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Significant Clauses Under The Shareholder Agreement

Company for raising funds from the market issue shares and the person being issued those shares of the company are called shareholder and those issued debenture are known as debenture holders.

The shareholder of the company is the person who actually owns the company; there are different types of shareholders:

  1. (A) equity shareholder
  2. (B) preference shareholder
  3. (C) debenture holder
Who are equity shareholders:
company when issue equity shares of the company; those shared been issued to shareholders known as equity shareholders.

Who are preferences shareholders:
Company when issue preference shares of the company those shares are issued to shareholders known as preference shareholders.

Who are debenture holders:
Company when raise capital through loans, such loans are issued from people known as debenture holders in the company.

What is Shareholder Agreement?
Shareholders agreement is the agreement between two parties that is company and the shareholder of the company. The purpose behind preparing this shareholder agreement is to restoring the rights and liabilities of the shareholder and to maintain a very healthy relationship between the company and the shareholder. It cannot always be assume that there will be no disputes between the shareholder and the company, so in those uncertain times this agreement helps to maintain a healthy relationship between company and shareholder

While starting the new business there are lot of risk involved including whether the company will succeed, will there be any profit maximization, will it be fit for the market, will it be able to compete in the market, what all economic challenges it has to bear, but most important risk for the company can be arise with the dispute between the shareholder and company. So to overcome that dispute shareholder agreement works as an instrument to avoid any dispute and escalate harmony in a company.

There are different clauses which comes under shareholder agreement in the company:

  1. Pre emptive rights and anti dilution rights
    These rights are issued to existing shareholders by issuing fresh new shares to existing shareholders. Preemptive rights are mentioned under section 62(1) of company's act 2013 which clearly states that any new furtherance of shares will be offered to the existing shareholders at first instead of third party.

    Earlier Acc to section 81 of company's act 1956 it was only allowed to have within 2 years of company to the existing shareholders but after legislation looked upon this matter had made the amendment on the part of existing shareholders and held that there is no time period prescribed for shareholders of the company to offer new shares.

    These rights are offered through different modes:
    1. by way of rights issue
    2. by employee stock options
    3. by way of preferential allotment
    Under shareholder agreement this clause is considered as the most important one because it assures the existing shareholders that first offer of new rights issue will be offered to them instead of third party.

    Anti dilution rights are protecting the investors from diluting their rights in a company; basically these rights protect or can say maintain the ownership percentage of investors whenever new shares are issued. Dilution is the result of issuing new shares while shareholders ownership decreases. Anti dilution rights protects an investors equity stake in a company from dilution.

    For instance- A is the investor in the company xyz with the stake of 25% in a company with outstanding shares. However if the company issue 100 more shares than the amount of stake of A will be diminish to from 25% to just half of it which will be 12.5% and issuing new shares in a company with curtail the earning per share (EPS) as the total number of shares extends.
  2. Drag along and Tag along rights
    Drag along and tag along rights create a balance between shareholders i.e. majority shareholders and minority shareholders. Drag along rights is dragged with the right of minority holders. For instance if the other company wishes to acquire 100% stake in a company , majority shareholders agree to sell the shares but minority shareholders do not allow to sell their shares in the hope that someday the price of company's share may rise.

    In such situations the majority shareholder has the right to drag along the shares of minority shareholders. It will protect the rights of majority shareholders. Anytime if minority shareholders denies to cooperate with the company's majority shareholder.

    Whereas Tag along rights are given and benefited to minority shareholders. So basically when the promoter/majority shareholder decides to sell its shares to new investors then shares of minority shareholders get tag along. Tag along rights binds the selling shareholders to sell their shares on same terms and conditions. The attempt to buy shares is invalid if tag along procedure is not followed and further it cannot be registered.

    For instance:
    If the majority shareholders want to sell its shares to incoming investors in that case it will have to take the consent of minority shareholders also and with the tag along rights the rights of minority shareholders is easily tag along with the other shareholders.
  3. Termination/exit Rights
    This shareholders' agreement clause deals with what happens when a shareholder leaves the Company under different circumstances. Upon achieving important milestones, the founders tend to offer buy out or the investors wish to exit from the business. If such milestones are predefined, this clause provides the manner of exit by the investors or even for the founders. Often, the shareholders take exit at fair value or with guaranteed premium on the acquisition.

    Often referred as bad leavers, are the shareholders who breach the material obligation, or do not achieve important milestones set out in the agreement initially. The parties may have this clause tailor-made based on the material obligations on each party. The defaulting party has to generally offer the shares to Company or other existing shareholders at discounted price.
  4. Buy out Rights
    This is the most important clause under shareholder agreement it means that when shareholder is incompetent due to certain reasons such as death, disability, marital dissolution or bankruptcy then the company has a right to buy back the shares of the existing shareholder. Under this clause it comes "expulsion" clause where the shareholder can expel any undesirable shareholder and buy his/her shares.
  5. Right of first refusal:
    This clause under the shareholder agreement talks about the right of refusal, for instance if the company is going to bankruptcy or losses and in that case shareholder shall have the first right of refusal . This protective clause for the shareholders restricts the transfer of shares. With increased number of shareholders/ investors, you may lose the control or influence over the Company. Transfer of shares can be one method to increase the number of shareholders without further issue.

    This clause ensures that the company's control is not transferred to undesirable third parties. A shareholder willing to transfer their shares has to first offer the same to other existing shareholders at the same price. Usually, the offer prices are derived from an independent valuer. If the existing shareholder is not willing to purchase the shares at given price, then the Company may find another investor. This way, the shareholders will have control over who they are doing business with.
  6. Consent of shareholders:
    This clause provides the right of shareholder in holding the power in a company by means of giving approval.

    This clause in shareholder agreement can be:
    1. consent of shareholder at the time of appointment of any member, manager or supervisor and dismissal
    2. consent while or before preparing any financial statements of the company or distribution of dividends
    3. in case of dissolving the company
    4. In case of any amalgamation or filing for bankruptcy
    5. In case of any amendment of article of association
    For instance in a agreement there is the clause of consent so if any transaction has to take place firstly approval, consent of the shareholder is to be made and it shall be in compliance with the terms and conditions mentioned under the agreement. If anyone fails to comply with the terms and conditions or do not take approval or consent of the shareholders it will be considered as breach of the agreement.
  7. Participation in critical decisions
    Some investors join the company or organization with expertise in technology while others are interested in just numbers. These dormant investors give free hand to directors to manage the organization but they also have right to participate in critical decisions of organization.

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