, the duties and powers of directors, procedures for transferring shares, and restrictions on shareholder actions.
On the other hand, the SHA is a private agreement between shareholders that delineates their rights and obligations within the company and in relation to each other. It offers a detailed framework for governance and addresses specific areas of conflict, promoting transparency, stability, and effective management. While the AoA is a public document available for all to see, the SHA is a private document, often kept confidential among the parties involved.
The intersection of the AoA and the SHA raises an important question: Which document prevails in the event of a conflict between their provisions? This question has been the subject of much legal debate and judicial interpretation.
In the landmark case of V.B. Rangaraj v V.B. Gopalkrishnan[i], the Supreme Court held that a private agreement between shareholders imposing restrictions on the transfer of shares not incorporated in the AoA contradicts the AoA and is thus invalid. In essence, any agreement between shareholders limiting who they can sell their shares to must be reflected and authorized by the company’s AoA to be enforceable.
However, this principle has been interpreted differently in subsequent cases. For instance, in World Phone India Pvt. Ltd. v WPI Group Inc., USA[ii], the shareholders had agreed to certain affirmative voting rights not included in the AoA. The Company Law Board initially held that these rights would be enforceable as long as they did not conflict with existing AoA provisions. However, the Delhi High Court later overruled this, stating that provisions not included in the AoA could not bind the company and its shareholders, particularly if the company were not a party to the SHA.
Further, in Premier Hockey Development Private Limited v Indian Hockey Federation[iii], the Delhi High Court observed that despite the provisions of the share subscription and holders agreement (‘SSHA’) not being included in the AoA, the agreement would still bind the shareholders and the company, as the company was also a party to the SSHA.
This brings us to a crucial takeaway: the importance of making the company a party to the SHA. When the company itself is a signatory to the SHA, it strengthens the enforceability of the agreement’s provisions, even if they are not mirrored in the AoA. Further, given these contradictory judgments, market practices have evolved to incorporate the terms of the SHA into the AoA for harmonizing the private agreement of the SHA with the public framework of the AoA and ensuring that the rights and obligations agreed upon by the shareholders are legally enforceable within the company’s governance structure.
However, it is essential to balance this integration, considering the AoA’s public nature and the SHA’s private nature. Not all commercial transactions and agreements need to be public; hence, careful thought must be given to what should be included in the AoA and what should remain in the SHA.
Operative Clauses of an SHA – Drafting the Core
Let us now understand and analyse the operative clauses of an SHA that outline the day-to-day operations and governance mechanisms of the company. In this section, we will delve into the critical considerations that must be taken into account when drafting these essential clauses. From decision-making protocols to transfer restrictions and board composition, each clause plays a vital role in ensuring smooth, transparent, and effective management.
Management Rights – Steering the Company’s Governance
The management rights clause is one of the most important sections within an SHA. This clause is fundamental as it encompasses the company's governance and management structures. Management rights typically include crucial elements such as the appointment and removal of directors, the conduct of board meetings, the procedures for shareholders’ meetings, reserved matter rights, and quorum rights. These provisions collectively ensure that the company’s leadership and decision-making processes are well-defined, balanced, and transparent.
Appointment of Board of Directors
First up is the number of directors to be nominated on the board. The Companies Act, 2013 (‘Act’) stipulates the minimum and the maximum number of directors for private and public limited companies.[iv] Consequently, parties cannot enter into contracts that conflict with the Act, ensuring all statutory requirements are fulfilled.
Next is determining the number of directors each shareholder can appoint, typically tied to the percentage of shares held by each shareholder. The investor director is usually a non-executive director, adding an additional layer of oversight without being involved in daily operations.
According to market trends, investors often appoint an observer on the board. This observer acts as the investor's eyes and ears during board meetings. However, it is important to note that the position of an observer is not recognized under the Act. This means the observer does not have voting rights or other formal powers. Their primary role is to observe meetings and report back to the investor silently.
But why would an investor, already empowered to appoint a director, also need the right to appoint an observer? The rationale lies in scenarios where the investor director might be unavailable. In such cases, the observer ensures that the investor remains informed about the board’s deliberations and decisions. Since the appointment of an observer is contractual, an investor can remove the observer without filing any requisite forms or calling for a board meeting.
If you are an investor appointing an observer, ensure the contract mandates the company to send board notices and agendas to the observer, just as they would to a director. Conversely, entering a confidentiality agreement is crucial if you represent the company or the promoters. Remember, unlike directors, the observer has no fiduciary responsibilities towards the company but will be privy to sensitive information. An ironclad confidentiality agreement helps ensure that this information remains protected.
The Act also includes a statutory provision governing the appointment of alternate directors, which empowers the board to appoint alternate directors if authorized by the AoA or by a resolution.[v] However, this authority could encroach upon shareholders’ rights who prefer to appoint alternate directors for their nominee directors. Therefore, negotiating the right of shareholders to appoint alternate directors in the SHA is essential.
Removal of Directors
The removal of directors is equally important. It is also a statutory right, and the procedure is enshrined in the Act.[vi] Further, all shareholders should ideally have the unilateral right to appoint and remove their nominee directors. Therefore, including clear language in the SHA in this regard ensures that the shareholders' decisions are effective and actionable without unnecessary delays or conflicts.
Conduct of Board Meetings
The conduct of board meetings is meticulously outlined in the Act, which specifies how meetings should be conducted and notices sent.[vii] Despite these clear guidelines, parties often spend significant time negotiating and drafting this part of the SHA. This is because, while the Act sets the minimum requirements, there is ample room for parties to tailor these provisions to suit their needs better. For example, the Act mandates at least one board meeting per quarter,[viii] but parties can negotiate to increase this frequency. More frequent meetings can ensure more rigorous oversight and provide timely updates, which is especially crucial for companies navigating rapid growth or complex challenges.
While statutory requirements must be adhered to, implementing stricter clauses through negotiation can bring additional benefits. By agreeing to hold more frequent board meetings, shareholders and directors can enhance governance practices, ensuring that the company remains continuously aligned with its strategic goals. These tailored provisions can facilitate more dynamic and responsive management, enabling the company to address issues promptly and adapt strategies in a timely manner.
Appointment of Chairman
Shareholders’ meetings can witness the most contentious arguments and tussles between shareholders. The entire process and manner in which shareholders’ meetings are to be conducted are entailed in the Act, including the process for an annual general meeting (‘AGM’), the quorum rights, the notice of such meetings, ordinary and special resolutions, and the chairman of the meeting.[ix]
In this process, the appointment of the chairman is one of the critical components of the management rights clause, which is negotiated in an SHA. The chairman’s role is pivotal in ensuring that shareholders' meetings are conducted efficiently and decisions are made effectively. According to the Act, members of the company can collectively elect a chairman from among themselves.[x] However, if the company’s AoA specifies otherwise, the individual who presides over the AGM may be selected as the chairman.
Moreover, the chairman of the meeting holds a casting vote in the event of an equality of votes unless the AoA states otherwise.[xi] This casting vote can significantly influence the outcome of closely contested decisions, making the position of chairman even more strategic. To exert control over the chairman appointment process and determine whether the chairman will possess a casting vote, parties often negotiate this aspect in the SHA. This negotiation ensures that the shareholders have a say in who leads the meetings and how tie-breaking votes are handled, thereby balancing power and maintaining fairness in decision-making processes. By carefully crafting this clause, shareholders can ensure that the company’s leadership aligns with their strategic interests and governance principles.
Reserve Matter Rights
Reserved Matter Rights, also known as Veto Rights or Affirmative Rights, are often the most contentious issues when drafting an SHA. These rights play a crucial role in safeguarding the interests of minority shareholders by ensuring they have a say in the company’s governance and management, even when their shareholding is relatively small.
Typically, shareholders’ resolutions are passed either by a simple majority, requiring 50% of the votes, or by a special majority, requiring 75% of the votes.[xii] But imagine a scenario where the promoter group holds 51% of the shares while another investor holds 49%. In this situation, the promoter group can pass all resolutions requiring a simple majority without needing the support of the minority investor. The minority investor’s vote would only be necessary for resolutions requiring a special majority. Consider an even more extreme scenario where the investor holds a mere 10% stake. In such cases, the investor’s vote might not be required even for resolutions requiring a special majority. This lack of influence can leave minority shareholders without a voice in crucial decisions affecting the company.
To address this imbalance and protect minority interests, parties often negotiate Reserved Matter Rights. These rights stipulate that specific matters cannot be resolved without the prior express consent of the minority shareholder granted these rights. For example, suppose Dhanraj holds 80% of the shares and Sangeeta holds 20% of BrightSun Private Limited. Sangeeta has an affirmative right regarding the company’s expansion and diversification. In that case, the company cannot expand its product line from manufacturing manual bicycles to electric bicycles without Sangeeta’s express prior approval. This ensures that Sangeeta has a significant say in strategic decisions despite holding a minority stake.
To further safeguard the minority shareholder’s influence, they are also often granted quorum rights.[xiii] These rights ensure that the quorum for the meetings is only deemed valid if the minority shareholder’s representative is present. This structure prevents any decisions on reserved matters from being made without the approval of the right holder, ensuring that their voice is always heard.
However, while drafting and negotiating reserved matters, one must be cautious of the risk of these rights being interpreted as ‘control.’[xiv] Regulatory bodies, including the Securities and Exchange Board of India (‘SEBI’), often interpret control to include the right to appoint a majority of directors or the ability to influence management or policy decisions, directly or indirectly, through shareholding, management rights, SHAs, voting agreements, or similar means, as in M/s Subhkam Ventures (I) Private Limited v SEBI.[xv] The Securities Appellate Tribunal held that control encompasses solely a proactive ability to influence, excluding control through negative rights. It deemed affirmative voting rights as essential safeguards for investors rather than indicators of control. This distinction is crucial as it underscores the protective nature of veto rights without necessarily implying control over the company.
Despite these protections, there can be challenges. For instance, if a shareholder with affirmative rights refuses to pass resolutions on key issues, it can lead to a deadlock, bringing company operations to a standstill. Most reserved matter rights pertain to crucial operational matters, so a deadlock can severely hinder the company’s functionality. This is where the concept of a deadlock resolution mechanism comes into play. A well-drafted SHA will include provisions for resolving such deadlocks, ensuring that the company can continue to operate smoothly even when disagreements arise.
Deadlock Resolution Mechanism – Breaking the Stalemate
In the dynamic world of startups and corporate governance, disagreements are inevitable. Sometimes, despite the best efforts of shareholders and parties involved, they hit a wall. This deadlock occurs when the parties cannot agree on a particular matter, especially when a shareholder with reserve matter rights blocks a resolution. Such deadlocks can arise from disagreements over key business decisions, strategic direction, management appointments, financial matters, exit strategies, or even personal conflicts among shareholders.
Deadlocks can significantly impede a company’s effective operations and hinder its growth and profitability. They may lead to delays in decision-making, operational inefficiencies, loss of business opportunities, erosion of shareholder value, and potentially even litigation. To mitigate these risks, shareholders often include robust deadlock resolution mechanisms in the SHA, outlining procedures and processes for breaking these impasses.
Mediation and Arbitration
One common approach to resolving deadlocks is mediation or arbitration. Engaging neutral third parties to negotiate and resolve the deadlock can be highly effective. In mediation, a neutral mediator helps facilitate discussion and negotiation between the parties, aiming to reach a mutually acceptable solution. Arbitration, conversely, involves an arbitrator making binding decisions to resolve the dispute. Both methods offer a structured and neutral way to overcome deadlocks without resorting to more drastic measures.
Russian Roulette
Another widely recognized mechanism is the Russian Roulette clause. This provision enables any shareholder to issue a notice to the other shareholders, presenting an offer to either purchase the other shareholders’ stakes at a designated price or to require the other shareholders to purchase the initiating shareholder’s stake at that same price. The shareholder who receives this notice has the choice to either sell their shares at the specified price or buy the initiating shareholder’s shares at that price. The underlying aim of this mechanism is to ensure that a fair price is proposed, as the initiating shareholder must carefully consider the offer; if the proposed price is too low, they risk being compelled to sell their own shares at that undervalued price.
Texas Shootout or Sealed Auction
Another approach to resolving deadlocks is the Texas Shootout, also known as a sealed auction. In this scenario, each shareholder submits a sealed bid to an independent third party, typically the company’s auditors or a reputable accounting firm, stating the price they are willing to buy the other shareholder’s shares. These bids are then opened simultaneously at a specified time, and the shareholder with the highest bid is obligated to purchase the other shareholder’s shares at the stated price. This method ensures a competitive and equitable resolution by relying on the shareholders’ financial commitments.
Liquidation
Liquidation is the last resort when deadlock persists, and no other resolution mechanism is agreed upon. Suppose shareholders cannot resolve their differences, and none of the above mechanisms are triggered after a predetermined period. In that case, the SHA may include a clause providing for the liquidation or dissolution of the company. This allows each party to take their share of the assets, but it also results in the demise of the company, which could otherwise be financially sound. Therefore, this should be the mechanism of last resort.
While these are some common resolution mechanisms, there are no hard and fast rules. The specific mechanisms can be tailored to the needs of the parties in the SHA. The goal is to provide a structured, fair, and efficient way to resolve deadlocks, ensuring the company can continue to operate smoothly and effectively.
Deadlock resolution mechanisms are crucial for maintaining a company's operational integrity and safeguarding shareholder interests. By including clear, well-defined mechanisms in the SHA, shareholders can ensure they can navigate through deadlocks, minimizing disruption and preserving the company’s value and growth potential.
Share Transfer Restriction
Share transfer restrictions are among the most critical concepts for any lawyer involved in drafting or negotiating SHAs. These provisions ensure that any shareholder looking to sell their shareholding to a third party must adhere to a specific process or set of restrictions. The two most common restrictions are ROFO and ROFR.
Our first insight on Decoding Term Sheets extensively covered these concepts but let us revisit them with a practical example. Consider BrightSun Private Limited, where Dhanraj and Sangeeta are shareholders holding 60% and 40%, respectively. Now, let us explore two scenarios: one where Sangeeta has an ROFO and another where she has an ROFR.
In the first scenario, with an ROFO in place, Sangeeta has the primary opportunity to buy Dhanraj’s shares before he can offer them to any third party. If Dhanraj wants to sell his shares, he must first offer them to Sangeeta at a specified price. This approach is advantageous for Sangeeta as it gives her the initial opportunity to acquire additional shares and increase her stake in the company without competing in the open market.
Conversely, in the second scenario, with a ROFR, Sangeeta can match or exceed any offer Dhanraj receives from a third party. If Dhanraj wants to sell his shares to someone else, he will have to offer such shares to Sangeeta at the price being offered by the third party, and only upon Sangeeta’s refusal will he be able to sell the shares to such third party. This ensures existing shareholders have the first opportunity to retain control of the company by matching outside offers.
Now, let us analyse the implications of these rights from an investor’s perspective. For an investor, having a ROFO in favour of the company’s promoters can be beneficial. With a ROFO, the investor can initiate negotiations with the promoters first, who are then obliged to state the price at which they are willing to buy the investor’s shares. This price is a starting point for negotiations and empowers the investor to conduct further discussions with third parties, using the promoters’ offer as a benchmark. This approach keeps the price discovery in the hands of the investor, giving them leverage during negotiations.
However, a ROFR in favour of the promoters presents a different dynamic. In this case, no third party would be interested in buying the investor’s shares without assurance that the sale will go through. Imagine an investor negotiating with a large investment firm interested in acquiring the shares. The investment firm would conduct a thorough and costly due diligence process to evaluate the company’s financial health, growth prospects, and the value of the investor’s shares. After completing this due diligence, the firm would submit an offer based on its fair market value assessment. However, before the investor can accept this offer, the promoters have the right to match or exceed it under the ROFR clause.
From the investment firm's perspective, an ROFR in the hands of the promoters significantly diminishes the attractiveness of the investor’s shares. Despite the firm’s thorough due diligence and fair market value assessment, there is a risk that the promoters will exercise their ROFR and block the sale. This uncertainty can deter potential third-party buyers from acquiring the shares, as they face the possibility of their efforts and expenses being wasted if the promoters decide to match their offer.
Thus, while these provisions protect the company’s existing ownership structure and give current shareholders first rights to buy, they also pose challenges in attracting third-party buyers due to the potential complications and uncertainties. Crafting these clauses requires a nuanced understanding of the parties’ objectives and the strategic implications for future share transfers. By navigating these complexities with skill and foresight, shareholders can safeguard their interests while maintaining a flexible and attractive investment environment.
Tag-Along and Drag-Along Rights – Navigating the Balance of Power
In the intricate dance of shareholder dynamics, Tag-Along and Drag-Along rights play crucial roles in balancing the interests of minority and majority shareholders. Though previously covered in our insight on Decoding Term Sheets, these clauses merit a short recap here due to their importance in an SHA.
Tag-Along Rights: Protecting the Minority
Tag-along rights, or piggyback rights, are designed to protect minority shareholders when a majority shareholder decides to sell their shares to a third party. Imagine you are a minority shareholder in a thriving startup. The majority shareholder receives an attractive offer to sell their stake. Still, without Tag-Along rights, you might be left behind, watching the new majority owner take control without having the chance to cash in on the deal. Tag-along rights ensure that if the majority shareholder sells their shares, minority shareholders have the right to join the sale under the same terms and conditions. This mechanism ensures that minority shareholders get the same opportunity to sell their shares and realize their investment, preventing them from being left out in the cold.
Drag-Along Rights: Empowering the Majority
On the flip side, Drag-Along rights, also known as bring-along rights, empower majority shareholders to force other shareholders to sell their shares to a third party under the same terms and conditions. This provision is crucial for facilitating smooth and efficient sales of the company, especially when not all shareholders are initially willing to sell their shares. Imagine a scenario where the majority shareholder has negotiated a lucrative deal to sell the entire company, but a small group of minority shareholders is reluctant to sell. Without Drag-Along rights, these holdouts could potentially derail the sale, causing delays and possibly jeopardizing the deal. Drag-along rights ensure that the sale can proceed smoothly, providing certainty and stability for potential buyers.
Both Tag-Along and Drag-Along rights are essential tools in the corporate governance toolkit. They balance the scales between protecting minority interests and empowering majority decisions. By including these clauses in an SHA, shareholders can create a fair and predictable framework for the transfer of shares, ensuring that all parties’ interests are considered and respected.
Pre-emptive Rights – Safeguarding Shareholders Ownership
A company perpetually needs funds to fuel its growth and operations. One effective way to raise this capital is by raising funds from its existing shareholders. Enter the concept of pre-emptive rights—a vital provision offering existing shareholders the first opportunity to maintain their ownership stake in the company without dilution. This provision is more than just a financial safeguard; it is a powerful tool that ensures shareholders can protect their control and the value of their investment.
Pre-emptive rights grant existing shareholders the first right to purchase additional shares before these shares are offered to external investors. By exercising this right, shareholders can maintain proportional ownership in the company, effectively preventing dilution of their equity stake. This not only safeguards their control over the company but also preserves the intrinsic value of their investment.
These rights can be both statutory and contractual. Under the legal framework, shareholders are privileged to offer additional shares to existing shareholders.[xvi] This statutory right is fundamental to shareholder protection, ensuring that current owners have the first chance to expand their stake in the company.
However, shareholders can also negotiate and modify this statutory right through contractual agreements. One common structure is that if one shareholder chooses not to exercise their pre-emptive right, the other shareholders are granted the opportunity to purchase all the shares offered. This arrangement ensures that the shares remain within the existing shareholder group, maintaining the balance of power and preventing external influence.
Alternatively, parties can negotiate an arrangement where shareholders have the right to purchase shares in proportion to their existing shareholding rather than acquiring all the available shares. For example, suppose a shareholder with a 30% stake in the company declines to exercise their pre-emptive right. In that case, the remaining shareholders can purchase the additional shares based on their current ownership percentages. This proportional approach ensures fairness and maintains the relative ownership structure within the company.
Thus, these pre-emptive rights represent a crucial mechanism for protecting shareholder interests and maintaining the integrity of ownership. By exercising these rights, shareholders can ensure their voice remains strong within the company, preventing dilution and preserving their influence over key decisions. So, as you navigate the complexities of shareholder agreements, remember the power of pre-emptive rights as they protect your stake and secure your influence in the ever-evolving landscape of corporate growth of the company.
Anti-Dilution Protection Clauses
In the high-stakes world of startup investments, anti-dilution rights are a crucial safeguard for investors, ensuring that their equity stakes are protected from the adverse effects of down-round financings. While we have extensively covered this topic in our insight on Term Sheets, let us quickly recap the essentials and explore the two common methods of anti-dilution protection: the full ratchet and the weighted average.
Full Ratchet Method
The full ratchet method is the ultimate armour for investors against dilution. This mechanism comes into play primarily during down-round financing, where new shares are issued at a lower price than in previous rounds. Full ratchet protection adjusts the price of the earlier investment to match the new, lower price, effectively granting the existing investor more shares to compensate for the decrease in valuation.
While this method robustly protects the investor, it significantly dilutes the ownership of the founders and other existing shareholders. Imagine an investor who initially bought shares at $10 each, and in a down round, new shares are priced at $5. Under the full ratchet method, the initial investor’s shares are repriced at $5, granting them additional shares to make up for the lower valuation. This heavy dilution can dramatically reduce the founders’ control and ownership percentage, making it a powerful but double-edged sword.
Weighted Average Method
The weighted average method offers a more balanced approach to anti-dilution protection. Instead of fully repricing the earlier investment to the new share price, this method calculates an adjusted conversion price that takes into account both the price adjustment and the number of new shares issued in the down round. The goal is to distribute the impact of the down round more evenly among all stakeholders.
For example, suppose new shares are issued at $5 while earlier investors paid $10. In that case, the weighted average method considers the total number of shares before and after the down round to determine a fairer adjusted price. This approach mitigates the extreme dilution effect on the founders and existing shareholders while still offering substantial protection to the investors. It strikes a balance, ensuring that the company can raise new funds without overly disadvantaging any single group of stakeholders.
Anti-dilution rights, whether through the full ratchet or weighted average method, are indispensable tools in an investor’s arsenal. They ensure that investors are protected against sudden drops in valuation, which can erode the value of their equity stakes. However, these protections must be carefully balanced to maintain harmony among all shareholders and sustain the company's growth and collaborative spirit.
In essence, anti-dilution rights are about maintaining fairness and stability in the ever-volatile world of startups. They provide a safety net for investors, encouraging them to support the company through thick and thin. At the same time, they require a thoughtful approach to ensure that the founders and existing shareholders do not bear an undue burden during challenging times.
Exit Rights
Exit mechanisms are crucial provisions that grant investors the flexibility to exit a company within specified timelines. These mechanisms define the circumstances under which liquidation or ownership transfer can occur, ensuring investors have a clear path to realize their returns. Typically negotiated at the blueprint stage of the term sheet, these exit rights are then woven into the definitive SHA with the same precision and foresight. Key exit routes include the following:
IPO: Going public allows investors to sell their shares on the open market, often at a significant profit, providing liquidity and signalling the company’s maturity.
Third-Party Sale: Selling to another business entity or individual can offer a quick and profitable exit, especially if a strategic buyer values the company’s assets.
Buy-Back: The company may repurchase shares from investors, offering a pre-determined return and allowing investors to exit without waiting for an IPO or third-party sale.
Drag-Along Rights: Majority shareholders can compel minority shareholders to participate in a sale under the same terms, ensuring a smooth and unified ownership transfer.
Exit mechanisms are strategic tools that ensure investors can realize their returns predictably and protect their interests. By defining clear exit routes, these provisions contribute to the overall stability and attractiveness of the company as it grows.
Conclusion
The abovementioned clauses and negotiations should not be viewed as rigid, one-size-fits-all solutions. Instead, they represent key principles that need to be considered when drafting and negotiating the terms of an SHA. Each SHA should be customized to fit the specific needs and dynamics of the parties involved and the unique circumstances of the transaction.
Flexibility is crucial in developing an effective SHA. The agreement must balance protecting shareholder interests with promoting the company’s growth and success. It acts as a dynamic document, evolving with the company’s needs and providing a solid governance, decision-making, and conflict-resolution framework.
By thoughtfully applying these principles, parties can create an SHA that serves as a true blueprint for the company’s future. It establishes rules of engagement, ensures fairness, and lays the groundwork for collaboration and mutual success. In the ever-evolving business landscape, a well-crafted SHA is not just a legal requirement but a strategic asset that helps navigate challenges and seize opportunities.
As you engage in SHA negotiations, remember that the ultimate goal is to create a living document that adapts to the company’s growth and evolution. With careful consideration and a flexible approach, you can develop an agreement that safeguards your interests and fosters a thriving and successful partnership.
End Notes
[i] (1992) 1 (SCC) 160.
[ii] 2013 SCC OnLine 1098.
[iii] 2011 SCC OnLine Del 2621.
[iv] Section 165 of the Act.
[v] Section 161(2) of the Act.
[vi] Section 169 of the Act.
[vii] Section 173 of the Act.
[viii] Section 173(1) of the Act.
[ix] Section 96 to 121 of the Act.
[x] Section 104 of the Act.
[xi] Paragraph 7.6 of the Secretarial Standards 2.
[xii] Section 114 of the Act.
[xiii] Section 103 of the Act.
[xiv] Section 2(27) of the Act.
[xv] 2010 SCC OnLine SAT 35.
[xvi] Section 62(1)(a) of the Act.
Authored by Sanyam Aggarwal, Advocate at Metalegal Advocates. The views expressed are personal and do not constitute legal opinion.