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.


Put and call options: New legitimacy but doubts remain

DeepaMookerjee.jpgIn what is being termed as an “investor friendly” move, the Securities and Exchange Board of India (“SEBI”), permitted put and call options in shareholders agreements through a notification dated October 3, 2013. It appears that it will help clear up some of the ambiguity regarding the validity of these options under Indian law.

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. Assume that there are two investors — A and B — in a joint venture company. A has a call option over twenty-six per cent shares held by B, which he can exercise once the foreign direct investment (“FDI”) cap is raised. This means that once the FDI cap is raised, A has a right to purchase twenty-six per cent shares from 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. Here, assume that A has a put option over twenty-six per cent of his own shares in the company. A can exercise this option once the company is insolvent. 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.

Historically, put and call options, along with other rights such as pre-emption rights and right of first refusal have been the subject of much controversy in India.

Prohibition under company law

Section 111A of the Companies Act, 1956 stated that shares of all public companies were freely transferable. Hence, any restriction on the transfer of shares (including options in shares) would be illegal. Since, put options and call options restricted a person’s right to transfer shares, such options were illegal. Based on this, some market players took the view that even though these options were prohibited in a public company, private companies were free to incorporate such conditions.

This issue has been put to rest in the Companies Act, 2013, which states in the proviso to Section 58(2) that any contract or arrangement between two or more persons in respect of the transfer of shares will be enforceable. Though there has been no formal explanation for its insertion, one could argue that the proviso recognises shareholders’ competence to contract. It appears therefore, that this proviso lends legal sanctity to put and call options, which are essentially agreements for the transfer of shares between shareholders.

Prohibition under securities law

The Securities Contracts (Regulation) Act, 1956 (“SCRA”) and the Securities and Exchange Board of India (“SEBI”) are the next set of roadblocks to these options. This is because, the SEBI had issued a notification in 2000, which provided that no person can enter into any contract for the sale or purchase of securities other than spot delivery contracts (Section 18, SCRA) or permissible contracts in derivatives. A “spot delivery” contract is one where the delivery and payment of shares takes place on the same or following day. (For a more detailed understanding of the development of the law, please look at Investment Agreements in India: Is there an “Option?”)

Through a number of decisions (the Cairn Vedanta case and the Vulcan case), the SEBI reiterated its view that call and put options were prohibited because:

  • they were not valid derivative contracts that can only be traded on a stock exchange (Section 18A, SCRA); and
  • put or call options give parties the right to trade on shares at a future date which makes it an invalid “spot-delivery” contract under Section 2 (i) of the SCRA.

Contingent contracts and the Bombay High Court

Securities-LawMoreover, the Bombay High Court in Niskalp Investments held that a clause permitting the buy back of shares if certain conditions were not met would be hit by the restriction in relation to spot delivery contracts. Contingent contracts were also therefore, hit by prohibitions on spot delivery contracts. One can argue that call and put options are contingent contracts that come into effect once they are exercised. Once exercised, the delivery of shares and payment can take place simultaneously. These clauses therefore, are not invalid spot-delivery contracts. This position gained legal backing in MCX Exchange, where it was held that options come into existence only once the option is exercised. Till such exercise, the option is not fructified and therefore not hit by the prohibition. From all this, it was clear that there was much judicial debate on this issue. No clear answer was emerging.

In its recent notification, the SEBI has permitted options in shares and rescinded its 2000 notification. Put and call options are now permitted provided the seller owned the “underlying securities” for at least one year from the date of the contract, the transfer is priced according to existing laws, and the underlying securities are delivered. This puts the controversy to rest as far as SEBI is concerned, to a certain extent.

The RBI’s view

The Reserve Bank of India (“RBI”) had also expressed doubts on put and call options. It felt that granting put options to non-resident investors was akin to a debt investment made by such an investor. This is because an investment backed by a put option meant that the non-resident was guaranteed a specific rate of return. Such a transaction would therefore need to comply with the External Commercial Borrowing (“ECB”) Regulations. In fact, the Consolidated FDI Policy of October 1, 2011 contained a provision that stated that equity instruments issued or transferred to non-residents having in-built options or supported by options sold by third parties would lose their equity character and such instruments would have to comply with the extant ECB guidelines.

Interestingly however, this statement was later deleted from the policy by a notification issued by the Foreign Investment Promotion Board. This led to further confusion. Did the withdrawal mean that the RBI had implicitly permitted these transactions or that it was simply a withdrawal due to public pressure? The RBI has not clarified matters and this confusion still exists. Therefore, even though listed companies may get the go ahead from the SEBI, the RBI may still be a roadblock.

The Bombay High Court, the RBI, the SEBI, and the Ministry of Corporate Affairs have all made their views on put and call options heard.
The Bombay High Court, the RBI, the SEBI, and the Ministry of Corporate Affairs have all made their views on put and call options heard.

To conclude therefore, the SEBI Notification has not put the controversy to rest. Since the SEBI Circular is only prospective, it only protects investments from October 3, 2013. Clarity is still required on the treatment of those arrangements entered into prior to October 3, 2013. Will those clauses be void?

Till these final issues are put to rest, the question mark still remains over the validity of put and call options.

(Deepa Mookerjee is part of the faculty on