Tag: shareholders

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Corporate

Governance rights, anti-dilution rights, exit mechanisms and other key elements of a shareholders’ agreement

PrivateEquityLawyer_AngiraSinghviShareholders’ agreements govern the rights and obligations of the shareholders. The company is also made a party to such agreements so as to make it binding on the company. Among other things, they set out the various rights of shareholders and provide for the conduct of business, the transfer of securities, and how to resolve deadlocks. Often, the company is also made a party to such an agreement and in an investment transaction, this is done at a “closing” by holding board and shareholders’ meetings that result in the amending of the original articles of association.

Governance rights

These rights set out the level of control that a private equity investor may exercise in the management of the target company.

The common methods of exercising control include:

– the ability to appoint the investor’s representatives to the board

The number of such representatives depends on the level of investment. In cases where the number of representatives is less than 50 per cent but more than 20 per cent, the investor attempts to ensure that the quorum required for any meeting cannot be complete without some or all of its representatives present and voting.

Where the parties cannot agree on such compulsory quorum requirements, a list of “affirmative vote” items is set out. These are items that the board cannot take a decision on without the investor’s consent. Some common “affirmative vote” items include entering into key agreements, the appointment of key personnel, the incurring of indebtedness and creation of security, and bringing about any changes to the business. How comprehensive this list of items is, also depends on the negotiations and the investment. For most startups, the investment is low and their independence in relation to the operations of the business is often instrumental to a transaction. Achieving a balance between such independence and the security of investment is a key point in the negotiations.

– provision of voting rights

In most cases, since the money is routed through a tax-friendly jurisdiction, investment is made in the form of compulsorily convertible instruments with a conversion pricing formula. This means that the instrument shall convert into equity at a later time (with a specific conversion event that should be clearly set out) under a formula that the parties agree on.

Until recently, it was assumed in the agreement that the instruments have already been converted into equity. The proportion of the investors’ (assumed) holding in the entire shareholding of the company would entitle the investor to exercise higher voting rights. After recent amendments to the company law however, only equity shareholders are entitled to vote. It is not clear whether convertible instrument holders can exercise their right to vote in the company. This may have substantially curtailed the voting rights of private equity investors. So while it may be safe(until challenged) to retain in the agreement, voting rights on the basis of an assumed conversion, there may even be a case to increase control at the board level until there is more clarity in the law.

Anti-dilution rights

Usually, in any investment transaction, it is stipulated that if the company carries out a share split, issue of bonus shares, consolidation of shares, combinations, recapitalisations or any similar event that may result in the dilution of the shareholding of the investor, including the issuance of any securities by the company, then the investors will be protected against any dilution of its shareholding in the company. For instance, it may be provided that the company shall take all necessary steps (including but not limited to the issuance of new shares) to ensure that the investors maintain their shareholding at the level prior to the occurrence of such event, without any consideration. However, in a case where there is additional funding required by the company and a party provides for such funding without a similar contribution by the other party, dilution of the non-contributing party cannot be avoided.

Transfer of securities and exit mechanism

At the time of investment, the terms of exit are also clearly set out in the transaction documentation. Sometimes, in a joint venture or a private equity investment, some restrictions are placed on a party’s right to transfer shareholding because their involvement in the company has some value that is not monetary alone. The common forms of restrictions placed on the transfer of securities are lock-in, right of first refusal or offer, tag along rights, and drag along rights. Further, unless there is a sale of the entire shareholding of the company to a competitor, a part of the shareholding is not permitted to be sold to a competitor.

Lock-in refers to a period following the closing of a transaction during which the investor will not be able to sell his shares to a third party. This restriction is essential to maintain a sense of continuity and settlement to the business. In private equity transactions, the investor is not the person who intends to run the business of the company. It invests in the capabilities of the promoters to run the business in a particular manner. In some cases, the involvement of the promoters is key to business and it is not ideal if the promoters divest their shareholding and cease to be a part of the business mid-way through the investment cycle. Therefore, a private equity investor will usually require an undertaking from the promoters that they will not exit from the business of the company, including through the selling of any shares.

Rights of first refusal or offer, and tag along and drag along rights are particularly important when either party wishes to sell its stake to a third party. Prior to the conclusion of such a sale, any of these restrictions in the shareholders’ agreement will require the selling party to offer its shareholding, first to the other shareholder party at a price at which it was contemplating the sale to a third party. In several cases, the selling party provides the other shareholder party an offer at which a third party is ready to purchase its shares. The shareholder party then gets a right to either accept or refuse such offer. Upon a refusal, the selling party is free to sell those shares to a third party but not at a price lower than the price that was offered or provided to the other shareholder party.

Sometimes, when the sale of shares to a third party is acceptable, the other shareholder party is also entitled to sell its stake along with the selling party to such third party. It is often the case that when the promoter sells its stake to a third party, the investor is no longer keen to be in the company or may not be keen to maintain such a high stake in the company any longer and may “tag” its shares along for sale to the third party. This is usually when the promoter retains some shareholding in the company.

The sale of an entire shareholding (known as a buyout) is usually governed by different terms and the provision of drag along rights are very common in such cases. Drag along rights refer to a right where a selling shareholder is entitled to drag the shares of the other shareholder and sell them to a third party at the same price and terms as that of its shares.

Exit rights

In mature private equity transactions, the investor is provided a basket of exit rights including taking the company to an initial public offer where preference is sometimes given to investors’ shares. There may also be provisions for the protection of investors’ money when things go wrong with the target company, a consideration that also influences the investor’s choice of instrument. In private equity transactions, usually, an internal rate of return or a pricing formula based on an acceptable manner of share valuation is determined at the very outset. At the time of exit, a put option is provided to the investor through which it can sell its shareholding to the promoter this pre-determined valuation. On some occasions, parties also have a call option where the other party’s shares may be purchased at a pre-determined value.

 

Angira Singhvi is a Partner with Khaitan & Khaitan and handles general corporate, joint ventures and private equity investments.

Categories
Corporate

All you need to know about drafting put and call option clauses

Drafting_for_Business_Deepa_Mookerjee.jpg“Call options” and “put options” are used frequently in shareholders agreements. As you know very well by now, a shareholders agreement specifies the rights and obligations of shareholders and sets out the manner in which the company will be governed. We have already seen some vital clauses used in these agreements such as condition precedent clauses and restrictions placed on the transfer of shares. Let us now look at “call” and “put” options.

Simply, a call option is a right but not an obligation to purchase shares at a specified price, on the happening of a specified event. If A and B are two investors in a joint venture company, A may have a call option over twenty-six per cent of the shares held by B, which he can exercise once the limit on foreign direct investment (“FDI”) is raised. This means that once the FDI cap is raised, A has a right to purchase twenty-six per cent of the shares held by B. If A exercises this right, B cannot decline to sell the shares to A.

A put option on the other hand, is a right but not an obligation to sell shares upon the occurrence of a specified event at a specified price. If A has a put option over twenty-six per cent of his own shares in the company that he can exercise once the company is insolvent, it means that if the company declares insolvency, A can sell his shares to B. Once A exercises his put option, B cannot decline to purchase A’s shares.

Junior lawyers should understand these mechanisms well because they can be used in a shareholders agreement in various scenarios. To think that call and put options are only useful in an FDI limit scenario or an insolvency situation (as discussed above), would be incorrect. Let us first go through some scenarios to understand how they may be useful.

Versatile options

Assume that there are two shareholders in a joint venture company – A and B. You are representing ‘A’. A comes to you with a simple question – what if B commits a material default of the provisions of the shareholders agreement and is unable to cure the defect or default? What are the options available to A?

PutAndCallOptions_ShareholderAgreementsYou can tell A that he can either ask for a mechanism by which he can sell his shares and exit the company (a put option) or a mechanism by which he can insist that B exits (a call option), when the material default occurs. The latter mechanism means he can continue in the company and ask B to exit. If you know these mechanisms well, you can give your client two options – either continue in the company and buy the other party’s shares (by exercising the call option) or sell his shares and exit the company (by exercising the put option).

Take another scenario. Suppose your client would like to continue as a shareholder in the company only if the company generates a certain amount of revenue after a specified period (say five years). If not, your client would like to exit. If you know what a put option is, you can simply suggest that your client include a put option over his own shares.

These two mechanisms can therefore be used throughout shareholders agreements to address different scenarios and the various needs of your client. There are some points that you should keep in mind while drafting them.

1. Be precise about whether your client has a right to sell shares or is under an obligation to purchase shares. Use words such as ‘right’ and ‘obligation’ wisely to ensure that the burden is being placed on the correct party.

2. Specify the amount or percentage of shares that are subject to the call or put option. At the time of enforcement, there should be no confusion on the amount of shares that can be sold or bought.

3. Remember, contractual arrangements can work in many permutations and combinations. For instance, if you are drafting a put option clause, it is not necessary that the shares always need to be sold to the other parties in the shareholder agreement. You can also have a right to sell your shares to a third party of your choice. Similarly, it is up to the parties to decide whether the option should apply to a part of the shares or all the shares that a party holds. As a lawyer, you should advise your client about the most appropriate form of the clause depending upon his or her intentions.

4. As always, the letter of the law plays an important role. For instance, the Reserve Bank of India has made it clear that a non-resident investor should not be guaranteed any assured exit price at the time of making an investment. The exit price must be a fair price calculated according to the prescribed guidelines and at the time of exit. Keep this in mind when you draft a put option for a foreign investor and always know the correct legal position before drafting.

5. Always flesh out the manner in which the clause will work. For instance, if your client has a call option on the shares held by the other party, you should specify the manner in which your client should send a notice to the other party indicating his or her intention to exercise the call option (known as a call option notice), the time period within which the other side must respond (the call option period), the price at which shares will be sold (the call option price), and the maximum time period within which the sale must take place. Specifying these details makes it simpler to execute the sale and implement the clause effectively.

Remember these basic points while drafting. Make sure that you are always clear about what a clause is intended to achieve. Take the time to understand the needs of your client and draft accordingly.

(Deepa Mookerjee is part of the faculty on myLaw.net)

Categories
Corporate

A brief history of the evolution and purpose of the Board of Directors

CompanyLawMatters_TanikellaRastogi_2Every practitioner of corporate and commercial laws will appreciate the increasingly important role and purpose of the board of directors (“BoD”) of a corporation. In India, as well as globally, the director is no longer a mere agent or nominee of the shareholders of a corporation. With the advent of independent directors, they are in effect, more akin to trustees of shareholder wealth and are answerable to public ownership. A practicing corporate attorney will need to answer several queries about the decisions and deliberations of the BoD and merely applying the law at hand may not always suffice. To make better decisions, it is also important to understand some of the principles and socio-economic factors that have guided the development of the law of business organisation.

The most basic constituent of any economy is the market, which comprises individual participants and the trade of goods and services. As economies grow however, individual participants alone cannot sustain the production of the goods and services needed to meet the growing demand. The capital and the resources employed by individual participants will necessarily be diversified and redeployed to cater to the increased demand. Thus pressed, the entrepreneur will seek out forms of business organisation that will most efficiently enable him to continue providing goods and services at a greater scale.

Separation of ownership and management

Law_of_agency_businessorganisation.jpgA direct consequence of the growth of a market economy is the separation of the actors involved in securing the capital of a business from those who specialise in employing the capital towards the production of goods and services. The simplest (and hence probably earliest) form of such division was the relationship of agency. To regulate this important function, a great deal of care and development went into the establishment of the law of agency.

The agents were responsible for carrying out designated functions (such as the employment of capital) on behalf of the owner (principal). The law in turn recognised the presence of two distinct actors and, to align the interests of the agent and the owner to ensure the efficient running of a business in the overall interests of the market, the law developed to hold owners vicariously liable for the acts of agents in the normal course of business. Over time, to bring greater alignment between the interests of the agent and owner, the economic society recognised the formation of partnerships. In the partnership form, multiple owners could pool in resources, collectively manage the business and share liability for the debt of the business. As the partners are at once owners and agents there is an expectation of greater scale, efficiencies and reduced agency costs.

The evolution of limited liability

AdvancedProfessionalCertificationinCorporateLawPractice_apcclpNevertheless all of the above forms of business organisation were premised on individual liability for whole of the debts of the concern. Traditionally only specialised community businesses such as guilds shared features akin to limited liability. This led to demand for limited liability partnerships that is, where partners were not responsible for the personal debts of other partners but all the partners were responsible for the debt of the partnership. The relationship between personal debt and partnership debt, that is, questions of which creditors would be preferred while paying back the money if the partner and the partnership both became insolvent, was complex. There was a need for a form of business organisation where the personality of the business was also entirely separate from that of its members and the liability of the members would be limited to the amount contributed by them to the business. With such a model, creditors would be assured of the financial standing of the business before they provide any debt to the business. Moreover, the members would be saved from the unlimited liability to the creditors of the business. The industrial revolution and the increased trade between countries dramatically increased the scales of production and businesses. The increasing exchange of goods and services at a global level required more manpower and a higher commitment of capital. This in turn gave rise to a need for a form of business organisation that permitted hundreds or even thousands of people with varied roles to work together for the production of goods and services and profitability. At this scale, as I have discussed, the legal fictions of a separate legal personality and limited liability were required as in its absence, entrepreneurs were discouraged from scaling up and engaging in international trade. The earliest forms of limited liability corporations were established by the state using an institutional charter to provide legitimacy to a form of business organisation that would be distinct from its ownership in terms of personal liability.

The need to protect shareholder interests

Especially where the ownership had devolved to the public at large to gain greater access to capital, a natural corollary to the separation of functions in a corporation was the need to align the interests of the owners and the management of the business. Thus, a group of experienced persons were designated as nominees of the shareholders and held responsible for the decision-making of the corporation. These representatives of the shareholders of the corporation came to be known as the Board of Directors and provided overall direction and oversight of the corporation’s business. The actual deployment of resources was tasked to managers who were specialist employees.

This arrangement naturally involved a two-stage assessment of any decision — first by the BoD at the stage of making the decision and later, by the managers while implementing it. Since these were entirely different sets of people, the assessments would be without any influence. The relationship of between the directors and the corporation was one of agency and gave rise to fiduciary duties of the directors towards the corporation and the shareholders. Today, the duty to act in good faith, the duty to act in the interests of the shareholders of the corporation, the duty to act with due and reasonable care, skill, and diligence, and the duties regarding conflict of interest and related party transactions are some of the fiduciary duties imposed on the directors by virtue of their position in the corporation.

Shareholder_Directors_Management
The modern corporation is a separate entity in the eyes of the law and is governed by its charter documents. The directors act as the agents of a corporation and take decisions on its behalf. The managers execute those decisions. However, as the ownership of the corporation resides with the shareholders and as they are the ultimate beneficiaries of every decision, the centralised management, that is, the BoD chosen by the shareholders, tries to ensure that the interests of the shareholders are protected. Having a BoD eliminates the socio-economic costs imposed by the alternative of shareholders having to meet and approve each decision of the corporation. In turn, the shareholders, by approving the charter documents of a corporation and its by-laws, establish the constitution within which the directors may function. Whenever the directors act on behalf of the corporation and take decisions therefore, they have a duty to not act in violation of the charter documents. These documents set out the structure of the BoD, the manner of appointing directors, the term of the directors, and the committees that need to be appointed to enhance the working of the corporation.

Every decision taken by the directors must consider the interest of all the shareholders – whether they are majority shareholders or minority shareholders. The nature of limited liability corporations however, carries an inherent risk. The directors, since they are agents and lack personal liability, may not act as efficiently as required, leading to erosion of shareholder capital and discouraging further investment and eventually stifling the growth of the business. In this scenario, the executive management serves as the second level of assurance to the shareholders about the efficient functioning of the corporation.

We can now proceed to examine the evolution of the directors from being primarily agents of shareholders to trustees of shareholder wealth and corporate assets. The independent director, in this regard, is a creature of law established in recent times to ensure that the functions of the BoD are not impeded solely by the representation of majority shareholder interests.

References:

llan, Kraakman, Subramanian, Commentaries and Cases on the Law of Business Organization, (Wolters Kluwer, 2009) 3rd ed., at 98.

(Jitender Tanikella is a corporate and tax lawyer with an advanced law degree from Columbia University. Anirudh Rastogi is a general corporate lawyer with an advanced law degree from Harvard University. They are part of Tanikella Rastogi Associates.)