Exit Strategy for Minority Shareholders in a Shareholders Agreement

Shareholder’s dispute is one of the prime problems of the corporate world across countries, at later stages, millions and billions are spent by the Investors in order to secure their interest in the company through Litigation with the uncertainty of Justice. Supreme Court of India held in the Needle Industries case directed the minority Indian shareholders to purchase shares held by the majority foreign shareholders, however, in the subsequent case of Yashovardhan Saboo that it is the majority that has the right to purchase the shares of the minority, labelling that majority rule is the “hallmark of democracy”. Hence, very little certainty is provided by the current active laws for minority shareholders to secure their interests in the company.

A widely accepted industry alternative has been to mitigate such risk at earlier stages of its arousal in order to make a smooth entry and exit for Investors while bagging the profits and avoiding the legal risks. This article aims to analyze such legal risks that an investor may face as a minority shareholder and precautions which helps such shareholder to smoothly exit such businesses.

Analysis of Legal Risks involved in Exit of an Investor

A corporation can modify its objectives from what is declared in the Red Herring Prospectus once a shareholder resolution is passed by the majority shareholders, according to current standards. However, there are no safeguards for minority stockholders. However, under the revised proposal, promoters would be required to acquire its minority position in the event of a post-IPO change in plans that the latter deemed undesirable.

This varies slightly, but the current system is not making the necessary progress. One of the safeguards for minority owners is the Takeover Code of 2011. In the most basic terms, a takeover bid is defined as the acquisition of voting shares with the express goal of acquiring control of the company’s management and affairs, either directly or indirectly, these purchases might be amicable or aggressive.

In general, a “takeover” refers to the acquisition of control over the assets or management of one firm by another, either directly or indirectly, through a transaction or series of transactions. Minority shareholders’ rights are primarily protected by three principal statutes and regulations: the Companies Act, 2013, SEBI Takeover Code, 2011 Regulations, and the Listing Agreement. While laying out the numerous rules to control acquisition and takeover plans in India, the SEBI Takeover Code, 2011 Regulations takes into account one of the most fundamental corporate governance concepts, “protection of minority shareholders.” Majorly, the code ensures that the stakeholders of the company are not refused the opportunity to look into their stature, i.e., the merits and demerits that the deal of acquisition or takeover has to offer and get an equitable and fair treatment from the acquirer company as well.

The rationale behind the exit opportunity is that same should be naturally provided when the change in control of the company, because of the restructuring schemes, is value-reducing for the minority shareholders. Whereas, in cases where the change is value-enhancing, the same change of control should not be impeded. The law provides some limited protection to minority shareholders; nevertheless, what the law does not offer should be covered by a contract, namely the Shareholder Agreement between the Shareholders and the Investor who decides to participate as a minority shareholder.

A shareholders’ agreement (SHA) is essentially a contract between some or all of the shareholders in a corporation, with the intention of conferring rights and imposing duties in addition to those given under company law. In contrast to the company’s articles of organization, which are a public document, the SHA is a private contract between the shareholders. Because it is a private contract, it only binds the parties to it, not the remaining shareholders in the firm. Shareholders can enter into any agreement in the best interest of the company, but the provisions in SHA cannot be contrary to the articles of association. Here are a few important clauses that secure the shareholder’s interest in such an agreement:

Fundamental Disputes: Disputes amongst shareholders can sometimes escalate to the point where a deadlock arises, which is unresolvable and has the potential to seriously harm the firm as a going concern. This might involve a disagreement over new funding for the firm, an increase or decrease in the number of shares, the payment of dividends, or a conflict over the sale of the business. A “fundamental disagreement” provision can be utilized in this scenario to give an escape plan by incorporating a mechanism for one or more shareholders to buy out the others. As previously stated in relation to limits on the transfer of shares, there might be an independent valuation or a pre-determined methodology.

If an agreement cannot be reached, a “shotgun” clause is also an interesting (but somewhat dangerous) valuation method, whereby if one shareholder makes an offer to purchase the shares at a certain price, the other shareholder can either sell their shares or purchase the offeror’s shares at that stated price.

“Good Leaver” and “Bad Leaver” provisions address the issue of what to do when stockholders quit the firm for various reasons, some of which are less blameworthy than others.

For example, Bad Leaver provisions require shareholders to transfer their shares back to the firm at the amount they paid for them or market value if they are dismissed owing to a serious violation of contract, misbehavior, or before completing a crucial milestone (whichever is lower).

In contrast, Good Leaver provisions may oblige a shareholder to sell their shares to the firm or another party if they are dismissed or leave the company by no fault of their own and/or after meeting certain milestones.

Tag Along/ piggyback Clause safeguards a current shareholder from being forced to participate in the partnership with new investors. If a third party makes an offer to buy a majority or controlling shareholder’s shares, the other shareholder might force the third party to buy their shares on the same conditions. Minority stockholders are often seen to benefit from this provision.

Drag-Along Clause is the inverse of a piggyback clause in that it requires a minority shareholder to sell their shares to a buyer who wants to buy all of the company’s shares under the same conditions and for the same price as a majority shareholder. It permits the majority of owners to capitalize on a favorable chance to sell the company.

 Deadlock Resolution Clause: This sort of clause is useful in describing the circumstances under which shareholders may be able to activate certain of the shareholder agreement’s departure clauses, such as a shotgun clause. It would be useful in clarifying the conditions under which a company is regarded to be in a stalemate.

Timing your Exit Plan

Timing involves factors such as expected benchmarks which the investee company is to achieve in its business plan, and the expected level of return that the venture capitalist wishes to achieve. However, this time varies from business to business and there is no straight jacket method to define the right time to exit however, an exit timing can be classified into two approaches, a conservative and a liberal approach. In a conservative approach, the investor will try to exit as soon as his target is reached without any further expectation and revision of his shareholder’s agreement. This may cause the investor to sacrifice some future profits that the company may have provided. On the other hand, an investor with a liberal approach shall hold as per his needs and focus on securing his interests on each revision of their shareholder’s agreement and at the time of the entry of a new investor. This may provide higher profits in case the company keeps growing but the possibility of risk will be liquid at all times with the entry and exit of new investors.

CONCLUSION

The traditional corporate norms of centralized control, majority rule, and a presumption of the corporation’s permanence expose minority shareholders in a close corporation to possible abuse from majority shareholders, a condition that reflects the fact that the relationship among participants in a close corporation is not that contemplated by the norms. Apart from acclimatizing their populace to a diet of buzzwords, steps have been taken by the more developed Indian economy to establish regional bourses, aimed at early-stage companies with high growth potential. Exit plans are the way to exit the business and get the profits without undertaking any long-lasting liability from the investee company and shall be only done under the supervision of legal and business professionals. Khurana & Khurana has a well-established corporate and commercial practice wherein we advise and draft company law and document your transactions through drafting and vetting contracts as per industry standards, henceforth, can be of great help to an existing minority shareholder looking to exit his firm.

Author: Ravi Raj (Legal Intern), Co-Author- Ajay Kacher – Legal Associate , in case of any queries please contact/write back to us at support@ipandlegalfilings.com or   IP & Legal Filing.