A business that appears promising and holds a bright future for itself will be considered for investment by an investor. Investing in a business can serve as an effective means to expand an investor’s wealth amidst the complex network of legal regulations.
A shareholders agreement is a legally binding contract that delineates the rights, duties and commitments of shareholders in a company. It addresses matters such as ownership stakes, decision-making procedures, dispute resolution and confidentiality, ensuring transparency and safeguarding shareholders’ interests.
The complex terms used in context of a shareholders agreement have been discussed below.
Liquidation Preference Clause
Under this clause, the right owners are entitled to a preference in the company’s dividends and other proceeds. This preference is exercised when a liquidation event occurs. Investors seek to exercise this right in several scenarios, such as mergers, acquisitions, sales, Initial Public Offerings (IPOs), changes in control of the company, bankruptcy and more. In such events, investors receive preferential treatment over other shareholders in terms of repayment of invested funds and other proceeds. Founders should avoid granting this right unless the business is winding up or facing bankruptcy. They should also be cautious about including provisions for interest on the invested money in case of a liquidation event and exclude a profitable exit from the list. Founders must thoroughly analyse the provision of liquidation events and limit them as much as possible.
Anti-dilution Clause
The Anti-dilution Clause is considered one of the most extreme clauses sought by investors to safeguard their investments in the company. In this provision, if fresh shares are issued to another investor, a request is made to maintain the percentage of their shareholding without dilution. Consequently, the founders’ shareholding would be diluted, resulting in a loss of their influence within the company.
Veto Rights
Veto Rights play a critical role in determining the autonomy of the company’s founders. To retain control over decision-making regarding the issuance of new shares and secure additional funding without relinquishing their controlling rights, founders prefer to avoid granting veto rights to investors. Within a Shareholders Agreement, investors are likely to request a veto right concerning the issuance of fresh shares, thereby preventing any third party from acquiring shares without the investors’ consent.
Conversely, founders should ensure that when investors exercise their exit option, the founders possess the power of influence or a veto right. This ensures that investors do not sell their shares to competitors at any price. The founders are unwilling to permit competitors to purchase the investors’ shares, as it would be detrimental to the company’s growth and performance.
Tag-Along and Drag-Along Rights
Tag-along and drag-along rights are provisions that play a significant role in safeguarding the interests of shareholders in a company. When it comes to tag-along rights, minority shareholders possess the right to have their shares bought by a third party under the same conditions and at the same price as majority shareholders who are selling their shares. This ensures that the minority shareholders are not left behind with unfamiliar partners if a majority shareholder decides to depart from the company. In essence, tag-along rights provide a means for the minority shareholder to exit the company without unfavourable consequences.
Drag-along rights, on the other hand, state that the minority shareholders must sell their shares to a bona fide purchaser on identical terms at an equivalent price to the majority shareholder. What it means in simple and practical terms is that if a third party is interested in acquiring the company and the majority shareholders, owning more than 75% of the shares, decide to sell, they can compel the minority shareholders to participate in the sale under the same conditions. This is advantageous for the majority shareholder, as the potential offering of the entire share capital becomes an attractive incentive for potential buyers.
However, it is worth noting that these clauses also hold benefits for the minority shareholders by ensuring that the terms for the purchase are the same as those offered to the majority shareholders.
Pre-Emptive Rights and Right of First Refusal Clause
The purpose of the pre-emptive rights and right of first refusal clause is to safeguard the current shareholders from involuntary dilution of their ownership in the company. Due to the existence of these rights, the initial opportunity for new shares is given to the existing shareholders or they can also refuse the sale of existing shares.
These rights also give existing shareholders the opportunity to buy more shares based on their current holdings before opening up the chance for new investors. This allows them to maintain their percentage of ownership in the company, provided the fact that they possess sufficient funds to acquire the newly issued shares.
One situation that can arise is that if an existing shareholder intends to sell their shares, the remaining shareholders hold the right of first refusal. This right grants them the option to purchase the shares before any third party can acquire them. The primary objective behind such rights is to protect the original shareholder base and limit external parties from acquiring shares in the company.
Usually, before completing the sale to a proposed buyer, the selling shareholder is required to offer their shares to the remaining shareholders on the same terms agreed upon with the prospective buyer.
Good Leaver Bad Leaver Clauses
When a shareholder chooses to leave the company, the terms of selling their shares and the corresponding value they will receive are determined by good leaver and bad leaver clauses. These clauses are applicable if a shareholder decides to depart from the company. In such cases, these clauses will guide the terms and value of share sales.
A good leaver refers to an employee who leaves the company due to reasons such as death, retirement, permanent disability, permanent incapacity caused by ill-health, redundancy (as defined in the Employment Rights Act 1996) or dismissal by the company. The determination of dismissal as wrongful or constructive is made by an employment tribunal or a court of competent jurisdiction without any possibility of appeal. Alternatively, a good leaver can also include any employee who leaves for any reason after a period of three years from their initial employment as a shareholder.
On the other hand, a bad leaver is an employee who departs from the company under unfavourable circumstances, such as breaching their employment contract, engaging in gross misconduct or leaving within a specified period of time. While a good leaver has the option to sell their shares upon departure, it is not mandatory. However, a bad leaver is required to sell their shares to the other shareholders upon exit. In such cases, the bad leaver will receive only the nominal value of the shares.
Non-Competition and Confidentiality Clause
When and how a shareholder may engage in rival activities during and after their time as a company shareholder is clarified by non-competition clauses. Ambiguity is removed and the clause encompasses the dos and don’ts along with the scope and duration of these restrictions.
The objective remains to guarantee the confidentiality of internal knowledge for the company to maintain its competitiveness.
Regarding confidentiality, provisions address the treatment of company information shared with shareholders. All information conveyed by the company must be treated as confidential by the respective shareholder.
It should be noted that the mere inclusion of non-competition clauses does not automatically imply their legal binding and enforceability. They need to be reasonable and avoid excessively broad drafting.
Deadlock Resolution Clause
Deadlocks are resolved through pre-agreed mechanisms, enabling the business to navigate away from potential dead ends. Such situations can arise in 50:50-owned companies when shareholders are open to changing their decisions or when a super-majority or unanimous consent is required but remains unattainable. In the event of a deadlock, the shareholders agreement must outline the definition of this impasse and the subsequent course of action to be followed. Different types of deadlock resolution clauses exist, each carrying distinct implications.
Ultimately, all deadlock clauses typically necessitate one party to sell their shares to the others, thereby effecting a change in control and allowing the remaining shareholders to vote on the matter.
Restrictions on Transfer of Shares
To protect shareholders, restrictions on the transfer of shares come into play. This ensures that shares cannot be sold to undesirable third parties without first offering them to the company or existing shareholders at the same price offered to that third party. In case of disputes over share prices, provisions can be made for independent valuation or the utilisation of a formula to determine fair value. If the offered price is lower than the original one, the shareholder may withdraw their notice to transfer the shares. Notably, restrictions on share transfers generally do not apply when shares are transferred to a shareholder’s family members or a trust.
Final Thoughts
A shareholders agreement is a vital tool for establishing clear guidelines and protecting the interests of shareholders in a company. By addressing various provisions such as liquidation preference, anti-dilution, veto rights, tag-along and drag-along rights, pre-emptive rights, good leaver and bad leaver clauses, non-competition agreements, deadlock resolution, confidentiality and restrictions on share transfers, the agreement ensures transparency, fairness and stability.
It is crucial for founders and investors to seek legal expertise when drafting a comprehensive shareholders agreement to address the complexities and intricacies of their specific business arrangements.
