Founder Series II: Decoding Shareholders' Agreements - Key Terms Index

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This article is the second instalment of our Founders Series, aimed at providing an overview to founders of emerging companies of some commonly used terms in transaction documents. This is an illustrative guide.
India Corporate/Commercial Law
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This article is the second instalment of our Founders Series, aimed at providing an overview to founders of emerging companies of some commonly used terms in transaction documents. This is an illustrative guide.

  1. Share Valuation and Ownership
    1. Convertible securities: ‘Convertible Securities' are financial instruments such as convertible debentures or preference shares that can be converted into a specified number of equity shares of the issuing company. Subject to statutory timelines, this conversion typically occurs at the discretion of the holder and can be triggered by certain events such as reaching a specific date or a milestone in the company's performance or, in some instances in the case of an event of default. Convertible securities provide investors with the potential for equity participation while initially offering certain additional benefits such as, fixed income/ downside protection in case of debt or dividend/ distribution benefits..
    2. Fully Diluted Basis: This represents the final capital table of a company, i.e., the total number of a company's shares that are outstanding, if all convertible securities were exercised and converted into equity shares, including currently issued shares and those that could be claimed in the future through conversion instruments like convertible bonds and employee stock options.
    3. Dilutive Issuance: A ‘Dilutive Issuance' typically refers to a ‘down round', i.e., dilution of the value of the shareholding of the existing investors through issuance of new shares by the company at a price lower than the previous funding round. Dilutive issuances can affect the proportionate ownership and voting power of existing shareholders unless they have anti-dilution protections in place (discussed below). Certain dilutive issuances are typically exempted from ‘anti-dilution' protection, such as issuances related to public offerings, shares issued under employee stock option schemes or other agreed arrangements.
    4. Anti-Dilution: ‘Anti-Dilution' clauses protect investors by adjusting the conversion rate of their securities when a company issues new shares at a price lower than what earlier investors paid(commonly referred to as a ‘down round'). These clauses ensure that the economic value of the initial investment is preserved by recalculating the ownership percentage. There are two main types of anti-dilution protection: full ratchet and weighted average. ‘Full ratchet' provisions provide for adjustment of the conversion price of the existing shares to the down-round price such that additional shares are issued to the existing investor, to obtain the shareholding it would have had, had it invested at the down round price originally. ‘Weighted average' provisions, in simple terms, provide for adjustment of the conversion price of the existing shares to a weighted average of the original price of the existing shares and the down round price, and are accordingly considered to be more ‘balanced' for both the company and the existing investors.
    5. Pre-Emptive Rights: ‘Pre-emptive Rights' allow existing investors to maintain their shareholding in the company by requiring the company to offer additional securities to them before issuing to third parties. Investors are typically permitted to participate in new issuances in proportion to their current shareholding.
    6. Super Pro-Rata Right: In contrast to a ‘Pre-emptive Right', a Super Pro-Rata Right grants existing investors the ability to require the company to offer additional securities to them beyond their pro-rata ownership share in subsequent funding rounds, giving them the opportunity to maintain and grow their influence and ownership as the company raises additional capital.
  2. Decision Making and Operations
    1. Information rights: Information Rights grant certain shareholders/ investors, the right to access specific financial and operational information about a company. This includes periodic financial statements, budgets, business plans, and updates on significant events or changes. These rights ensure that investors are kept informed about the company's performance and major developments, enabling them to make informed decisions regarding their investment. Often, investors require specific reporting in formats required for investors' internal assessment and compliance.
    2. Inspection rights: Inspection Rights allow certain shareholders, usually investors, to visit the company's premises, review its books and records, and consult with its officers and employees. These rights ensure that investors can conduct thorough due diligence and oversight to verify the company's compliance with agreements, assess its financial health, and monitor its overall operations and governance.
    3. Investor Directors & Observers: Investors may nominate directors to the board of directors of the company to represent their interests, providing oversight and/or strategic expertise. It is pertinent to note that every director has a fiduciary duty to act in the best interests of the company and the shareholders as a whole (and not just of the nominating investor) as per the Indian law. An ‘Observer' may be nominated to the board by an Investor, typically in place of a ‘director' for representing the investor at board meetings and providing insights without voting rights. Unlike directors, observers are not bound by any fiduciary obligations towards the company or the other shareholders.
    4. Non-Executive Status and Indemnification of Investor Directors: An executive director is involved in the routine management and is in the whole time employment of the company. ‘Non-Executive Status and indemnification' refers to provisions where Investor Directors are acknowledged as serving in a non-executive capacity. Non-executive directors do not manage the company's day-to-day operations, make ordinary business decisions, or ensure legal compliance, and are not considered officers, employees, or senior management of the company. Companies are typically required to indemnify and protect these non-executive directors from any claims arising due to their role as directors to ensure that they are not held personally liable for the company's actions or decisions.
    5. Affirmative Voting Matters / Investor Approval Matters: These are significant decisions that require the approval of investors, ensuring that key stakeholders have a say in critical company decisions. Examples of typical approval matters include, amendment of the company's charter documents, approval of annual budgets or business plans, corporate restructuring of the company, major strategic decisions, amendments to the company's capital structure, and appointment/removal of key executives. When there are multiple investors, then, to avoid decisions being stalled by an individual investor, it is now common for affirmative voting rights to be granted to an ‘Investor Majority', i.e., identified investors who qualify a certain shareholding/ voting power threshold instead of an individual investor.
  3. Share Selling and Transfer Provisions
    1. Deed of Adherence: A ‘Deed of Adherence' is a legal document that new shareholders are typically required to sign when acquiring shares in a company. By signing such document, a new shareholder signifies their consent to be bound by the terms of the existing shareholders' agreement (“SHA”), ensuring they adhere to the same rights and obligations as the current shareholders. Such deeds ensure continuity and consistency in the enforcement of the SHA across all shareholders.
    1. Founder Lock-In and Vesting: A lock-in period restricts founders from selling or transferring their shares for a specified time, ensuring they remain committed to the company's growth. It is common for transaction documents to contain (a) exemptions to lock-in restrictions on a minor portion of founder shares or for liquidity and/or estate planning purposes; and/or (b) ‘vesting' schedules that gradually “unlock” shares available for transfer to founders over time, incentivizing long-term contribution.
    2. Right of First Offer (ROFO): The Right of First Offer (ROFO) grants the ROFO holders the opportunity to purchase shares before the selling shareholder can offer them to external parties. The selling shareholder must first offer the shares to the ROFO holder who will make an ‘offer' specifying the price at which they intend to acquire the shares. If the such offer is not acceptable to the selling shareholder, then, the selling shareholder is free to sell the shares to third parties, at a price not less than offered by ROFO holder and on similar terms. Price discovery for the shares is undertaken by the ROFO holder in this case. Both for ROFO and ROFR (below), overall transfer restrictions to competitors typically continue to apply.
    3. Right of First Refusal (ROFR): The Right of First Refusal (ROFR) grants the ROFR holder priority to purchase the sale shares before the selling shareholder can sell them to an external third-party by matching/ out-bidding the offer received by the selling shareholder from the third-party. In this process, the third-party undertakes the diligence for price discovery of the shares and makes an offer to the selling shareholder, who in turn notifies the ROFR holder of the offer. A ROFR obligation is considered to be more onerous than a ROFO as it is seen to dissuade a third-party from undertaking price discovery and making an offer in the first instance as the sale may be easily blocked by a ROFR holder by offering a marginally better price than that offered by the third party.
    4. Tag-Along Rights: These rights allow the ‘Tag Right' holders to join a sale initiated by other shareholders, typically founders and other shareholders apart from investors, ensuring they can exit the company under the same terms.
  4. Exit Provisions
    1. Exit: An ‘Exit' refers to the process through which investors realize their investment in a company, typically by selling their shares or the company's assets. Exit strategies provide liquidity to shareholders and can occur through various mechanisms, including public offerings (IPOs), mergers, acquisitions, strategic sales, or third-party sales. The goal is to maximize the return on investment while ensuring a smooth transition for the company.
    2. Accelerated Exit: An ‘Accelerated Exit' is a provision that allows investors to expedite their exit from the company, often triggered by specific events such as a significant corporate transaction, a change in control, or a material breach by the company or its founders. This mechanism ensures that investors can promptly liquidate their holdings and recover their investment under predefined circumstances.
    3. Drag-Along Rights: A ‘Drag-Along Right' entitles the majority shareholders to compel the other shareholders to sell their shareholding in the Company along with the drag-right holders to a third party purchaser identified by the drag-right holders. This is typically used to facilitate a complete exit if a buyer is interested in acquiring the entire company.
    4. Liquidation Preference: ‘Liquidation Preference' determines the order and amount that investors are paid in the event of a liquidation, ensuring that the preferred shareholders get their investment back before any proceeds are distributed to other shareholders.
    5. Trade Sale/ Strategic Sale: A ‘Trade Sale/ Strategic Sale' provision requires the founders and /or the company to cause the sale of the company's shares or assets to a third party. This type of transaction provides an exit opportunity for the shareholders, allowing them to liquidate their investments.
  5. Additional Terms
    1. ABAC compliances: ABAC (Anti-Bribery and Anti-Corruption) compliances refer to the policies, procedures, and practices that companies may be required to implement to prevent, detect, and respond to bribery and corruption. For foreign investment funds, adherence to ABAC compliances by the target companies is often mandated as an internal policy requirement to ensure compliance with global anti-corruption laws and mitigate risks associated with legal penalties, reputational damage, and financial losses in relation thereto.
    2. Affiliate: ‘Affiliates' typically refer to entities or individuals that have a control relationship with another entity or individual, including those under common control. Typically, for funds, the term includes their general partners, limited partners, and any related investment entities where the general partners are involved in management roles.
    3. Call Option: A ‘Call Option' gives a shareholder the right, but not the obligation, to compel another shareholder to sell their shares to the call option holder at a predetermined price within a certain timeframe and/or upon occurrence of specific events.
    4. Put Option: A ‘Put Option' gives a shareholder the right, but not the obligation, to compel another shareholder to purchase the shares of the put option holder at a specified price within a certain timeframe and/or upon occurrence of specific events.
    5. Clawback: A ‘Clawback' restriction is typically imposed upon founders and/or other employees, that obligates them to return all or part of the shares allotted to them, upon occurrence of certain ‘default events' such as a founder/ an employee leaving the company before a specified period or failing to meet performance milestones. This mechanism ensures that shareholders remain aligned with the company's long-term goals and protects the interests of the company and its investors. Shares may be ‘clawed back' through a buyback by the company or sale of such securities to an ESOP trust or to certain shareholders at a reduced price.
    6. Good Reason: Good Reason refers to specific conditions outlined in a SHA that justify a founder's voluntary departure without triggering adverse consequences related to their securities. These conditions typically include substantial changes such as a significant reduction in compensation or responsibilities, relocation requirements, or a change in reporting structure. By defining what constitutes a Good Reason, the SHA provides protection for founders, ensuring they can exit the company under fair circumstances without forfeiting their vested shares or facing other penalties typically associated with a departure.
    7. Reserved Shares: Shares held by founders that are subject to certain restrictions such as claw back or lock-in (as the case maybe) and vesting schedules to ensure alignment with long-term company goals.
    8. ‘Cause' Event /'Event of Default': Please refer to our article on the nuances of definition of a ‘Cause' event at .

This primer merely provides the commonly used definitions of the aforementioned terms and does not substitute for professional legal counsel for your specific transaction. The definitions may vary depending on the nature of the transaction and the drafting specifications.

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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