Key terms and explanations
A shareholders’ agreement (SHA) is a contract between a company’s shareholders and often the company itself. A SHA specifies shareholders’ rights and obligations, regulates the management of the company, ownership of shares, privileges, voting and various protective provisions for shareholders. A SHA aims to bind shareholders to rules to preempt issues that could become contentious in the future.
While articles of association are the basic constitutional documents for all companies, they are typically standardised and mandatory. Articles of association bind a company and its shareholders in their capacity as shareholders and articulate the responsibilities of the directors, the kind of business to be undertaken and the means by which the shareholders exert control over the board of directors.
A SHA may contain terms found in articles of association; however, a SHA is typically more extensive and provides more protection to shareholders. There is no standard form, which makes SHAs flexible to fit the specific needs of shareholders. Articles and SHAs are often complementary. In many jurisdictions, articles of association can be amended only by the passage of a special resolution (75% or more of the shareholders present and voting at a general meeting). However, a SHA often requires unanimous agreement for its revision but can also require supermajority approval (a number of votes far greater than half of the shares with a right to vote but less than 100%).
Additionally, a SHA is private, between the parties to the SHA while articles of association are public, which makes them inappropriate for addressing matters such as director remuneration and the provision of private contact details or other sensitive or confidential internal matters. Furthermore, a SHA is an inexpensive way to minimise the potential for business disputes by clarifying how certain decisions must be made as well as providing a framework and procedures for dispute resolution.
While a SHA and articles of association should not contradict each other, a SHA can contain a supremacy clause to ensure the SHA overrides the articles of association (in the event of an inconsistency the shareholders can then amend the articles accordingly). Because articles of association follow a statutory model they are unable to deal with matters which are personal to the shareholders as this would fetter the company’s statutory powers. Conversely, a SHA may deal with all aspects of the relationship between the shareholders and can address particular issues unique to those shareholders or that company and even indicate further agreements that must be entered into between individual shareholders and the company such as directors’ employment agreements, management agreements and technology transfer agreements (e.g., intellectual property licences, patents, trademarks or copyrights) among other things.
This article does not exhaustively address all the possible terms and variations of a SHA but those that are most commonly used. SHAs should ideally be entered into at the inception of a company between the parties who intend to form it and will be its initial shareholders, though SHAs can be entered into after a company is formed and operating. Specific transactions or the needs of different stage investors often require different terms and will likely be subject to negotiation and possible later amendment. There can also be variations of terms in the case of companies with different kinds of shares, as different share classes carry different rights and obligations that are normally specified in a company’s articles of association; however, all shareholders, regardless of class, are typically bound by a SHA. This article does not consider the laws of any specific jurisdiction.
A SHA usually addresses share transfers. The three kinds of share transfers that are commonly covered are: 1) permitted; 2) voluntary; and 3) automatic.
Permitted transfers are often share transfers from an existing shareholder: to another existing shareholder; to an entity controlled by an existing shareholder; or to an existing shareholder’s relative (e.g. spouse, child, parent, the spouse of such relative or to a trust created for the benefit of an existing shareholder or its relatives). In this instance, a ‘relative’ can be defined as broadly or as narrowly as the shareholders desire or can be disallowed entirely. Typically, a SHA will contain clear language that, in the event of a permitted transfer, there must still be consent by a certain voting threshold of the remaining shareholders (those not transferring their shares).
Voluntary transfers usually refer to the disposition of an existing shareholder’s shares via a straightforward sale, an assignment, encumbrance or pledge; this can include direct or indirect transfers to receivers, creditors, trustees or receivers in bankruptcy proceedings.
Automatic transfers are typically triggered when a shareholder: dies; is convicted of a crime; is dissolved or liquidated (if the shareholder is a company); files for bankruptcy; has its employment with the company terminated (where the shareholder is also an employee); materially breaches the SHA; materially breaches other referenced ancillary agreements that could harm the company; or breaches a duty to the company, among other things. Shareholders can determine what acts or omissions will trigger an automatic transfer and as long as clearly specified in the SHA, they are binding.
Transfers restrictions exist to protect the company and the other shareholders from undesirable third parties that could become shareholders or protect the company should an existing shareholder breach its duty to the company or put itself in a situation that could significantly damage the company’s reputation.
Buyback rights and rights of first refusal
A SHA can give a company buyback rights so that in the event of any transfer other than a permitted transfer, the company will have the exclusive right to purchase those shares. If such a provision is included in a SHA, the price for such buybacks is typically determined by a valuation mechanism specified in the SHA. In the case of a voluntary transfer, the price may be based on the value attributed to the shares by a proposed bona fide transferee (the person to whom the shares are to be sold or otherwise transferred). In the case of an automatic transfer, the purchase price would typically be the fair market value determined by a qualified appraiser or based on the value of the company’s shares as declared by the company’s board of directors at its last annual meeting. It should be noted that company buybacks typically must be made using undistributed profits of the company and are normally considered a share capital reduction, which involves a number of procedures to extinguish the shares.
A SHA also often gives shareholders rights of first refusal so that, if the company does not exercise its buyback rights or only partially exercises them, the non-transferring shareholders will have a priority right to purchase those shares in proportion to their existing share ownership. A SHA should clearly articulate the detailed mechanism by which shareholders can exercise their rights of first refusal and how shares so acquired are to be paid for. In the case of a voluntary transfer, the non-selling shareholders may have the opportunity to acquire more than their pro-rata proportions of shares if any of the other non-selling shareholders do not exercise their rights of first refusal. However, in the case of an automatic transfer, the non-selling shareholders must normally acquire all the ‘offered’ shares. If, for some reason, the non-selling shareholders are unable to fully-exercise their rights of first refusal then the company would have to buy back the shares otherwise those shares could end up in undesirable hands. The SHA can specify that in this instance payment for the shares will be made in instalments over a specified period.
To be clear, rights of first refusal apply to the right to purchase existing shares held by another shareholder (as opposed to pre-emption rights, which are a form of anti-dilution protection that gives a shareholder the right to maintain its proportional ownership interest in relation to shares issued in the future).
Tag-along (piggy-back) rights
In the case of a voluntary transfer, the selling shareholder must ensure the terms of the offer to purchase its shares is also extended to the other shareholders in proportion to their respective share ownership. Tag-along rights exist to protect minority shareholders so, if a majority shareholder sells its shares, it gives the other shareholders the right to join the transaction.
Thus, piggy-back rights protect minority shareholders by giving them the right, but not the obligation, to sell shares together with a majority or stronger shareholder. This protects minority shareholders from being forced to accept a deal on lesser terms or being forced to remain a shareholder in the company after a majority sale.
Drag-along rights enable a majority shareholder to force minority shareholders to join in the sale of a company. The shareholder doing the dragging must give minority shareholders the same price, terms and conditions as any other seller.
A company merger or acquisition normally triggers a drag-along right because buyers usually seek complete control of a company. Drag-along rights help to eliminate minority owners and allows for the sale of 100% of a company's securities to a potential buyer. Drag-along rights are meant to protect the majority shareholder. However, drag-along rights also benefit minority shareholders because they require the price, terms, and conditions for the sale of shares to be identical for all shareholders, which can enable minority shareholders to realise sales terms that may otherwise be unattainable.
All shareholders have rights to company financial and management reports that are usually provided annually. Larger shareholders may be accorded the right to reports on a monthly or quarterly basis. Larger shareholders may also negotiate rights to inspect company records, which can entail company visits, in person discussions with company officers and the ability to copy records, among other things.
Board of directors
A SHA will typically specify the number of initial board members (and often their names and other details) and sometimes the rights of specific shareholders to appoint a certain number of board members. Other shareholders without the right to appoint directors must vote in accordance with the company’s articles of association.
In this clause of a SHA, provisions often exceed the protections in statutory or standard articles of association and provide supermajority provisions to approve certain acts. A supermajority requires a large majority of shareholders (generally 67% or more) to approve important changes. Standard articles of association often only require a vote by a simple majority (50%) for numerous issues. Supermajority provisions are protective because they require a large number of shares to vote to approve matters such as, share buybacks, mergers and acquisitions or dispositions of assets (including intellectual property), issuance of new company securities, amendments to the company’s articles of association, adjustments to the number of board members, entering into obligations or debt commitments in excess of a certain threshold and the decision to sell shares to the public, among other things.
Shareholder non-competition and non-disclosure obligations
Shareholders will often have access to a company’s trade secrets, standard operating procedures, customer and source lists, research and development, financial details and other sensitive or confidential information. A SHA can include non-disclosure and non-competition clauses that bind shareholders to secrecy and prevents them from working for, with or on behalf of competitors or such other parties that could damage the interests of the company. Additionally, this language can also include a non-solicitation clause that restricts or blocks a shareholder from doing any business with any company or person that was or is a client or customer of the company.
Additional shareholders, transferees and deeds of accession
If capital is raised which brings in new shareholders, or where an existing shareholder transfers shares to any third party by any number of means (including family members), such shareholders must be bound to the SHA. In order to achieve this, a SHA should clearly specify that any new shareholder or transferee must be a party to the SHA prior to receiving the shares. This can be achieved by requiring such a transferee or later share purchaser/investor to sign a document in the form of a deed whereby they agree to be bound by all the terms of the SHA. Such a document is a ‘deed of accession’ or ‘deed of adherence.’
Funding and future issuance of shares
All companies have funding requirements and sometimes working capital and cashflows are insufficient to meet its needs or growth requirements. A SHA should specify the methods of seeking additional capital and the priority in which such funding sourcing should be sought. Such additional funding is often obtained via: external funding, including mezzanine financing (convertible debt sometimes with a sweetener such as warrants), from outside investors and traditional loans from banks or other financial institutions; shareholder loans; and cash calls. The order in which such additional funding is sought should also be specified.
External funding, and related terms and conditions, is usually determined by a company’s board of directors and must comport with any protective provisions included in a SHA. The SHA, in this instance, may specify that such external funding must be obtained without any guarantees or support from the shareholders (unless each gives prior consent).
A shareholder loan is typically a form of debt-financing provided by shareholders. It is commonly the most junior debt issued by a company. Therefore, because it is subordinate to other more senior loans, other more ‘senior’ creditors will have priority rights to repayment of debts owed by the company. Shareholder loans may also carry long maturities with low or deferred interest payments. Shareholder loans can also be convertible into [a class of] shares. This form of financing is typical in the case of young companies that are unable to raise debt from banks.
A cash call often occurs as a last resort. Cash call clauses typically provide that if the company requires additional funding and cannot obtain such funding externally then the shareholders must, with advance notice, provide cash in proportion to their share ownership in the company. Such SHA provisions will normally specify if cash calls will be structured as an outright sale of shares, a shareholder loan or a loan convertible into shares.
If any shareholder fails to subscribe for all or part of its pro-rata proportion of cash call shares by the deadline specified, then the other shareholder(s) can acquire those remaining shares. Where a cash call results in the acquisition of new shares by a shareholder directly or via a loan convertible into shares, the net result will be the dilution of the shareholdings of those shareholders that failed to participate in the cash call.
Cash call clauses ensure shareholders continue to invest funds in the company and reward shareholders that invest in the company when it is needed. Shareholders should consider the possibility of a cash call when investing in a company in relation to their finances and liquidity.
Shotgun (buy-sell) clause
A shotgun clause forces a shareholder to sell its stake or buy out an offering shareholder. It is a mandatory purchase and sale mechanism between shareholders triggered when one shareholder makes an offer to another shareholder to purchase or sell all of its shares. If one shareholder makes an offer to purchase the shares of another shareholder, the shareholder that receives the offer must either 1) sell its shares at the offered price or 2) buy the shares of the shareholder that made the offer for the same price and conditions.
This mechanism ensures the shareholder that makes the initial offer cannot offer to purchase the shares of the other shareholders at a significantly lower price than it would be reasonably willing to accept. However, the price, or method of determining the price in this case is not pre-set. A shotgun clause is effective when shareholders cannot get along or fail to agree on the management of the company by allowing one to buy out the others. This can also help to avoid lengthy and costly dispute resolution. However, if one shareholder has limited liquidity or capital it would be at a disadvantage vis-à-vis another shareholder with deeper pockets that knows of the other shareholder’s limited resources. The ‘wealthier’ shareholder can make the ‘poorer’ shareholder an offer to purchase its shares at a heavily discounted price knowing the weaker shareholder cannot raise that amount to acquire the offeror’s shares in order to reverse the buy-out offer per the terms of a standard shotgun clause.
Put and call options
Put options in SHAs give a shareholder a right, but not an obligation, to sell its shares back to the company (or the other shareholders) at a future date or upon one or more specified events for a specific price or one determined by a pre-specified formula. Investors that want to be able to exit a company early because it fails to achieve certain revenues by a specified date often require a put option. A put option can specify that a shareholder may sell all or only a portion of its shares back to the company (or the other shareholders). A caveat with respect to put options is that the company or remaining shareholders may not have the funds to buy out the shareholder exercising the put. One way to mitigate this problem if there must be a put option is to specify that payments can be in instalments, and until fully paid, the put shares will be held in escrow. In this instance, it would be important to specify who will have the voting rights attached to the shares in escrow.
Call options in SHAs entitle shareholders or the company to compel a shareholder to sell its shares to them or the company for a specific price or one that is determined by a pre-determined formula. A call option encompasses different triggers than that for automatic transfers and can be an effective way of removing a shareholder from a company. A call option can be restricted and tailored, becoming exercisable on or by a future date or triggered by certain events, such as where: the shareholders cannot agree on certain specified matters; the required level of approval for specific matters such as capital expenditures or dividend payments cannot be achieved; or a shareholder is simply a problem, causes trouble or is incompatible.
To clarify, a shotgun clause requires one shareholder to make an offer to another shareholder, which in turn triggers reciprocal rights of purchase or sale. A put and call option will specify a price or clear means of determining a price whereas a shotgun clause allows the offeror to set a price. Additionally, an option needs to have a clear exercising trigger whether a date or some event whereas a shotgun clause can be invoked merely by an offer to buy or sell.
Anti-dilution clauses typically arise in the context of raising capital or where more shares are issued. Dilution is simply a reduction in a shareholding that can either be a dilution of value (economic dilution) or relative ownership (percentage dilution). Anti-dilution provisions give an investor the right to maintain its proportional ownership of a company by allowing it to buy a proportionate number of shares of any future issue of shares of the company at specified or adjusted prices.
Percentage dilution occurs if an existing shareholder does not purchase that number of newly issued shares necessary to maintain its current proportional ownership (e.g. if a shareholder currently owns 10% of a company’s shares it must purchase 10% of newly issued shares to maintain its relative ownership).
Economic dilution reduces the value of an existing shareholder’s investment and occurs if shares are issued at a price that reduces the average value per share. Economic anti-dilution provisions protect investors from ‘down rounds,’ the risk of new shares issued by the company at a lower price than at the time the investor made its investment. If future capital raises occur at higher valuations then anti-dilution provisions are unlikely be triggered.
If, for example, an investor buys preferred shares in a company for $20 each, convertible on a one-for-one basis into common stock and the company later conducts another round of capital raising that values the common shares at $15 each (a down round), the investor’s shares would be devalued (economic dilution). The investor could not convert its preferred shares into common shares without losing $5 per share. An economic anti-dilution provision would protect that investor by specifying that if the company issues shares at a price lower than in the prior round in which that preferred shareholder invested, then it can obtain more shares of common stock when it converts in order to make it whole.
A number of kinds of anti-dilution provisions are normally found in SHAs, including preemptive rights, ratchet and weighted-average provisions.
Pre-emptive rights, the most basic and common form of percentage dilution protection, give shareholders the right, but not the obligation, to buy new shares issued by a company in the future on a pro-rata basis in order to maintain their proportional ownership of shares. This right can apply to all classes of shares or only certain classes of shares.
Full ratchet anti-dilution, a form of economic dilution protection gives an investor the right to buy shares at the new lower price/valuation and provides the greatest protection for investors but is the most restrictive if there will be multiple fundraising rounds.
Weighted-average anti-dilution is also a form of economic dilution protection and gives an investor the right to acquire shares at a price that accounts for the difference in the old and new prices and is more company-friendly than full ratchet anti-dilution.
Under full ratchet anti-dilution, when a shareholder converts its preferred shares into ordinary shares, the conversion price of its preferred shares will be reduced to reflect the share issue price of the new round. This means that a preferred shareholder can convert its preference shares at the new, lower price. If the shareholder holds ordinary shares, additional shares will often be issued after the new round to make it whole. In both cases, the investor will receive more shares for its initial investment to ensure its stake in the company is not diluted.
Under weighted-average anti-dilution, the conversation rate equals a weighted average of the prior and new share issuance price. If this case, the SHA should include a formula to calculate the weighted average share price based on the 1) amount raised by the company before the additional fundraising round and 2) the average price per share compared with the subsequent capital raise and lower share price. While a weighted average formula will not protect investors from dilution to the same extent as full-ratchet, it will mitigate the effect.
The typical formula used in weighted average anti-dilution provisions is as follows:
CP2 = CP1 x (A+B) / (A+C)
CP2 = Conversion price immediately after new issue of shares CP1 = Conversion price immediately before new issue of shares A = Number of shares of common stock deemed outstanding immediately before new issue of shares B = Total consideration received by company with respect to new issue divided by CP1 C = Number of new shares issued
Anti-dilution clauses exist to protect external investors and are often at the expense of founders, prior unprotected external investors or other shareholders. They are not ideal for the non-beneficiaries of the anti-dilution provisions, but the reality is that most serious and experienced investors will expect anti-dilution protections.
Because anti-dilution provisions can cause limitations on a company’s future fundraising, they can be structured as a ‘pay-to-play’ provisions. This operates to protect investors from dilution only if they participate in subsequent rounds of capital raising. Investors that do not participate do not receive anti-dilution protections. This benefits both the company and the investors because it encourages all investors to continue to fund the company.
Under a more punitive variation of pay-to-play, an investor’s failure to participate in a future capital raise (whether dilutive or not) will cause that investor’s preferred shares to be converted into common shares. Consequentially, the investor will not only lose anti-dilution protection but also any liquidation preferences and other special rights attached to its preferred shares.
Another alternative anti-dilution approach is the issuance of springing warrants to investors that participate in dilutive financing. Springing warrants allow investors that participate in a dilutive financing to purchase that number of additional shares of common stock allocable to them as calculated using the applicable anti-dilution formula for a nominal sum.
Founders of a company do not typically include complex anti-dilution provisions in an initial SHA (other than preemptive rights). Such terms are usually negotiated, if not dictated, by external investors and are dependent upon the relative bargaining power of the parties. They are not designed to protect founders but act as a safeguard for savvy investors. Anti-dilution provisions constitute one of the numerous inducements often necessary to satisfy investors and mitigate their risks in investing their money in a company that requires capital.
An experienced lawyer is indispensable for crafting a shareholders’ agreement that sufficiently meets the needs and objectives of shareholders and investors. Hill Dickinson, founded in 1810, has lawyers with decades of experience in dealing with a full range of corporate matters involving both conventional and complex investments and structures, venture capital, mergers and acquisitions, private equity, joint ventures, business sales, corporate reorganisations and capital markets offerings.