Know your Shareholders’ Agreement (SHA) — 3 of 5

Attention, all founders! Are you considering taking investments in your startup from financial investors or VCs? If yes, it is important to decide on the exit option upfront in the SHA in order to avoid investors attaching your personal assets in the process!

In the last post of this series, we discussed the kinds of transfer restrictions investors propose in an SHA and how founders can protect their interests.

In this post, we will begin a discussion on the ‘exit options,” which are provisions for the exit of investors from the company. A critical examination of each and every option proposed by the investor for its exit is required by the founders in order to ensure that the same is in sync with the business plan of the company and its practicality.

The founders are often allocated 36 to 60 months to identify an exit for the financial investors, particularly venture capital funds.

Investors try to select the type of exit they would want, but founders must agree to a waterfall system, where they first choose their preferred exit type and only choose a different one if the first doesn’t work.

IPO and QIPO

An “IPO,” or initial public offering, is one of the most common exit options found in an SHA. A “QIPO,” or qualified initial public offering, is another.

An IPO is a process by which a privately held company goes public and offers shares of its stock for sale to the public. A QIPO, on the other hand, is a private placement of shares available only to qualified institutional buyers.

Shareholders who own shares in the company can sell their shares to the public through the stock exchange, providing an opportunity for them to exit the company.

The choice between an IPO and a QIPO will depend on a variety of factors, including the company’s size, industry, and growth plans, as well as the current market conditions and investor demand. If a company is well-established, has a strong brand, and wants to generate broader public awareness, an IPO may be the better option. On the other hand, if a company is early-stage or has a more limited track record, a QIPO may be more appropriate, as it provides a faster and more cost-effective way to raise capital.

STRATEGIC SALE

A strategic sale is the second most common method of exiting the market after an IPO or QIPO. It denotes the acquisition of the target entity (in whole or in significant part) by a strategic third-party buyer.

Because it has the potential for a high sale price and a quicker exit than other exit choices, such as an IPO or QIPO, a strategic sale as an exit option may be an appealing decision for founders.

It’s crucial to keep in mind, though, that not every founder will find that a strategic sale is the best way out. While evaluating an exit plan, variables like the state of the market, the viability of the business, and the founders’ personal objectives and preferences must be taken into account.

BUY-BACK

It is only when these two exit routes are not feasible that a founder must opt for the next option, which is the buyback of shares. This is generally provided as a way for investors to sell their shares back to the company at a premium price and receive a return on their investment.

But wait, is it this easy? No! Many founders fall into the trap of confusing buybacks with the put option of the investors that investors try to clandestinely provide in the buyback provisions in the SHA.

It is typically stated in the SHA that if the company fails to buy back the subject shares, the same will be sold to the promoters in the event investors exercise their put option right.

Buyback in India is subject to regulatory restrictions and compliance. A company can only buy back up to 25% of the total paid-up capital and free reserves of the company. Therefore, a buyback as an exit option sometimes may not suffice, and a put option right against the promoters is what investors look for.

Make sure you read the SHA thoroughly to escape this trap!

DRAG ALONG

The drag-along provision is a powerful exit option that the investors proposed. It allows the investors to force the founders, promoters, and sometimes other existing shareholders to sell their shares in a company to a third-party buyer identified by the investor at the same price and terms.

However, selling shareholders should be aware of the potential risks associated with this provision.

They may not receive the same level of control over the sales process and may be forced to sell their shares at a price that they deem too low. Therefore, drag-along provisions must provide for a minimum exit price below which the shares cannot be dragged. Also, make sure that the drag option falls last in the exit options designed in the SHA.

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