Transfer Restrictions In A Shareholder Agreement (No. 6)

In addition to preferential rights of all kinds, investors in a start-up are always interested in influencing the future development of the shareholder structure, especially when it comes to the sale of shares. This is mainly regulated by so-called transfer restrictions, which specify how shares in a start-up can be sold and whether under certain circumstances they must even be sold.

Permitted transfers

First, however, the good news: where there are restrictions, there must also be exceptions. Shareholders' agreements therefore regularly provide for a list of transactions that are not subject to the general transfer restrictions. These exceptions typically include any form of estate planning under inheritance law, the transfer of shares due to divorce or other cases in which shares are transferred to family members, as well as transfers to a privately held company owned by a private shareholder. It is particularly important for private individuals to ensure that they can continue to conduct their private business without being blocked by transfer restrictions. For their part, investors usually reserve the right in these clauses to transfer shares within a group of companies without being subject to transfer restrictions.

In general, transfer restrictions are primarily intended to regulate sales to third parties, but not family or intra-group transfers for succession planning purposes.

Right of first refusal

The right of first refusal guarantees certain shareholders or shareholder groups the right to acquire shares before they are sold to a third party. However, this right can only be exercised under exactly the same conditions as those under which the third party would have acquired the shares.

The parties are free to structure the order of priority in a right of first refusal as they see fit. For example, rights of first refusal are often first granted to the class of shares with the highest preference and then cascade down to the next class of shares, provided that the priority group (or groups) has not already acquired all the shares. Rights of first refusal are also possible within the class of shares from which the shares are to be sold. The right then passes to other share classes in accordance with the agreed cascade.

Often, the start-up itself also receives a preemptive right within the cascade, either at the beginning or later on. However, depending on the volume of shares to be sold, it may happen that the start-up wants to exercise its preemptive right but is legally prevented from doing so. Under Swiss law, companies may hold a maximum of 10% of their own shares (20% in exceptional cases), provided that it has freely available reserves for the acquisition or can create them. If a major shareholder intends to sell their stake, the start-up may only be able to acquire part of it, even though it would have priority in the sequence of right of first refusal rights.

Finally, there is the option that is most unfavorable for founders: the right of first refusal only applies to the sale of common shares, while investors can freely sell their preferred shares.

Drag-along right

Probably the most important transfer restriction, especially in the context of a company sale, is the drag-along right. This contractually agreed obligation requires a shareholder to sell their shares to a third party as soon as a defined "drag-along event" occurs. The shareholder subject to the drag-along right is typically not directly involved in the sale negotiations, but must accept the negotiated terms and participate in the sale due to their obligation under the shareholders' agreement.

The shareholders' agreement will stipulate certain hurdles for the co-sale obligation that must first be overcome in order to enforce the obligation vis-à-vis other shareholders. The most common hurdle is the specification of a minimum percentage of the share capital that shareholders willing to sell must represent (e.g. at least 50%). If the contractually stipulated conditions for the applicability of the co-sale obligation are met, the obligated shareholders must sell their shares. If they fail to comply with this obligation, enforcement can be sought in court.

Tag-along right

Under certain circumstances, other shareholders may be contractually permitted to join a sale to a third party. In contrast to the drag-along right, a shareholder with a tag-along right is free to decide whether to exercise this right. The tag-along right enables a shareholder to participate in the success of another shareholder's negotiations. At the same time, it preserves the option of remaining a shareholder in the start-up and not participating in a sale.

Purchase option

Furthermore, the shareholders' agreement may provide for a general purchase right that allows a shareholder to acquire the shares of another shareholder without a third party being involved in the sale. Such purchase rights are typically linked to the breach of contractual obligations under the shareholders' agreement, cases of insolvency, or criminal acts by a shareholder to the detriment of the company or other shareholders. The purchase right can be considered a contractual form of penalty under the shareholders' agreement and is intended to ensure that, in certain cases, destructive actions or circumstances caused by one shareholder do not harm all shareholders of a start-up.

Reverse vesting obligation for founders

Also regularly agreed in connection with transfer restrictions are repurchase obligations for founders. The earlier an investor invests in a start-up and/or the more involved a founder is in the start-up's business, the more crucial the repurchase obligation is—usually in addition to a non-competition clause—as an incentive for the founder to remain fully committed to the start-up even after an investment. The repurchase obligation defines the conditions (for what reason a founder leaves the start-up) and/or deadlines (how soon after an investment a founder leaves the start-up) that result in a founder having to sell back part of their shares to the start-up in the event of an early termination of engagement by such founder. Further information on the position of founders in a shareholders' agreement can be found in the blog Best Co-Founders Forever? Anticipating Legal and Tax Considerations for Founders of Swiss Startups (No. 4).

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The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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