Important Clauses To Look Out For While Raising Capital

A shareholder’s agreement is a contract between the shareholders of a company which sets outs their rights and obligations. It maps out how the company should be managed, establishes share ownership and share transfer rules and also provides for solutions to any disputes that may arise. 

During the registration of a company in Kenya, the Company’s Act requires the company to file its articles of association. A company’s articles of association specifies its operational regulations and defines the company’s purpose. It defines how the company should be run and it is, basically, the primary document that guides the daily running of the company. 

In contrast to the articles of association, the Company’s Act does not require a company to have a shareholder’s agreement, however, it is advisable. Further, the shareholder’s agreement is recognized as secondary to the articles of association and specifically governs the conduct of shareholders in relation to running of the company. However, the articles of association may take precedence should the shareholders agree as such, and in cases where the agreement is silent on certain matters, the articles take precedence and vice versa. These two documents complement one another on the daily running of a company. Whilst articles of association are compulsory public documents that have to be filled at the Company registry, a shareholder’s agreement is a private contractual document that need not be filled at the registry. The latter comes in handy especially when a new shareholder joins the company; for instance, when an investor takes an equity stake in the company. 

Important Clauses In The Shareholder Agreement

A shareholder’s agreement can have any number of provisions as it takes the form of a contract and the parties are free to decide what provisions to include. However, in an instance of a small company allocating shares to an outside investor, it is important to protect oneself and one’s interests. Amongst some key clauses to include are;

Management of the company

The shareholder’s agreement can and should make provisions on the composition of the board of directors and the appointment and removal of board members.  In some cases, majority shareholders may limit the participation of minority shareholders and may consequently restrict the right to board seats to persons with a specific shareholding limit. This clause can also protect minority shareholders by giving them rights to appoint board directors if they have reached the minimum shareholding limit.  

A restricted activity clause

Despite owning a percentage of the company, shareholders are usually not involved in the day to day running of a company. The shareholder’s agreement could have provisions that certain major decisions in the company such as taking loans or entering into contracts must be approved by the board either through a majority vote or a unanimous vote.

The board of directors hold a key position of authority in the company and such power ought to be regulated or provided for. A helpful clause would be one providing for an eventuality of death on the part  of a shareholder and on the running of the business thereafter. In this instance, the law provides that the legal title to shares in a company automatically passes to the deceased’s shareholder’s heirs. Many a times, the said heirs may lack the requisite skills or expertise to fill the shoes of the deceased in the business and the personal representatives may then be required to sell off the shares of the deceased to the surviving shareholders at an agreed upon price.

Pre-emptive rights (Right of First Offer and Right of First Refusal)

Pre-emptive rights protect the existing shareholders from the dilution of their stake in the company. The right of first offer clause will require that whenever the company issues new shares, they should first be offered to the existing shareholders before being issued to anyone else. The right of first refusal requires shareholders seeking to sell their shares to first offer their shares to fellow shareholders to purchase. If they fail to purchase the said shares, then they will be allowed to offer them to third parties. Alternatively, the selling shareholder may be required to first procure an offer from a third party and to make an offer to existing shareholders to purchase the shares on the terms and at the price the third party is willing to pay.

Anti-dilution clause 

Whenever new shares are issued in a company, the percentage of ownership by the existing shareholders reduces or, in other words, is diluted. There are some clauses that can be included in a shareholder’s agreement to protect existing shareholders. One method is a price-based anti-dilution clause and contractual based clause. 

Clauses on pre-emptive rights can provide some anti-dilution protection and may be drafted to provide that existing shareholders will have a right to purchase the newly issued shares in proportion to their current shareholding with the effect that shareholders retain the same percentage shareholding after the new issue. Therefore, the price based anti-dilution clause protects existing shareholders by ensuring that any new shares issued by the company are not sold at a price lower than what the original shareholders purchased them for. 

Another form of an anti-dilution clause would be to have a clause that ensures that if any additional stocks are issued, then the existing shareholders are issued additional shares in order to maintain their percentage of ownership.

Tag along and Drag along rights 

Tag along rights, also called co-sale rights, are, essentially, meant to protect a minority shareholder in a company, especially in the event that a majority shareholder wishes to sell their shares to a third party. A tag along right will then entitle the minority shareholder to participate in the sale at the same time for the same price of the shares; the minority shareholder ‘tags along’ with the majority shareholder’s sale. 

Tag along rights are usually worded to state that if the tag along procedures aren’t followed then any attempt to buy shares in the company would be invalid and the shares wouldn’t be registered. The importance of this clause is to protect the minority shareholders from being left behind when a majority shareholder decides to sell their shares. If a minority shareholder held 10% of the shares in a company, it would be difficult to sell as most buyers will want 100% of a company. This puts minority shareholders at risk of being forced to sell their shares at a price substantially lower or has no relationship to the actual value of the company.

Drag along rights 

These are the opposite of tag along rights and tend to favor majority shareholders in a company. A clause on a drag along right allows a majority shareholder of a company to force the remaining minority shareholders to accept an offer from a third party to purchase the whole company. In essence, the majority shareholder who is ‘dragging’ the other shareholders must offer the minority shareholders the same price, terms and conditions that the majority shareholder has been offered. For example, when a majority shareholder holding 75% of the shares in the company agrees to sell their shares to a potential buyer, they must offer the same price for the shares to the minority shareholders if they want to ‘drag them along’. This clause is very important especially when an outside party wishes to purchase the entire company.

Conclusion

When starting a company or seeking for an investor, one should be keen on the percentage of the company that they are willing to part with. It may seem trivial but giving away too much stake in the company effectively undermines one’s authority as the founder of the company and the general running of the business. It is thus advisable to seek the services of an advocate to draft a comprehensive shareholder’s agreement that will protect all the parties concerned and prevent or resolve any future disputes. It is also important to remember that a shareholder’s agreement takes the form of a legally binding contract, therefore, before entering into such a contract one should ensure they are protected in the event of a dispute.