Sarthak Advocates & Solicitors | View firm profile
Unlike regular agreements such as services agreements, lease agreements, employment contracts etc. which the parties normally enter into in their usual course of business, Share Subscription Agreement (SSA), Share Purchase Agreement (SPA) and Shareholder’s Agreement (SHA) are one such category of agreements which are not executed on regular intervals and can be said to be highly technical as these agreements tend to regulate the legal relationship between multiple stakeholders like new investor or investors, existing investor or investors, other shareholders, founder or founders of the investee company and the investee company.
Therefore, before initiating the drafting of SSA, SPA or SHA, it is necessary to understand certain basic differences, clauses and concepts related to these complex transactional agreements.
Difference Between Share Subscription Agreement, Shareholders’ Agreement and Share Purchase Agreement
Share Subscription Agreement – In simple terms, when an investee company issues new securities to any new incoming investor or an existing investor of such investee company, then an SSA is executed between such parties. Such investment is subject to fulfilment of certain conditions precedent as well as subsequent to the receipt of investment amounts which are duly inserted in the SSA for securing the interests and investment of the investor.
Share Purchase Agreement – Unlike the SSA, an SPA is entered into when the new investor or the existing investor wishes to purchase the existing securities of the investee company.
Shareholders’ Agreement – An SHA governs the relationship between new investor or investors, existing investor or investors, other shareholders, founder or founders of the investee company and the investee company. It is a comprehensive document which mainly focuses on the management and control of investee company between the aforesaid parties.
Major Clauses and / or Concepts Related to an SHA
- Anti-Dilution and Pre-emptive Right of Investors
The abovementioned phrase talks about two concepts which most of the stakeholders consider to be synonymous in nature but however, are different in essence. In simple terms, these two different concepts, i.e., Anti-Dilution Right and Pre-emptive Right deal with protection of the ‘proportion of shareholding’ of an investor who does not want his proportion of shareholding to be dropped in future due to issuance of new securities by investee company in the subsequent rounds of investment.
- Anti-Dilution Right
Now, the anti-dilution right protects the investment of an investor in terms of proportion as well as its value. This can be explained with the help of an example. For instance,
Scenario 1 – An Investor XYZ holds 1,000 Equity Shares of INR 10/- each in the Investee Company and the Issued Equity Share Capital (10,000 Equity Shares multiplied by per unit price) of the Investee Company is INR 1,00,000/-. Effectively, the proportion of shareholding of the Investor XYZ comes out to be 10 per cent. Now, the Investee issues another 10,000 Equity Shares to another Investor ABC which resultantly reduced the proportion of shareholding of Investor XYZ to 5 per cent from the erstwhile 10 per cent. Therefore, issuance of new securities by the investee company has diluted the proportion of shareholding of Investor XYZ. Hence, anti-dilution right protects such Investor XYZ from such dilution and bounds the Investee Company to issue as many Equity Shares to the Investor XYZ so that its proportion of shareholding remains undiluted and intact.
Scenario 2 – An Investor BCD holds certain Convertible Preference Shares in the Investee Company and conversion price of single Convertible Preference Share is say, INR 10 per share. Now, if the Investee Company issues more such shares at conversion price lesser than INR 10 per share (Say, INR 5 per share) in the subsequent rounds of investment, then pursuant to anti-dilution right of the Investor BCD, the conversion price of the existing Convertible Preference Shares shall be adjusted downward to the price at which new such shares are issued in later or subsequent investment rounds. In this case, without going into the complexity of calculating the new conversion price, the Investor BCD will have the ability to buy twice as many shares to protect his value of investment and proportion of shareholding. Therefore, the Investor BCD’s investment remains safeguarded if the conversion price of the new shares is lower than the price at which the Investor BCD’s shares can be converted.
- Pre-Emptive Right of Investor
In the event wherein the Investee Company wishes to issue new shares in the subsequent round of investment, a pre-emptive right safeguards the proportion of shareholding of an investor by obligating the Investee Company to first offer the pro-rata shares to the existing investor before they can be publicly available to other third party. Pursuant to a pre-emptive right, the existing investor has a right but not an obligation to buy the offered shares. In the event, the existing investor wishes to exercise its pre-emptive right, then the Investee Company shall issue and allot such number of shares as subscribed by the existing investor to enable him to safeguard his proportion of shareholding in the Investee Company. If the existing investor declines to exercise his pre-emptive right, then the Investee Company is free to issue and allot the offered shares to a third party buyer.
Therefore, anti-dilution and pre-emptive rights not only protects the value and proportion of shareholding of an investor but also reduces the chances of gaining control by third parties other than existing investors and shareholders.
- Vesting and Reverse Vesting of Shares
- Vesting of Shares
Vesting of shares in simple terms mean ‘belonging of shares completely and legally’. Generally, this phrase, i.e., “vesting of shares” is usually heard in respect of founder’s shares and employee stock option plans for employees. In the SHAs, investors usually ask for a vesting schedule for the founders of the investee company which normally lasts between 3 to 5 years to ensure their continuity with the investee company for such period. It discourages the founders to quit the investee company before the actual vesting of shares happens. Such vesting schedule protects the interests of other founding members of the investee company as in the event wherein one of the founders decides to leave the investee company, then such a restriction ensures that the leaving founder does not acquire unfair benefits from the hard work put in by the other founding members of the investee company who stay behind to develop a business.
- Reverse Vesting of Shares
Reverse Vesting is a concept which restricts the founders of a company to leave. It discourages the founders to terminate their association with their company by providing an option to the company to buy back founders’ shares in the event they decide to leave the organization prematurely. Such a clause protects the interests of the company, shareholders, and investors, in the event wherein a founder decides to quit the company and taking away with him a substantial number of shares as well as control.
However, the percentage of shares the company can buy back in such an eventuality decreases as the duration of the founder’s stay with the company increases. In simple terms, it means that the longer a founder stays with the company, the lesser the number of shares the company can buy back from him if he decides to quit.
For instance, if a Founder ABC owns 20 per cent stake in a company, and as per the reverse vesting clause in the agreement, Founder ABC shall be allotted permanent ownership of 20% of the shares every year, then in order to gain the permanent ownership of all his shares, the Founder ABC needs to stay with the company for 5 years so that he could sell those shares at his own discretion, or otherwise dispose-off such shares. However, this doesn’t mean that 20% shareholding of the company is unowned. The voting power for that 20% stake still rests with Founder ABC in the interim.
After 5 years, this reverse vesting schedule will be complete, and the company shall not be empowered to buy back Founder ABC’s shares even if he decides to quit after such period. Suppose, Founder ABC decides to quit the company after 3 years of his association, therefore, as per reverse vesting clause, he shall retain 12 per cent stake in the company. The remaining 8 per cent of his stake can be bought back by the company at a reduced cost to retain voting powers.
- Drag Along and Tag Along Rights
The concepts of drag-along and tag-along is related to protection of interests of shareholders by providing an option to such shareholders to sell their shareholding and exit the investee company. However, there lies a difference between these two rights which is explained below:
- Drag-Along Right
A drag-along right enables a majority shareholder to drag the minority investors to sell their shareholding to a third-party potential buyer. This right obligates the minority investors to accept the terms and conditions of the deal negotiated by the majority investors. Often, potential buyer(s) seeks 100 per cent control of the investee company which might not be possible if minority shareholders object to part with their ownership. Therefore, to avoid such a situation, majority shareholders are armed with such right to drag the minority shareholders along with them and sell the aggregate shareholding to such potential buyer provided the minority shareholders’ shares are sold at the same price, terms, and conditions.
- Tag-Along Right
The tag-along right is opposite of drag-along right which safeguards the interests of minority shareholders. In the event wherein the majority shareholder decides to sell his stake in the investee company to a potential buyer, then such right obligates the majority shareholder to tag along the minority shareholders and offer the combined shareholding of both majority and minority shareholders while negotiating the deal with such potential buyer. The right of tag-along is essential in a way that the price, terms and other conditions of a deal which can be negotiated by a majority shareholder may not be negotiated by a minority shareholder. Therefore, it ensures that the minority shareholder gets the same benefits out of a deal as chalked out by the majority shareholder for itself thereby ensuring greater liquidity to minority shareholders. However, the tag-along right may also obstruct a selling process in the event wherein the potential buyer doesn’t want to increase or change the terms of their offer in order to please minority shareholders.
- Right of First Refusal and Right of First Offer
The right of first refusal (ROFO) and right of first offer (ROFO) are the rights which restrict the transfer of shares in an investee company by the transferor. The transferor could be a founder, existing investor or investors or other shareholders of the investee company. It depends on the negotiated terms of the SHA which define who is entitled to exercise such rights against the transferor. The ROFO and ROFR are invariably the most common clauses any SHA the concepts of which are explained below:
- Right of First Refusal
In the event wherein a transferor wishes to sell his shareholding or any part of it (Sale Shares), then he shall offer such Sale Shares first to the holder of ROFR at such an offer price as solicited by such transferor from the potential buyer. In case the holder of ROFR exercises its ROFR, then the transferor shall be obligated to sell such Sale Shares or part of Sale Shares as accepted by the holder of ROFR. In the event, the holder of ROFR rejects the offer of transferor, then the transferor may sell the Sale Shares to the potential buyer at the same price, terms and conditions which was offered to the holder of ROFR.
For instance, in an investee company, there are 2 shareholders, i.e., Shareholder Y and Shareholder Z. In the SHA, there is a clause which provides that transferee has a ROFR against the transferor. Shareholder Y decides to quit the investee company and sell his shares. Accordingly, he is able to solicit a price of INR 500 per share from an external potential buyer. Now, as per ROFR clause, Shareholder Y is bound to offer his shares to Shareholder Z at the same price of INR 500/- as solicited by him from the external potential buyer. In case the said offer price, terms and conditions are agreeable to Shareholder Z, then he exercise ROFR and purchase the offered shares. In case, such price, terms and conditions are not agreeable to Shareholder Z, then Shareholder Y can go ahead and sell his shares to such external potential buyer at the same price, terms and conditions.
- Right of First Offer
Now, if a transferor wishes to sell his shareholding or any part of it (Sale Shares), then he shall offer such Sale Shares first to the holder of ROFO. The ROFO holder has a specific amount of time to make an offer before the right expires. The transferor may reject the offer of ROFO holder in the event the transferor is able to solicit better price, terms and conditions which was offered by the holder of ROFO.
For instance, in an investee company, again there are 2 shareholders, i.e., Shareholder P and Shareholder Q. In the SHA, there is a clause which provides that transferee has a ROFO against the transferor. Shareholder P decides to quit the investee company and sell his shares. Accordingly, ROFO Holder, i.e., Shareholder Q makes an offer to purchase the Sale Shares at Rs.100/- per share. Shareholder P can reject the offer so made to him by Shareholder Q and sell the Sale Shares to an external buyer only if such external buyer offers a better price, terms and conditions than what was offered to him by Shareholder Q.
So, therefore the similarity between the ROFO and ROFR is twofold as explained below:
- Firstly, the main object of these rights is to prevent the transfer of shares to any external third-party buyer against the wishes of non-disposing investors; and
- Secondly, these rights ensure benchmarking of a ‘floor price’ below which the Sale Shares cannot be transferred to the external third-party buyer if not the existing non-disposing investors.
The list of concepts and clauses discussed above is inexhaustive in nature but invariably form part of any negotiation among the stakeholders for execution of SSA, SPA and SHA. Therefore, in order to draft the clauses giving effect to the above rights and obligations as discussed, it is necessary to understand the implications and mechanism of how such things work in the real world.