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Aakash Saxena (changed name), a former technical head of a very famous travelling website, quits a 1 Cr package for a startup which he feels worth millions. He, with his other partner, founded a venture, a platform for hotels to start their own websites. In 3 months, there venture started to pick up and hence they decided to form a company. They want a less regulated country, so they decided to form a company in Singapore instead of India. In the mean time, they look for venture capitalists to raise investment and they did find some but they declined because offer wasn’t lucrative.
Amit, the other partner and the holder of 75% share capital of the company, decided to have a shareholder agreement between him and Asheesh. Asheesh has no knowledge about the legal, so he came to us for help. If investment is to be raised, then this shareholder agreement plays a very important role, because whatever is written in the agreement is binding on both the shareholders and can sometimes proven very harmful if not drafted carefully.
When we vetted the shareholder agreement, we find 5 clauses which can steal the celebration of raising investment from the shareholders. We pointed out that 5 clauses and told to Asheesh to either amend or delete the clauses from the agreement.
Since, this era is moving very fast for start ups and millions of dollars are being invested, so we tried to share our experience with you all and to caution you from these 5 points which every founder should look into the shareholding agreement while getting into it.
- DRAG ALONG CLAUSE: Drag along clause favors the major shareholders. This right enables the major shareholder to compel the other shareholder to sell their shares even if the other shareholder/s doesn’t wants to. As the name suggest, it allows the major shareholder to drag the other shareholders along. Imagine a scenario, where you hold 49% of the ownership and other one holds 51%. The major shareholders wants to sell the ventures as he wants to move forward to another idea, but the you, because you have putted everything into the venture don’t want to sell as you believes in this idea. In this situation, if you have signed the shareholding agreement which has this DRAG ALONG CLAUSE, then you have no right to oppose and you will have to sell your shares as well. Sometimes, this clause may be useful to you. In case you holds 90% ownership then you don’t want that other 10% holder should intervene if you wants to sell the ventures, because VC’s sometimes rejects the funding proposal if you do not offer 100% ownership shares. These types of cases happen, so always take care of this clause while signing the shareholding agreement.
- TAG ALONG CLAUSE: Now this clause is designed to protect the minority shareholder from being left behind when a majority shareholder decides to sell. As the name suggest, it gives the right to the minority shareholders to join the deal and sell their stake at the same terms and conditions as would apply to the majority shareholder. This clause is very important especially for the minor shareholder. In order to protect your interest, you need to look into this clause and always be cautious.
- PRE EMPTION RIGHT: In business terms, it is a contractual right to acquire new shares before it can be offered to any other person or entity. It is also called “first option to buy.” This right will protect you from stock dilution which is always a concern for every business founders. Remember the case of facebook.com, where the shares of co founder Eduardo Saverin has been reduced from 34% to 0.03%, and the important thing is that he didn’t even get to know when did his shares were diluted. However, you can protect yourself by entering this clause into the shareholder agreement.
- RIGHT OF FIRST REFUSAL: In business terms, this clause gives the right to the existing shareholder to claim damages in case any shareholder sells his shareholding to the third party without offering them. This right protects the existing shareholders from intrusion of any unknown person into the board and ownership of the company which they do not wants to. This right might also helps the existing shareholders to increase their percentage of ownership into the business at the pre determined price which they can also agree through this clause.
- PERMITTED USE: Finance is the lifeline of any business and hence its use should be optimum. This clause gives the right to minor shareholders to restrict the use of funds of the company in any matter or area which they think is prejudicial to their interest. Understand this by way of example: suppose Mr.A has invested around 80 lakh in the business which only worth 20% of the capital, in this case, there is a risk to Mr.A, that other shareholders might use the funds in area’s which Mr.A thinks is prejudicial to him, then he can use the power of this clause to restrict the use of funds in any particular area.
We have tried to use the language as simple as possible to make the entrepreneurs understand the important aspects while raising investment. Apart from the above, there are certain other clauses are also there which can also prove vital in your business. It is your business, it is your world, be cautious and go and win the world.
Disclaimer: This is only about information and does not purport to be specific legal advice. For any specific query, readers are advised to contact their legal consultants. [If you wish to share your expert opinions with our community, do get in touch with us at editor@startupfreak.com]
