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IV.Ensure that investment is protected
  1. Board representation
In any shareholders agreement, an investor will typically have a right to nominate his representatives to the board of directors of the company. The investor’s representatives are appointed to the board as part of the closing actions. The investor’s directors do not actively participate in the day-to-day affairs of the company - their objective is to essentially keep a watch and stay informed about the activities of the company. Occasionally, the board may also have an observer. An observer does not have voting rights but his presence only ascertains that there are no irregularities in the process of conducting meetings and that the members are able to exercise their rights as per the articles of association of the company.

Some investors invest jointly or in groups. For example, if a particular fund manager has examined a deal and found it worthy of investment, another investor (who invests based on the business decision of the first investor) may also participate in the investment process. If for such reason there are multiple investors in the company, each investor may insist on the right to nominate a director. This should not be a problem as long as majority of the board members are appointed by the founders.

A little voting trick

Since directors are appointed by a ‘majority vote’, investors cannot on their own appoint their representatives to the board (being minority shareholders), without the cooperation of the founders. Therefore, shareholders agreements include a clause requiring promoters to exercise votes in a manner such that investor representatives can be appointed to the board (called a ‘pooling arrangement’).
  1. Affirmative Voting

Reserved matters

A shareholders agreement will typically contain a list of ‘reserved matters’ in an annexure, on which any decision can only be taken by the company with the ‘affirmative voting right’ of the investor. If the company proposes to take a decision on a matter listed as a reserved matter in a board or shareholder meeting, it will be required to obtain investor consent. These are not day-to-day matters, but are usually on key issues which are outside the ordinary course of business. Some of them are listed by way of example below:
  • issuing further shares
  • taking a loan
  • incurring financial burden,
  • modifications of rights of existing shareholders,
  • declaration of dividends,
  • initiation of winding-up proceedings,
  • transfer of assets in a manner which is inconsistent with the business plan submitted to the investor,
  • change in directors of the company
  • initiation of legal proceedings against any other entity


Negotiation points

  1. Usually the list of reserved matters can run into 2-3 pages. Founders should examine it carefully to see if any of the matters will interfere in carrying out ordinary business activities of the company.
  2. For certain actions, affirmative vote is only required if the issue meets a minimum threshold. For example, initiating a court proceeding against a competitor may require an investor’s consent if the proceeding is over INR 5 lakhs. The threshold is usually linked to the investment amount –for example it could be triggered if an action has financial implications to the tune of upto 5 percent of the investment amount. Some investors may put very low thresholds – entrepreneurs should ensure their operational flexibility is not impaired by unreasonably low thresholds
  1. Information covenants
Investors typically require the company to provide periodic information relating to the affairs and performance of the company. For example, they may require periodic financial statements such as balance sheets, cash-flow statements, projected budgets, business and marketing plans, etc. (which could be on a monthly or a quarterly basis). They may also require written explanations for any deviations from the projected statements (which could be a tedious affair for the investee).


Negotiation points
Preparation of financial statements takes significant effort. An early stage start-up may not have the necessary financial resources and personnel to be able to furnish financial statements at the frequency requested by the investors. Founders should negotiate the frequency and the number of statements that is required to be furnished periodically. Any request to submit audited financials at a higher frequency than required under applicable law should be excluded through negotiation, as auditing is an expensive and time-consuming affair.


  1. Right to inspect
As shareholders of the company, investors have the right to inspect the books of accounts and other statutory documents of the company. The shareholders agreement provides the investor’s representatives a right to inspect the books by providing reasonable notice in advance. Their representatives also have the right to conduct an audit (at the investor’s cost) of the statement of accounts of the company.
  1. Right to first refusal (ROFR)
A right to first refusal clause ensures that the investor has the first right to purchase the stake of the founders, in case the founders intend to exit (founder exits are typically only permissible after the lock-in period, or otherwise with the consent of the investor). In an ROFR situation, the person who intends to exit is permitted to solicit offers in the market for his stake. When he receives an offer which he intends to accept, the exiting shareholder must permit the remaining shareholders to buy his shares on the same terms. He can sell out to a third party only if the existing shareholders refuse or are unable to buy his shares. Often, the ROFR and the tag along may be clubbed together. Hence, if a founder is contemplating an exit, an investor has two options – he can either drive out the founder by purchasing his stake, or himself exit with the fouder by exercising the tag along.

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