Drafting a Shareholders Agreement: The fundamentals (part 2)

shareholders
26 Jan 2024

In Part 1, we delved into the provisions that define the relationship between shareholders and the company.

With this article, we will consider the dynamics among the shareholders themselves. We will examine the important considerations surrounding pre-emptive rights, drag and tag-along provisions, buy and sell provisions and forced sale provisions.

Pre-emptive rights of shareholders

As Derick continues to navigate the complexities of drafting Vector AI’s Shareholders Agreement, he turns his attention to pre-emptive rights, a critical aspect often misunderstood due to general misconceptions about the Companies Act, 2008 (the “Act”).

Contrary to common belief, the Act doesn’t automatically grant shareholders pre-emptive rights when they intend to sell their shares to a third party. It merely states that private for-profit companies’ MOI restricts their securities’ transferability, but this doesn’t inherently include pre-emptive rights.

Understanding this distinction, Derick recognises the importance of explicitly including pre-emptive right provisions in the Shareholders Agreement. Such provisions are crucial in ensuring that existing shareholders have the first opportunity to buy shares before they are offered to external parties.

To illustrate how these provisions work, Derick considers a scenario within Vector AI, which has four shareholders (A, B, C, and D), each holding an equal 25% share. If Shareholder A decides to sell their stake, the pre-emptive rights clause in the agreement mandates that A must first offer these shares to B, C, and D.

The process unfolds as follows:

Notification: Shareholder A informs B, C, and D about their intent to sell, including sale terms like the share price.

Each of B, C, and D has the right to buy a portion of A’s shares proportional to their current holdings. This means they can each acquire an additional 8.33% (one-third of 25%).

B, C, and D must decide whether to exercise this right. They can buy the full amount they’re entitled to, a part of it, or none.

If all exercise their rights fully, they each gain an additional 8.33%, maintaining the ownership balance.

If only B, for instance, exercises the right fully, B could end up owning 50% of Vector AI, altering the company’s power dynamics.

If any portion of A’s shares remains unsold among B, C, and D, A can then sell that portion to an external party under the same terms.

By incorporating these pre-emptive right provisions, Derick ensures that Vector AI maintains a balanced ownership structure, allowing existing shareholders to protect their interests and potentially increase their stake in the company before any external involvement. This mechanism is key to Vector AI’s strategic planning in preserving internal control and stability.

Drag and tag-along rights

As Derick progresses with drafting Vector AI’s Shareholders Agreement, he turns his focus to the critical clauses of drag-along and tag-along rights, which play a pivotal role during the sale of a company. These provisions are essential for balancing the interests of different shareholders in significant transaction scenarios.

To illustrate these concepts in the context of Vector AI, let’s consider a hypothetical scenario. Vector AI has three shareholders: Shareholder A, who owns 50% of the issued shares, and Shareholders B and C, each owning 25%.

Imagine Shareholder A receives an offer to sell their 50% stake to an outside investor interested in acquiring the entire company. If Vector AI’s shareholders’ agreement includes a drag-along provision, Shareholder A has the ability to “drag” the other shareholders (B and C) into the sale. This obligation means that B and C must sell their shares under the same terms and conditions as A, facilitating the investor’s acquisition of the entire company. Drag-along rights are particularly advantageous for majority shareholders, like A, as they allow for a complete and efficient sale of the company.

Conversely, consider if Shareholder A receives an offer to buy their 50% stake, but the outside investor isn’t interested in purchasing B and C’s shares. In this case, if Vector AI’s agreement includes a tag-along provision, B and C have the right to join the sale and “tag along.”

This means they can sell their shares on the same terms as A. However, if the investor declines to purchase B and C’s shares, then A is restricted from selling their shares to the investor. Tag-along rights protect minority shareholders like B and C, ensuring they can capitalise on favourable sale terms secured by a majority shareholder.

In both drag-along and tag-along scenarios, these provisions ensure fair treatment for all parties involved in the sale of Vector AI. They provide a mechanism to balance the power dynamics between majority and minority shareholders, ensuring that the interests of all shareholders are considered during significant transactions. Derick’s inclusion of these provisions in the Shareholders Agreement signifies a well-thought-out strategy for handling potential future sales of the company, safeguarding both the company’s and shareholders’ interests.

Buy and sell provisions

Next, Derick addresses a critical aspect of corporate continuity planning: buy-and-sell provisions.

These provisions are activated in scenarios such as the death or incapacitation of a shareholder, a situation that can pose significant risks to the stability and control of the company.

Under these provisions, each shareholder of Vector AI, is required to take out a life insurance policy on the other shareholders. The structure of this policy ensures that the surviving shareholders are the beneficiaries. The policy’s coverage aligns with the value of each shareholder’s stake, ensuring that the buyout amount reflects the fair market value of the shares.

If a shareholder, say Shareholder B, were to pass away or become incapacitated, the buy-and-sell provision would be triggered. The surviving shareholders must use the life insurance proceeds to buy out Shareholder B’s shares. This mechanism provides immediate liquidity, making it feasible to acquire the shares without imposing financial burdens on the remaining shareholders.

One of the key reasons Derick considers this provision essential is its ability to prevent shares from becoming part of the deceased or incapacitated shareholder’s personal estate. Without such a provision, shares could pass to heirs or spouses with no interest or experience in Vector AI’s business. This could lead to complications in company governance and decision-making.

Forced sale provisions

As Derick continues to refine the Shareholders Agreement for Vector AI, he recognises the importance of including forced sale provisions.

These provisions are crucial for managing situations where a shareholder’s actions or significant changes in their personal circumstances could negatively impact the company.

Derick considers scenarios like a corporate takeover of a shareholder. For example, if an external company acquires Shareholder C, this might trigger a forced sale. The rationale is that the new controlling entity could have different objectives or strategies that might not align with Vector AI’s vision and operational philosophy.

Another situation Derick considers is where a shareholder faces financial issues leading to insolvency, liquidation, or business rescue. This could destabilise Vector AI.

Derick is also aware that any involvement of a shareholder in illegal or fraudulent activities poses a risk to Vector AI’s reputation and operations. The forced sale provisions would enable the company to distance itself from such shareholders, thereby protecting its integrity and public image.

Lastly, Derick considers the situation where a shareholder is an individual who is subject to a divorce order. In such a situation, there’s a risk that their shares might be transferred to an ex-spouse who is not part of the original agreement. Derick designs the forced sale provisions to prevent such unintended transfer of shares, ensuring that ownership remains within the intended group.

Incorporating these provisions into Vector AI’s Shareholders Agreement, Derick aims to mitigate risks that could arise from changes in the shareholders’ status or behaviour.

These provisions are not just protective measures but are essential for maintaining a structured and equitable approach to potentially complex situations. They ensure the company’s smooth operation and help preserve its value and strategic direction.

Conclusion

The above provisions strengthen Vector AI’s corporate governance framework and demonstrate a deep understanding of the complexities of shareholder relationships and their pivotal role in shaping a company’s future. Derick’s careful crafting of the Shareholders Agreement positions Vector AI for long-term success, equipped to navigate the dynamic and often unpredictable landscape of company ownership and management.

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(This article is provided for informational purposes only and not for the purpose of providing legal advice. For more information on the topic, please contact the author/s or the relevant provider.)
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