Shareholders agreement drafting in IndiaThe clause set, the articles amendment, and the FEMA layer if the money is foreign.

At a glance

What a shareholders agreement does that the articles do not

The articles of association are the company's constitution: a public document, filed with the Registrar, that binds the company and its members. A shareholders agreement is a private contract between the shareholders, and usually the company as well.

Each does something the other cannot.

In practice you need both, and the drafting job is to decide which clause goes where. If the company is not incorporated yet, start with private limited company registration.

Why the articles have to be amended

This is the question that decides whether an agreement works, and it is where copied templates fail.

The starting point is that a contract binds its parties. The proviso to section 58(2) of the Companies Act, 2013 provides that "any contract or arrangement between two or more persons in respect of transfer of securities shall be enforceable as a contract", and Indian courts have upheld arrangements of that kind between shareholders: a right of first refusal was held valid in Messer Holdings Ltd v Shyam Madanmohan Ruia, the position that shareholders may contract with each other so long as the arrangement conforms to governing law was confirmed in the Bajaj Auto and Western Maharashtra Development Corporation line, and the NCLT has accepted contractual pre-emption rights under the 2013 Act.

So the answer to "is my SHA enforceable" is yes, between the people who signed it. What is not settled is the company's position. Different High Courts have reached different conclusions on a restriction that appears only in the agreement, which is why commentators continue to ask for the point to be put beyond doubt by statute.

We do not draft on an unsettled point. The rule we apply:

• A clause the company must act on goes in the articles. Restrictions on registering a transfer, pre-emption, the composition of the board, and anything the board or the company secretary has to refuse or permit.
• A clause between shareholders stays in the agreement. Reserved matters as an obligation on the investor's shares, anti-dilution formulas, information undertakings, non-compete, warranties and indemnities.
• A private company already has the hook. The articles of a private company restrict the right to transfer its shares, so the transfer machinery has somewhere to live.
• The amendment is a real filing, not a formality. Alteration of the articles needs a special resolution under section 14, and the resolution is filed in Form MGT-14 within 30 days under section 117. See change to MoA and AoA, and budget the ROC fee.

An SHA signed on Monday with an articles amendment nobody ever filed is the single most common finding in the due diligence exercise three years later.

The clause set

Control: board seats, observers and reserved matters

Board seats and reserved matters have to be read together. One without the other tells you nothing about who controls the company.

• Board composition. How many directors each side appoints, who chairs, whether the chair has a casting vote, quorum, and whether an investor director must be present for the quorum to be valid. That last one is a control right disguised as housekeeping.
• Observer rights. A seat at the table without a vote or a director's liability. Often the better answer for a small investor.
• Reserved matters. The list of decisions that cannot be taken without the investor's consent, as an affirmative vote at the board, at the general meeting, or both. Typical entries: issuing shares, borrowing above a limit, changing the business, selling assets, related party transactions, the annual budget, senior hires, litigation above a threshold, winding up.
• The length of the list is the negotiation. A long reserved matters list combined with board seats can hand over control on economics that still look founder friendly. Keep the list to decisions that really do protect the investment, and put a threshold on every money item so it does not catch ordinary trading.
• Where it goes. The board composition and the consent requirement belong in the articles as well, because the company has to be obliged to refuse a resolution passed without the consent.

Economics: anti-dilution and liquidation preference

These are the clauses the term sheet named and the agreement actually implements. We do not re-argue them here, because the negotiation happens before this document: see term sheet review for the clause-by-clause analysis and the worked arithmetic.

What the agreement has to get right:

• The anti-dilution mechanism, written as a formula, not as a label. Full ratchet and broad based weighted average produce very different numbers on the same down round.
• How the adjustment is delivered, which in an Indian private company means an issue of further shares or a conversion ratio adjustment on convertible instruments, each with its own approval and pricing steps. Where the issue needs headroom in the authorised capital, see increase in share capital.
• The liquidation preference waterfall, stated as an order of payments with worked definitions, including what counts as a liquidation event.
• The ESOP pool, and whose shareholding it is carved out of: see ESOP scheme drafting.

Transfers: pre-emption, right of first refusal and right of first offer

Three different rights, often used loosely.

Drafting points that decide whether these work: the notice periods and how they are served, what happens if only part of the offer is taken up, whether the right applies to a transfer to an affiliate or a family member, and the lock-in period during which nobody may sell at all. Every transfer that does complete still has to be executed properly: Form SH-4 delivered to the company within 60 days of execution under section 56(1), with stamp duty at 0.015% of the consideration. See share transfer, and, where the holding must be dematerialised before a transfer, demat of shares.

Drag along and tag along

The two most misunderstood clauses in the document.

• Tag along protects a minority. If a majority shareholder sells, the minority can require the buyer to take their shares too, on the same terms. Without it, the majority exits and the minority is left with a new controlling shareholder they did not choose.
• Drag along forces a minority. If holders above a stated threshold accept an offer, they can require everyone else to sell on the same terms. Without it, one small holder can block a sale of the company.
• The threshold is the whole clause. A drag that an investor can trigger alone means a sale can be forced at a price the founders would not accept. A drag that needs the founders and the investor together is a different document.
• Both belong in the articles too, because the company has to be obliged to register the resulting transfers and to refuse a transfer made in breach.

Exit

An investor is buying an exit, so the clause is always in the document. What it can promise depends on who the investor is.

• The usual ladder: a listing, a trade sale, a secondary sale to another investor, and a buy-back or promoter purchase as the fallback.
• Obligations, not outcomes. The enforceable version is a set of obligations to cooperate: appoint a banker by a date, run a process, provide information, not obstruct. A clause that promises a price or a date is the one that fails.
• Buy-back is not a signature. A company purchasing its own shares has to meet the conditions the Companies Act, 2013 sets for a buy-back. Where the fallback is a promoter purchase instead, say whose obligation it is and how the price is fixed.
• If the investor is a non-resident, read the FEMA section below before agreeing any exit price mechanism.

Information, warranties and the housekeeping clauses

The clauses nobody negotiates and everybody later relies on.

• Information rights. Monthly or quarterly management accounts, audited financials by a date, the cap table on request, and access to books. Say what is provided, in what form and by when, so the obligation is capable of being met.
• Warranties and indemnities. Usually in the share subscription agreement rather than the SHA. Whichever document carries them, cap them and time-limit them.
• Confidentiality, and what may be disclosed to the investor's own investors.
• Non-compete and non-solicit on the founders. Enforceable while they are engaged; a post-exit non-compete is generally void to that extent under section 27 of the Indian Contract Act, 1872. See founders agreement.
• Governing law, and either a named court or arbitration with a named seat. Name the seat, not only the venue, because the seat decides the supervising court.
• Deed of adherence, so a new shareholder is bound by the same agreement without renegotiating it.

When the investor is a non-resident: the FEMA layer

The moment any investor is a non-resident, a second rulebook applies to the same transaction, and two clauses in the agreement have to be drafted against it. This is the part founders are most often surprised by.

Pricing

For an issue of equity instruments to a person resident outside India, the price must be not less than the fair value worked out on an internationally accepted pricing methodology on an arm's length basis, certified by a Chartered Accountant, a SEBI-registered merchant banker or a practising cost accountant. The valuation certificate must not be more than ninety days old as on the date of the investment. See valuation under Rule 11UA for the certificate.

For convertible instruments, the conversion price or the formula has to be determined upfront, and the conversion price cannot be lower than the fair value at the time of issue. Fully and mandatorily convertible preference shares and debentures are equity instruments for these purposes, which is why a CCPS round is treated as equity and not as debt.

On a transfer of shares from a resident to a non-resident, the price cannot be below fair value on the same basis, with the certificate again not older than ninety days. A transfer from a non-resident to a resident is subject to its own pricing rule in the other direction, and we confirm the applicable position before the transfer is priced rather than stating a figure here.

The drafting consequence: the agreement should tie every issue and transfer price to a valuation obtained on the correct basis and within the ninety-day window, and should not fix a rupee price in a clause that will be performed months later.

Reporting

See FC-GPR filing and FDI reporting and FC-TRS for the procedure and the documents. The agreement should put the reporting obligation on a named party with a deadline, because the late submission fee is paid by whoever was supposed to file.

Exit clauses that FEMA will not carry

This is where a template drafted for a domestic round becomes a problem.

An exit clause that guarantees a non-resident investor a return, or fixes a price that ignores the pricing rules, cannot be performed lawfully when the time comes. A put option against the founders or the company, exercisable at a pre-agreed price years later, has to be tested against the pricing rules that will apply on that future transfer, not against the price the parties liked at signing.

What we do instead: draft the exit as obligations to run a process, tie any price to a valuation obtained on the prescribed basis at the time of the exit, and say expressly that performance is subject to the applicable FEMA position and to the necessary approvals. An exit clause that is honest about this is worth more than one that promises something nobody can deliver.

Two equal shareholders, and deadlock

A 50-50 company with no mechanism cannot act, because neither shareholder can pass a resolution alone.

If that is your structure, the agreement has to carry a deadlock route, and it has to be drafted to work inside a private company's transfer restrictions rather than copied from a foreign precedent. The usual ladder is escalation to a named advisor or mediator, then a buy-out mechanism, then a wind-up as the last resort. Whichever mechanism you pick, the machinery for the resulting transfer, being the pre-emption route, the valuation basis and the SH-4 execution, has to be in the articles as well or the company is not obliged to give effect to it.

Fees

How we do it

Step 6 is the difference between a signed agreement and an enforceable one, and it is where a document-only provider leaves you.

What we need from you

• The term sheet, if there is one, and any draft the investor has already sent.
• The current cap table, including convertible instruments, ESOPs granted and anything promised but not issued.
• Who the investor is, and whether they are resident in India. If not, their jurisdiction, and whether the investment is coming as equity, CCPS or CCDs. If the investor asks for a holding structure abroad, see Singapore holding company.
• The board you want after the round, and the decisions you are willing to give a consent right over.
• Any existing agreement between the founders or with an earlier investor, because the new document has to sit on top of it without contradicting it.
• Whether a valuation has been done, by whom and on what date, because the ninety-day window matters.
• Whether the round includes a financial due diligence exercise, and the report if there is one.

Mistakes we see in shareholders agreements

1. The articles were never amended. The agreement says the board must refuse a transfer; the company has no obligation to, and the transfer is registered.
2. A drag along the investor can trigger alone. A sale of the company can then be forced at a price the founders would not accept.
3. A reserved matters list with no thresholds. Ordinary purchasing decisions need investor consent, and the company stops moving.
4. An exit clause that promises a price. Especially with a non-resident investor, where the pricing rules at the time of exit decide what can lawfully be paid.
5. A rupee price fixed in a clause performed months later, with no link to a valuation obtained within the ninety-day window.
6. Anti-dilution written as a label, not a formula. "Standard anti-dilution protection" is not a term; full ratchet and broad based weighted average are.
7. No deed of adherence. Every new shareholder becomes a fresh negotiation.
8. Venue named instead of the seat. The seat of arbitration decides the supervising court, and naming only a venue leaves that open.
9. The reporting obligation left unassigned. The late submission fee is paid by whoever was supposed to file, so name them and give them a deadline.

Why founders and investors use Regikart

Regikart is a CA and CS firm with 250+ clients. The agreement is drafted and issued by an advocate we work with. Regikart works out the company-law and FEMA mechanics, the cap table arithmetic and the articles amendment, and does the filings that make the document operate.

• We draft the clause map before anyone drafts the clauses. What goes in the agreement, what goes in the articles, and what the FEMA layer adds.
• The arithmetic is done by the people who do it for a living. Dilution, the option pool, the liquidation waterfall and the anti-dilution formula, worked on your actual cap table.
• The FEMA layer is not an afterthought. Pricing basis, the ninety-day valuation window, FC-GPR and FC-TRS deadlines and the late submission fee are priced into the plan, not discovered after allotment.
• The follow-through is included in the scope: the special resolution, MGT-14, the register of members, the valuation certificate and the RBI reporting.
• Offices in Kolkata (Head Office), Delhi and Bengaluru, with clients across India served online. Call or WhatsApp +91 70444 94804, or email [email protected].

Related: term sheet review · founders agreement · change to MoA and AoA · FC-GPR filing · ESOP scheme drafting · share transfer