Key Terms of Shareholder Agreements for Investment

1.            Overview

A shareholder agreement is an agreement between the shareholders of a company.

Shareholder agreements establish additional rights and obligations between the shareholders themselves, and supplement the rights under Articles of Association. As Articles of Association are public, often the shareholders wish to set out certain rights in a private Shareholder Agreement.

The Shareholder Agreement is an enforceable contract in its own right and can be enforced even if the Articles of Association contains different provisions. The best practice to follow is to make sure that the Shareholder Agreement and the Articles of Association are aligned and provide the same terms for the same subject matter.

Also, a Shareholder Agreement will contain a provision requiring the shareholders to approve changes to the Articles of Association to remove inconsistencies with the Shareholder Agreement.

The most negotiated terms in a Shareholder Agreement for investment are:

1. Corporate governance
2. Information rights
3. Anti-dilution rights
4. Share transfer restrictions and rights
5. Liquidation preferences

2.            Corporate governance

A Shareholder Agreement will set out terms regarding the corporate governance of a company.

You will typically see terms regarding the holding of board meetings (such as frequency and quorum), composition of the board, and board reserved matters. Investors will seek seats on the board and a quorum that includes their appointed director. This will give the appointed director a deeper insight into the operations of the business and the appointed director will participate in critical decisions. This is an important issue for founders as founders will wish to maintain control of the board of directors so that the founders can continue to operate the business with reasonable freedom.

In respect of shareholder governance, you will see the quorum of shareholders meetings and shareholder reserved matters. Shareholder reserved matters are a list of actions that the company can only take with the appropriate prior approval threshold set out in the Shareholder Agreement. This will typically require approval from the share class in which the investor has subscribed even though those shares may represent a minority shareholding in the company.

3.            Information rights

Under the Hong Kong Companies Ordinance, a minority shareholder has limited access to information of a company. Therefore, investors will seek additional information rights in the Shareholder Agreement. These rights can include rights to unaudited accounts, rights to inspect records, and rights to receive copies of budgets and business plans of the company.

4.            Anti-dilution rights

Anti-dilution provisions are clauses to allow an investor a right to maintain their percentage or value of their ownership in a company if the company issues new shares. Investors will seek two types of anti-dilution protection: rights of pre-emption and down round protection.

Under a pre-emption right, the company must first offer new shares to investors on the same terms as it intends to offer new shares to other persons. The offer will be in such amount of new shares as will allow the investor to retain its current percentage shareholding once the share offering is completed and fully subscribed.

A down round occurs if the company issues shares in a fresh round that is at a lower price per share than in the previous round. An investor may require protection that requires the company to either issue new shares without fresh capital as if that lower valuation applied when the investor originally invested, or alternatively to adjust the conversion ratio for the investor’s shares so that the investor will receive additional shares on conversion of their shares from preferred shares to ordinary shares in a liquidity event.

5.            Share transfer restrictions and rights

There are various share transfer rights and restrictions such as rights of first refusal, co-sale rights and drag along rights. These will apply in respect of secondary transactions when founder shareholders wish to transfer shares in the company to others.

Under a right of first refusal, a founder shareholder who receives an offer for his shares from a third party must first offer those shares to the existing shareholders who will have the right to accept or refuse this offer before the third party buys the shares. The terms will be the same as those offered by the third party.

Under a co-sale right, after a first refusal process, if a founder shareholder proceeds with a sale of shares to a third party, then an investor can require that a pro rata proportion of the investor’s shares are included as part of the sale of shares to the third party. This will allow a partial exit by the participating investor but will deprive the founder shareholder of selling his full desired number of shares in the transaction.

Under a drag along right, if a majority shareholder or a majority of the shareholders choose to sell their shares, they can force the minority shareholders to also sell their shares. This is a useful mechanism as, often in a trade sale, purchasers want 100% ownership of the company. The majority shareholder can use the drag-along right to force all the minority shareholders to sell their shares so that the purchaser can buy all the shares of the company. This prevents minority shareholders from blocking the sale of a company. Care should be taken to consider who can exercise the drag along right. As it is a majority shareholder right, it should be the founders who hold this right. Investors will typically require that a threshold valuation and threshold percentage investor approval is obtained before the drag along right can be exercised against them.

6.            Liquidation preference

Liquidation preferences are common rights given to holders of preferred shares. The liquidation preference defines preferential rights of distribution arising from a liquidity event, such as a trade sale. The liquidation preference will define the share of investors in the proceeds of a liquidity event by reference to a prior right to receive amounts before other shareholders (the preference), and then whether the investor will continue to participate pro rata with other shareholders once its preference is satisfied (participation right).

A common liquidation preference is a 1X participating preference. An investor who holds this preference will be paid from the proceeds of a liquidity event the full amount he originally paid for the shares in the company, before and in priority to shareholders who do not hold this preference. Then, once his prior right is satisfied, the investor will continue to share (or participate) in the remaining distributions on a pro rata basis as if he was an ordinary shareholder. A shareholder agreement is a technical and complex agreement, and Shareholder Agreements used in venture capital financing have additional special features. Even for topics in this article, there is a range of drafting choices to suit each case and for which specific legal advice is needed. Parties must seek legal advice before signing a Shareholder Agreement.

Tara Chan

If you would like to discuss any of the matters raised in this article, please contact:

Pádraig Walsh
Partner | E-mail

Disclaimer: This publication is general in nature and is not intended to constitute legal advice. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.