A Share Subscription and Shareholders’ Agreements is a promise by a potential shareholder, also known as a subscriber, to make payment of funds to a company (Company) in an agreed number of “tranches”, in return for the Company issuing and allotting a certain number of shares at a certain price, such that the subscriber becomes a shareholder (Shareholder). A Share Subscription Agreement must include the number of shares that will be issued to the Shareholder and the order and timing by which funds will be advanced. Sometimes it seems that a Share Subscription Agreement merely sets out the provisions of a term sheet (Term Sheet) in a fuller and more precise manner.
Common clauses in Share Subscription and Shareholders’ Agreements
- Condition Precedent
Condition Precedent are acts which must occur before the Agreement is to come into force, for example, the Subscriber may be required to deliver a consent to be a member to the Company, or the directors of the Company may have to pass certain resolutions to sign the shareholders agreement.
The conditions precedent to definitive document signature in the term sheets and presented should be fair, because there can be circumstances when a condition precedent can become unfair, though. For example – If an investment round was predicated on finding the co-investor, the new investor might require the co-investor before signature of the term-sheet. However, if the new investor is abnormally selective, this could hold up the necessary investment for the company. The investee should put a time-limit or a clause that states that approval should not be unreasonably withheld.
Another type of condition precedent is one before funding. These focus on actions that take place after signing the definitive documents, but before funds have been transferred, and the investment round considered closed.
- Subscription of Shares
Subscription rights are sometimes called “anti-dilution provisions,” “preemptive rights,” or “subscription privileges.” Subscription rights are particularly relevant for convertible preferred stock. Let’s look at an example.
Assume you purchase Private Company XYZ preferred stock for $15 per share. The preferred stock is convertible, which means that you have the right to trade one share of preferred stock for one share of common stock.
Now let’s assume Company XYZ decides to go public and issue common shares at $10 per share. This clearly devalues the incentive to convert your preferred share into common shares, because you’d be trading your $15 investment for a common share worth only $10. Subscription rights could protect you against this if it states that if Company XYZ issues shares at a price lower than in previous financing rounds, the preferred shareholder gets more shares of common stock when he or she converts.
There are two kinds of subscription rights: the “weighted-average” provision and the “ratchet-based” provision. The ratchet provision offers existing shareholders the right to buy shares at the new lower price. The weighted-average provision gives shareholders the right to purchase shares at a price that accounts for the change in the old and new offering prices.
Closing means the closing of the sale and purchase of the Preferred Shares and the Warrant.
- Representations and Warranties
These are the statement of facts on the affairs of the company which is expressed to be true (at a particular point in time). A warranty from the company could state that the liabilities against the company is not more than INR 5,00,000. Such warranties are stated on the date of signing and are expressed to be true on the date of closing. In a case of breach of warranties the company (or promoters) may be required to ‘indemnify’ the investors of any losses suffered by them. Founders have to be careful if the indemnity clause puts a personal obligation on them to indemnify for any loss since the investment is for the company there shouldn’t be any personal liability. Founders may include ‘knowledge qualifiers’ instead of absolute warranties- by stating that there is no liability against the company to the best knowledge of the promoters.
- Corporate Governance
Corporate Governance refers to the set of system, principles and processes by which a company is governed. Corporate Governance is based on principles such as:
- Conducting the business with all integrity & fairness,
- Being transparent with regard to all the transactions,
- Making all necessary disclosures,
- Complying with applicable Law,
- Accountability & responsibility towers the stakeholder.
Clause 49 of “Listing Agreement” deals with the complete guidelines for corporate governance. Following are the provisions, a company, must comply to implement effective corporate governance.
Corporate Governance: In order to comply with clause 49(1) a company must adhere with some following principles.
(1) Right of Shareholder – As shareholders are the ultimate owner of the company, the company should seek to protect and facilitate the exercise of right of shareholders. A company must always be transparent with its shareholders and shareholders should have all the rights regarding General Meeting such as information about meeting, participate, Vote and questioning in GM etc.
(2) Role of Stakeholders – A company must take care of stakeholder’s right and encourage cooperation between company & stakeholders. Their rights can be by Mutual agreement or by Applicable law or statute.
(3) Disclosure & Transparency – It is the obligation on company to be transparent with its stakeholders by giving disclosures of all material matters on timely basis. Disclosure can be regarding financial position, Performance, ownership and Governance etc. Non disclosure of Material Matter is Strictly Prohibited.
(4) Responsibility of Board – Members of the Board should disclose their interest in company and in any individual transaction and contract. They should also maintain the rule of confidentiality. They should also perform their key function such as preparation of major action plan, corporate Strategy, execution of Board, and effective financial Performance.
- Further Issue and Transfer of Shares
A. Veto Rights: To ensure that their control in the company remains and their stakes are not diluted investors may ask for veto rights against an issue of fresh shares.
B. Pre-emption Rights: In cases where there is a fresh issue of shares the stake of the existing shareholders may get diluted. To maintain their shareholding percentage the existing shareholders get a right to proportionately subscribe to a fresh issue of shares so that it is not diluted.
C. Tag Along Rights: This right allows the investor to sell his shares the moment founders sell a portion of their shares. Lock-in provisions are inserted by the investors (which do not allow the founders to sell their portion of the shares for a significant period of time generally, 4-5 years) after the expiry of which if a founder dilutes his shareholdings then the investor gets to preserve his freedom to exit the company due to tag along rights.
- Anti-dilution Clause
It may be possible that in a subsequent round of fundraising fresh shares are issued at a lower valuation to the third parties than they were issued to the investors. The old investor would want in such situations that the fresh shares are issued to him to adjust the amount the investment amount at a lower valuation. The earlier investment is treated as if it was done at the new (lower) valuation. Ideally, a weighted average anti-dilution protection is executed – the adjustment of the price is dependent upon the ratio of shares that new investor has subscribed to.
- Non-compete Clause
To protect the commercial interest of the investors a non-compete clause is included in the agreement. It prohibits the founders from competing with the business of the company. The restriction applies till the duration of the investment horizon or for some time period after they have exited from the company (due to termination or transfer of shares). Competing businesses should be clearly defined, a vague definition may widen the scope and include related business as well which will be against the interest of the founders if they want to start any other business.
Then there are some general clauses like Exit, Notice, Termination, Governing Law.
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