Clauses Promoters should never sign in a Shareholders' Agreement with Minority Investors

Securing investment is a pivotal moment for any startup. It brings not only much-needed capital but also the potential to accelerate growth, scale operations, and onboard strategic insights. However, when this investment is from a minority stakeholder, promoters—the visionaries and drivers behind the venture—must proceed with caution.

The Shareholders Agreement (SHA) becomes the governing framework of this relationship, and unfortunately, the initial draft often favours the investor. Backed by experienced legal teams, minority investors may propose clauses that, despite their small stake, grant them disproportionate control or protection—often at the promoters’ expense. From unnecessary veto rights to post-exit restrictions, these clauses can undermine a founder’s ability to lead their company, dilute equity unfairly, and restrict future opportunities.

This article explores 10 critical clauses that promoters should be wary of when negotiating SHAs with minority investors, offering practical guidance and negotiation tips to protect their long-term interests.

1. Disproportionate Board Control

While minority investors deserve board representation commensurate with their investment, promoters must resist clauses that grant them disproportionate control over the board of directors. This often manifests as a majority of board seats or, more dangerously, veto power on key operational and strategic decisions. Such clauses can paralyse the company's ability to act swiftly and decisively, especially if the investors' interests diverge from the long-term vision of the promoters.

Why to Avoid: It allows minority shareholders to dictate the company's direction despite not bearing the primary risk or having the same long-term commitment as the founders.

Negotiation Tip: Tie board representation and veto rights strictly to the percentage of equity held, and ensure that key operational decisions remain within the promoters' purview. For instance, a 10% investor should ideally have 1 out of 10 board seats, with veto power limited to fundamental structural changes—not daily operations. Alternatively, they may be given the right to appoint only a Board observer instead of a Board of Director.

2. Overly Broad Veto Rights

Veto rights for investors are common, particularly on fundamental issues like mergers, sale of substantial assets, or issuing new shares. However, promoters must vehemently oppose overly broad veto rights that extend to routine business operations. Requiring investor approval for hiring key personnel, marketing strategies, or product development can stifle innovation and hamstring the promoters' ability to manage the day-to-day affairs of the company.

Why to Avoid: It creates unnecessary bureaucracy and slows down decision-making, hindering the company's agility and responsiveness to market changes.

Negotiation Tip: Limit veto rights to truly transformative events that fundamentally alter the company's structure or future.

3. Automatic Ratchet-Down Anti-Dilution

Anti-dilution provisions protect investors from the impact of future funding rounds at a lower valuation. However, automatic ratchet-down clauses can severely and unfairly dilute the promoters' stake. These clauses automatically adjust the conversion price of the investors' shares based on the lowest price in subsequent rounds, irrespective of the company's performance or prevailing market conditions.

Why to Avoid: It punishes promoters for market fluctuations or strategic funding decisions beyond their immediate control, leading to a significant and often unwarranted reduction in their ownership.

Negotiation Tip: Advocate for weighted-average anti-dilution provisions, which offer a more balanced adjustment based on the number of new shares issued and the price per share.

4. Drag-Along Right

Drag-along rights allow a majority of shareholders to force minority shareholders to sell their stake in the event of a company sale. While necessary for a clean exit, promoters should avoid drag-along clauses with excessively low triggering thresholds. A small percentage of investors shouldn't have the power to compel the founders to sell their life's work against their will or at an unfavourable time.

Why to Avoid: It can leave promoters vulnerable to being forced out prematurely, potentially missing out on future growth and value creation.

Negotiation Tip: Ensure the drag-along threshold requires a significant majority of all shareholders, including the promoters, to initiate a sale.

5. Lack of Promoter Reserved Matters

Just as investors seek protective provisions, promoters must ensure the SHA includes reserved matters that require their explicit consent, even with investor representation on the board. These should cover fundamental aspects of the company's vision and long-term strategy that the founders are deeply invested in.

Why to Avoid: It can lead to a scenario where key strategic pivots or significant changes to the company's core business can be made without the founders' agreement.

Negotiation Tip: Clearly define core strategic areas (e.g., changes to the core business model, mission-critical technology decisions) that require promoter consent.

6. Excessive Information Rights

While investors have a right to be informed, promoters should push back against extensive and unnecessary information rights with overly frequent reporting requirements. Demanding granular data on a daily or weekly basis can create an undue administrative burden, diverting the promoters' focus from core business activities.

Why to Avoid: It can distract the management team from execution and create unnecessary overhead, especially in the early stages of growth.

Negotiation Tip: Agree on reasonable and periodic reporting that provides investors with necessary insights without overwhelming the company's operations.

7. Overly Restrictive Post-Exit Covenants

Non-compete and non-solicitation clauses are common in exit scenarios. However, promoters should avoid signing restrictive covenants that extend beyond a reasonable timeframe or geographical scope after they leave the company. These can unfairly limit their future career and entrepreneurial opportunities.

Why to Avoid: It can stifle the promoters' ability to leverage their expertise and experience in the future, hindering their next ventures.

Negotiation Tip: Limit the duration and scope of post-exit restrictive covenants to a reasonable period and a specific industry or geographic area directly competitive with the exited business.

8. Absence of Non-Compete for Investor:

The Shareholder Agreement might lack a crucial clause preventing the minority investor from investing in or running businesses that directly compete with the promoters' company. This oversight presents a serious conflict of interest. Armed with the company's sensitive information (business plans, customer data, technology, strategies), the investor could unfairly advantage their competing entity. This creates an imbalanced scenario, potentially incentivizing the investor to favor the competitor, thereby hindering the invested company's growth, market share, and ultimately, the promoters' equity value.

Why Avoid: This absence directly opposes the fundamental alignment of interests needed for the company's success. The investor's divided loyalties can lead to biased decisions and unfair market rivalry.

Negotiation Tip: Demand a non-compete clause that restricts the investor's involvement in directly competing ventures for a reasonable duration during their shareholding and for a limited period post-exit. Minor investments in publicly traded competitors could be an acceptable exception.

9. Unduly Restrictive Transfer of Promoter Shares

This clause imposes limitations on the promoters' ability to sell their personal shares in the company, even in situations where legitimate personal financial needs arise and the sale would not negatively impact the company's operations or control. While transferability of shares in Indian private limited companies is often governed by the Articles of Association (AoA) and the Shareholder Agreement (SHA), unduly restrictive clauses can trap the promoters' wealth in illiquid assets for an extended period. This lack of flexibility can lead to personal financial hardship. While mechanisms like the Right of First Refusal (ROFR) or Right of First Offer (ROFO) among existing shareholders are common and acceptable to maintain a stable cap table, overly broad restrictions without valid cause are problematic. These restrictions should clearly define the process, including valuation methodologies for such transfers and reasonable timelines for response.

Why Avoid: Such clauses unfairly limit the promoters' financial autonomy and fail to recognise their potential need for personal liquidity.

Negotiation Tip: Ensure that any transfer restrictions included in the SHA are reasonable in scope and duration. Negotiate for clear carve-outs allowing transfers for legitimate personal reasons, subject to standard pre-emptive rights (ROFR/ROFO) for existing shareholders. Avoid absolute prohibitions on share sales without justifiable reasons, such as preventing hostile takeovers or maintaining cap table stability during crucial early stages. The valuation mechanism for ROFR/ROFO should also be fair and clearly defined.

10. Unfavourable Liquidation Preferences

In India, the Companies Act, 2013 distinguishes between Equity Shares and Preference Shares. Liquidation preferences dictate the order in which shareholders receive proceeds during a company's winding up or liquidation. Clauses that heavily favour Preference Shareholders (the investors in this context, who often subscribe to Preference Shares with specific rights) at the expense of Equity Shareholders (the promoters, holding common equity) should be carefully scrutinised.

The Danger: An agreement might stipulate that Preference Shareholders receive not only their initial investment back, possibly with a premium or a multiple, but also have a preferential right to the remaining assets before Equity Shareholders receive anything substantial, or even anything at all. This is particularly concerning with structures that lack a reasonable cap on the returns for Preference Shareholders. Even if the company has grown significantly due to the promoters' efforts, such clauses can leave the Equity Shareholders with minimal returns in a liquidation scenario. While Preference Shares inherently carry a preferential right in liquidation under Indian law (Section 43 of the Companies Act, 2013), the extent of this preference in the SHA can be excessively skewed.

Why Avoid: While Preference Shares have a statutory preference in liquidation, the SHA should not exacerbate this to the point where Equity Shareholders bear all the risk with minimal potential reward in a downturn or even a moderate exit.

Negotiation Tip: Ensure that the liquidation waterfall outlined in the SHA provides for a fair distribution of proceeds that recognises the contribution and risk undertaken by the Equity Shareholders. While acknowledging the preferential rights of Preference Shareholders as per Indian law, negotiate reasonable caps on their returns or explore structures where Equity Shareholders also participate meaningfully in the upside, especially after the Preference Shareholders have received their due as per the agreed terms and legal provisions.

Conclusion

Bringing on minority investors can be a game-changer for a growing company. However, promoters must approach the Shareholders Agreement with a keen eye for detail and a deep understanding of the potential implications of each clause. By being aware of these ten critical areas and negotiating diligently, founders can ensure they forge a partnership that benefits all stakeholders without sacrificing their vision, control, or future prospects. Remember, a well-negotiated SHA is not about winning or losing, but about establishing a clear, fair, and sustainable framework for the company's journey ahead.