Emerging Trends in Shareholder Agreements for Cross-Border Investments

The surge in investments by foreign investors in India along with the rising disputes amongst founders and investors in established startups have led to the renewed focus on the execution of carefully structured investment documents to clearly demarcate the rights and obligations of investors, other shareholders and founders of a company.

One of the crucial investment documents, regardless of the nature of the investment transaction, is shareholders’ agreements (“SHA”) as it is the primary document which lays down the roles and obligations of the founders and the investors of a company. SHAs are legally binding contracts agreed among the shareholders of a company that outline their rights, responsibilities, and obligations. These agreements serve to protect the interests of shareholders by establishing clear terms regarding management, decision-making processes, and the distribution of profits.

In this article we have tried to extrapolate the key features of SHAs which are necessary to ensure the success of a transaction. Furthermore, we will look at certain key emerging trends in SHAs which are increasingly being adopted to ensure a smooth business process and provide the greatest option for foreign investors to get the best return for their investment.

Key considerations for a shareholders’ agreement for cross border transactions

In cross-border transactions, SHAs provide clarity and understanding between foreign investors and domestic investees. By clearly defining the rights and obligations of all parties involved, these agreements reduce legal ambiguities and potential conflicts that may arise from differing legal systems. They provide a framework for cooperation, aligning expectations and facilitating smoother operations in diverse regulatory environments. The key provisions that play a major role in structuring cross border shareholders agreements are as follows:

Provisions protecting dilution of investor holding:

• Anti-Dilution: Anti-dilution provisions are used in foreign investment transactions to protect the value of the investor holdings from the adverse effects of share dilution. These provisions, determined in the form of weighted average and full ratchet anti-dilution, adjust the conversion price of shares or grant additional shares to the holders of the rights when new shares are issued at lower prices. This safeguard is particularly crucial in early-stage companies where multiple rounds of funding occur and is used as a mechanism to enhance investor confidence and providing a strategic tool for negotiation, ensuring that investors who are existing shareholders have a fair stake in the company despite new capital-raising activities.
• Pre-emptive Rights: Preemptive rights enable existing shareholders to purchase additional shares at the time of new issuances which generally occur during future investments, allowing them to maintain their ownership percentages and prevent dilution of their stake in the company. These mechanisms provide the framework for the issuance of new shares to the right holders. In foreign investment transactions, preemptive rights are utilized to ensure that eligible shareholders can safeguard the value of their investments, and incorporation of the same in investment document make the company more attractive to potential investors.

Customized Voting Structure:

• Differential Voting Rights: Keeping in mind the intent of the investment as made by an investor, i.e., whether as a strategic or a financial investor, companies are increasingly providing differential voting rights to their investors. These differential voting rights allow the promoters to attract investments in the company despite retaining their control in the company. Further, such differentiated rights also provide the investor with the right to enjoy the benefit of the dividends without requiring allocating their extensive time and resources. Therefore, these rights accommodate the diverse needs of foreign investors. These structures allow for different voting powers for different classes of shares, enabling promoters to attract investment while retaining control among a specified group.
• Specific Veto Right with respect to Reserved Matters: Foreign investors frequently pursue specific veto rights in the investee companies for determining major strategic decisions thereby reflecting a broader trend towards assured running and growth of business. They usually seek board or advisory committee seats as well as the right reserved for their special approval in order to ensure that all major decisions which may impact their investments are undertaken by the company with their consent.

Dispute Resolution Mechanism: 

Shareholders disputes are very tricky and can result in oppression against minority shareholders thereby requiring the corporate tribunals to intervene. However, in order to resolve disputes amicably, it is crucial that the dispute resolution mechanism is appropriately drafted to cater to the interest of all the shareholders. SHAs are increasingly incorporating negotiation and mediation components in dispute resolution clauses to provide parties with an option to internally resolve any disputes prior to resorting to statutory mechanisms such as arbitration or courts. Additionally, as a measure of investor-friendliness, foreign seated arbitration based out of suitable jurisdictions to provide an optimal mechanism for resolving disputes which may arise.

Exit Strategies

• Drag Along and Tag Along Rights: Drag-along and tag-along clauses in SHAs are aimed at ensuring that investors get the best value for their shareholding. Drag-along rights allow shareholders holding the said right, generally the shareholders holding the majority shareholding, to compel minority shareholders to sell their shares if a third party offers to buy the entire shareholding of the company at specified rates, therefore facilitating smoother transactions and maximizing valuations. Tag-along rights, on the other hand, grant right holders who are generally minority shareholders, the option to sell their shares alongside majority shareholders on equal terms, ensuring they can exit under favorable terms and prevents them from being left behind when the majority shareholders of a company have taken an exit. These mechanisms enhance investor confidence and aim at balancing interests among different shareholder groups.
• Buyout Clause: The companies lay significant emphasis towards strategic planning over how and when the investors are to exit while making sure that the operations of the company remain unhindered. In order to ensure that, investors and founders agree to include the buyout clauses under SHAs which specifically cater to the situations when an investor embarks to dispose of its stake in the company to the other existing stakeholders sometimes at an agreed base price or at fair market value. Such options allow investors with clear exit pathways thereby preventing disruptions arising in business due to investor disagreements.

Regulatory Impacts on Shareholders’ Agreements

• Regulations pertaining to Foreign Direct Investment: Foreign direct investment regulations invariably affect the structuring of investment documents, especially SHAs. Most countries will prescribe limits for foreign investments or require government sanctions and/or approvals for undertaking investments into certain sectors in the interest of protecting national interests. Therefore, SHAs usually include a specific provision in relation to such regulations, i.e., obtaining government approval concerning relevant investment reporting requirements. Such an inclusion ensures that investments proceed seamlessly while complying with the law.
• Compliance with Local Laws: Applicable local laws also significantly impact SHAs in foreign investment transactions, requiring companies to ensure legal compliance across multiple jurisdictions. As countries continuously update their local laws relating to corporate governance, tax, and labor standards, companies must adapt their investment agreements to be in compliance with these applicable laws. Failure to comply can lead to legal challenges or penalties, leading to huge legal costs for parties.

Current Trends in Cross Border Investment Structures

Rise in ESG (Environmental, Social, and Governance) Provision: 

Inclusion of ESG (Environmental, Social, and Governance) provisions under the SHAs are increasingly becoming popular among foreign investors in order to ensure that their investments are focused towards the principle of sustainability. The integration and adoption of ESG criterion by a company attracts socially conscious investors and thus builds the reputation of the company in favor of a more responsible business ecosystem.

Digital Integration in Foreign Investments

Facilitating the application of blockchain-based smart contracts in executing SHAs will reflect a more transparent and efficient structure for a company. Since these self-executing contracts automatically trigger when specified conditions are met, thereby they enhance in enforcing the terms of the contract and reduce the ambit of disputes amongst concerned parties. Further, digital voting platforms are also setting the pace for foreign investors who want to participate in shareholder meetings regardless of their location.

Consequences of Inadequately drafted Shareholders’ Agreements

Poorly designed SHAs pose huge risks for the affected parties of a company thereby attracting numerous litigations followed by monetary losses and disgruntlement of investors. The ambiguity in drafting can lead to disputes amongst shareholders due to different interpretations and opinions resulting in costly and time-consuming legal proceedings. Besides, these disputes not only result in companies incurring financial losses through legal overheads and settlements but also erodes global confidence thereby restricting foreign capital infusion in a territory leading to grievous economic harm.

Conclusion

Keeping abreast of the latest trends in foreign investments along with their related investment documents such as shareholder agreements, is essential. Companies have to change their agreements according to new headwinds, emerging regulations, changing market dynamics, and expectations of investors just to keep themselves alive in the race. Further, the companies must strive to introduce new developments in practice, such as ESG integration and digital voting mechanisms, which can help them to attract valuable investors. Better understanding of future trends in economics translates into better governance and greater synergies among stakeholders, thereby contributing to the success of businesses in the long run.