How to Draft Shareholders Agreement?

A shareholders’ agreement is a vital document in the corporate world that governs the relationship between the shareholders of a company. In India, where the corporate structure is rapidly evolving, having a robust shareholders’ agreement is crucial for the smooth functioning of the company and to safeguard the interests of all stakeholders. A well-drafted shareholders’ agreement addresses various aspects of the company’s governance, including the rights and obligations of shareholders, dispute resolution mechanisms, transfer of shares, and the protection of minority shareholders.

This article aims to provide a comprehensive guide to drafting a shareholders’ agreement for an Indian audience, with a focus on legal requirements, best practices, and critical clauses that should be included to ensure the agreement is enforceable and effective in the Indian context.

What is a Shareholders’ Agreement?

A shareholders’ agreement is a private contract between the shareholders of a company that governs their relationship with each other and with the company. The primary purpose of this agreement is to regulate how the company will be managed, how decisions will be made, and how disputes will be resolved.

Unlike the Articles of Association (AoA), which is a public document and contains the broad principles of how the company will be governed, a shareholders’ agreement is a private document. It can include more specific and flexible provisions that cater to the unique needs and expectations of the shareholders. A well-drafted shareholders’ agreement provides greater protection for shareholders, particularly minority shareholders, by outlining their rights and ensuring that they have a say in critical company decisions.

In India, the provisions of the Companies Act, 2013 govern various aspects of a company’s operations. While the Act does not specifically mandate a shareholders’ agreement, it recognises the importance of protecting shareholders’ rights and preventing disputes. A well-crafted shareholders’ agreement complements the provisions of the Companies Act and can help in mitigating risks and ensuring smoother business operations.

Why Do You Need a Shareholders’ Agreement?

A shareholders’ agreement is essential for several reasons, especially in India, where family-owned businesses, startups, and joint ventures form a significant part of the corporate landscape. Some of the key reasons to have a shareholders’ agreement include:

Protecting Shareholders’ Interests

The agreement ensures that the interests of all shareholders, particularly minority shareholders, are protected. It outlines specific rights, such as voting rights, access to financial information, and the ability to participate in critical decisions like mergers, acquisitions, or the issuance of new shares.

Avoiding Disputes

A shareholders’ agreement provides a clear framework for decision-making and dispute resolution. It lays down processes for resolving conflicts that may arise between shareholders or between shareholders and the board of directors. This helps in minimising the risk of prolonged legal disputes, which can be time-consuming and costly.

Clarifying Roles and Responsibilities

The agreement defines the roles and responsibilities of the shareholders in managing the company. This includes matters related to appointing directors, deciding on major corporate actions, and outlining how profits will be distributed.

Regulating Share Transfers

One of the most critical aspects of a shareholders’ agreement is regulating the transfer of shares. It ensures that shares are not transferred to unwanted third parties, protecting the ownership structure of the company.

Providing Flexibility

Unlike the Articles of Association, a shareholders’ agreement can be modified by mutual consent of the parties involved without going through the formalities of obtaining approval from regulatory authorities. This flexibility makes it a valuable tool for tailoring the governance structure of the company according to the specific needs of its shareholders.

Key Clauses in a Shareholders’ Agreement

A shareholders’ agreement should be carefully drafted to cover all relevant aspects of the relationship between the shareholders and the company. The following are some of the essential clauses that should be included:

Parties to the Agreement

The first and foremost clause in a shareholders’ agreement is identifying the parties involved. This includes the company and its shareholders. In cases where a company has both majority and minority shareholders, the agreement should clearly define the rights and obligations of each category of shareholders.

Board of Directors and Management

This clause outlines how the board of directors will be constituted and how it will function. It should specify:

• The number of directors on the board.
• The process for appointing and removing directors.
• The frequency of board meetings.
• The quorum required for board meetings to be valid.
• The powers and responsibilities of the board of directors.

This clause ensures that shareholders have a say in the management of the company and that critical decisions are made in a transparent and accountable manner.

Rights of Shareholders

Shareholders’ rights are at the heart of a shareholders’ agreement. Some of the key rights that should be included are:

• Voting Rights: Specify the voting rights of shareholders in general meetings and how decisions will be made. For instance, some decisions may require a simple majority, while others may require a supermajority.
• Information Rights: Shareholders should have the right to access key financial and operational information about the company, including audited financial statements, board meeting minutes, and business plans.
• Pre-emptive Rights: In the event of the company issuing new shares, existing shareholders should have the right to purchase these shares before they are offered to third parties, thus preserving their ownership percentage.

Transfer of Shares

The transfer of shares is one of the most critical aspects of a shareholders’ agreement. The agreement should clearly outline the procedure for transferring shares, including:

• Right of First Refusal: If a shareholder wants to sell their shares, they must first offer them to the existing shareholders before selling them to outsiders.
• Drag-Along Rights: These rights allow majority shareholders to compel minority shareholders to sell their shares if a third-party buyer offers to purchase the company.
• Tag-Along Rights: These rights protect minority shareholders by allowing them to “tag along” and sell their shares if the majority shareholders decide to sell theirs.

Reserved Matters

Certain decisions are too important to be left to the board of directors alone and must be approved by the shareholders. These are called “reserved matters” and typically include:

• Changing the company’s Articles of Association.
• Issuing new shares or changing the capital structure.
• Mergers, acquisitions, or the sale of substantial assets.
• Taking on significant debt or entering into large contracts.
• Dividend policy.

Minority Shareholder Protections

Minority shareholders often have limited control over company decisions. Therefore, a shareholders’ agreement should include provisions to protect their interests. Some of the protections that can be included are:

• Veto Rights: Minority shareholders can be given the right to veto certain key decisions, such as changes to the Articles of Association or the sale of the company.
• Buyout Provisions: In case of a deadlock or a major dispute, minority shareholders may have the right to be bought out by the majority shareholders.

Deadlock Resolution Mechanism

A deadlock occurs when shareholders or directors cannot agree on a critical decision. A well-drafted shareholders’ agreement should include a mechanism for resolving deadlocks, such as:

• Mediation or arbitration.
• Referral to a third-party expert.
• Buyout provisions, where one party buys the shares of the other party.

Exit Clauses

The agreement should clearly define the conditions under which shareholders can exit the company, including:

• Voluntary exit by selling shares to other shareholders or third parties.
• Involuntary exit in cases of death, incapacity, or bankruptcy of a shareholder.
• Procedures for determining the value of shares in case of an exit.

Confidentiality and Non-Compete Clauses

To protect the company’s intellectual property and trade secrets, the shareholders’ agreement should include confidentiality clauses. Additionally, non-compete clauses can be included to prevent shareholders from starting or participating in competing businesses during or after their involvement with the company.

Dispute Resolution

Dispute resolution mechanisms are crucial to avoid lengthy and expensive litigation. The shareholders’ agreement should specify how disputes between shareholders or between shareholders and the company will be resolved. Common mechanisms include:

• Negotiation: The parties attempt to resolve disputes through good-faith negotiations.
• Mediation: A neutral third party helps the parties reach a mutually acceptable solution.
• Arbitration: A binding decision is made by an arbitrator or panel of arbitrators, often preferred because it is quicker and more cost effective than litigation.

Governing Law and Jurisdiction

Since Indian law governs companies incorporated in India, the shareholders’ agreement must specify that it is governed by Indian law. The agreement should also identify the jurisdiction where any disputes will be resolved, usually in a court or arbitration forum within India.

Steps to Drafting a Shareholders’ Agreement

Drafting a shareholders’ agreement requires a careful understanding of the company’s structure, the interests of the shareholders, and the legal framework. Here’s a step-by-step guide to drafting a shareholders’ agreement in India:

Step 1: Identify the Parties

Clearly identify all parties to the agreement, including the company and each shareholder. If the company has both majority and minority shareholders, specify the percentage of shares held by each.

Step 2: Consult with Legal Experts

It is highly advisable to consult with corporate lawyers or legal experts who are well-versed in Indian corporate law, particularly the Companies Act, 2013. They can ensure that the agreement complies with all relevant laws and regulations.

Step 3: Define the Objectives

The next step is to outline the objectives of the shareholders’ agreement. Are the shareholders looking to protect their financial interests, ensure their participation in management, or establish clear rules for exiting the company? The objectives will guide the drafting process.

Step 4: Draft Key Clauses

Draft the essential clauses, including:

• Shareholder Rights and Obligations.
• Management and Governance Structure.
• Dispute Resolution Mechanisms.
• Exit Strategies and Share Transfers.
• Reserved Matters.
• Confidentiality and Non-Compete Clauses.

Step 5: Review and Negotiate

Once the draft agreement is ready, circulate it among all shareholders for review. This stage may involve negotiations, particularly over key clauses like voting rights, reserved matters, and share transfer provisions.

Step 6: Finalise and Execute

After all parties have agreed to the terms, finalise the agreement and have it signed by all shareholders. It is advisable to have the agreement witnessed and, if necessary, notarised.

Step 7: Periodic Review

A shareholders’ agreement should not be static. It should be reviewed periodically, especially when there are significant changes in the company’s structure, such as the addition of new shareholders, issuance of new shares, or changes in the company’s business model.

Common Pitfalls to Avoid in a Shareholders’ Agreement

While drafting a shareholders’ agreement, it is essential to avoid certain common mistakes that can render the agreement ineffective or unenforceable:

Failure to Align with the Articles of Association

Ensure that the shareholders’ agreement does not conflict with the company’s Articles of Association. In case of a conflict, the provisions of the Articles of Association will generally prevail, unless the shareholders’ agreement specifically states otherwise.

Ambiguity in Key Clauses

Ambiguous language can lead to disputes over the interpretation of the agreement. All clauses, particularly those related to voting rights, share transfers, and dispute resolution, should be clearly worded to avoid confusion.

Not Addressing Future Scenarios

A good shareholders’ agreement should account for potential future events, such as the exit of a key shareholder, the company going public, or new shareholders coming on board. Failing to address these scenarios can lead to disputes down the road.

Ignoring Minority Shareholder Protections

In many cases, majority shareholders may dominate the decision-making process, leaving minority shareholders with little control. The agreement should include robust protections for minority shareholders to prevent oppression or unfair treatment.

Overlooking Dispute Resolution Mechanisms

Disputes are inevitable in any business relationship. If the agreement does not include clear and effective dispute-resolution mechanisms, it can lead to prolonged and costly litigation.

Sample Draft Shareholders Agreement