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Shareholders Agreements

(Essential clauses, commercial interests and negotiation)

The previous chapter provided a description of the various stages in an investment transaction and the legal documents that are typically executed at each stage. This chapter explains the different clauses in a shareholders agreement entered with a financial investor in greater detail and the commercial objective behind each clause. In this discussion we refer to the financial investor as an ‘investor’.  We also explain how an entrepreneur can negotiate specific clauses. Instead of going clause-by-clause through a shareholder’s agreement, we shall examine the clauses based on the corresponding interest of the investor sought to be protected.

An entrepreneur’s commercial intent

An entrepreneur wants the funding, with maximum freedom to operate. Financial investors do not intend to take a controlling stake. If it were up to the entrepreneur, he would prefer the simplest document possible (may be one to three pages) which simply mentioned that his company was receiving money in return for issuing a certain number of shares at a specific price and valuation. However, that is an over-simplistic understanding of an investment transaction. Before we move on to discuss details of a shareholders agreement, let’s understand an investor’s commercial intent. This will form the basis on which an entrepreneur or his advisor will negotiate the agreement.

The investor’s commercial intent

Let’s understand some of the core interests of an investor:

1. He wants to maximise his return from the company and minimize the downside. The investor’s intended exit is by selling his stake (partly or completely) to another investor in future investment transactions at much higher valuations, and eventually exiting the company at an IPO. Although investments in many companies can fail, investors stand to make huge windfall gains if the investments are successful – for example, Sequoia’s USD 12.5 million investment in Google was worth USD 2 billion at the time of Google’s IPO (see the story and analysis here).

An investor will also insert mechanisms to ensure that he can recover his investment back (sometimes with a minimum guaranteed return) if the company does not perform as expected..

2. He wants certain protective rights to ensure that the money he has invested is not misused by the company. Although there is relative flexibility with the founders to manage day-to-day affairs of the company, an investor will have the right to provide or withhold consent for major actions taken by the company.

3. Through his investment, an investor acquires a certain percentage of shareholding in the company, which entitles him to certain rights in the company. He wants to ensure that his investment is not prejudicially diluted (i.e. reduced) by the company through additional issue of shares. For example, imagine a company which has issued 100 shares. If it issues 100 more shares to a third person, an investor who had 15% stake earlier will only be left with a 7.5% stake.Or, imagine he paid Rs. 50 per share for a company. He has therefore valued the company at Rs. 50 x (no. of shares of the company). He will not want the company to issue shares at a lower value (say, Rs. 40) to a subsequent investor. In case that happens, he may insist on being issued additional shares that ensure that he invested in the company at a valuation of Rs. 40 per share.

4. He wants the promoters or founders to stay invested into the company (till he exits the company) and work for the company on a full-time basis. He does not want the founders to be engaged in other activities or vocations, and does not want them to be substantially invested in other businesses.

5. He wants to ensure that there are mechanisms for him which enable him to exit the company within the investment horizon that he has contemplated for the investment. Some of these mechanisms may be triggered upon the happening of specified events, which may occur even before the investment horizon of the company.

An investment transaction is mistakenly understood by many people as having only two important variables – the amount of funding proposed to be provided by the investor and the amount of stake (shareholding percentage) that he will take. However, this is a mistaken view. The reason that a shareholders agreement is such an elaborate document is because it must protect the above interests of the investors and strike a balance with the entrepreneur’s interest of having the freedom and flexibility to carry out operations of his company.

Customarily, when an investor decides to invest in a startup, he will present a term sheet to the entrepreneur. Typically, the term sheet is in a table format with bullet points and has commercial terms. Negotiation of the first draft of investment documentation is prepared by the investor’s lawyers. Negotiations begin once the draft is circulated with the investor, on the basis based of this draft.

Now, we shall examine the clauses based on the interest they seek to protect.

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