Shareholder’s Agreement: Restrictions on share transfers

In the fourth part of our series on “Introduction to shareholder’s agreement”, we present to you clauses that restrict Share Transfers

Pre-emptive clauses in shareholders’ agreement mandate a shareholder offers their shares to the other shareholder(s) before selling it to a third party.

It requires that the shareholder notifies their intention of selling to the other shareholder(s) along with the number of shares for sale and their price. If no one steps forward and purchases the shares at the quoted price, the shareholder can sell their shares at that price to a third party.

A breach in the pre-emptive clause can render sale and transfer of shares to a third party ineffective. However, it can be argued that the breach relates to the shareholders’ rights as between themselves rather than the conduct of the company’s affairs. So the pre-emption rights don’t translate to the desired remedy and enforcement isn’t thorough. To overcome this limitation, the shareholder agreement should specifically provide for consequences to flow from a breach of a pre-emption clause.

Pre-emptive rights can complicate a start up’s fundraising. Though a standard in Series A deals, it’s generally in the company’s interest to limit the scope of pre-emptive rights for greater flexibility in fundraising. This could be accomplished by giving investors the right to maintain their pro rata ownership in the company or granting the rights to major investors – venture capitalists and large angel investors.

Investor(s) may require a start up to include an anti-dilution clause in the shareholders’ agreement when looking to raise capital in exchange for equity.  The anti-dilution clause serves to protect the shareholder from a dilution in their shareholding in the subsequent fundraising rounds.

There are two main forms of anti-dilution clauses:

Full ratchet: The full ratchet anti-dilution clause is the strongest protection for investors, albeit the most restrictive for multiple fundraising rounds. When a shareholder converts their preference shares to ordinary shares, the conversion price is reduced to reflect the share issuance price for the following round. Similarly, an ordinary shareholder is issued ordinary shares immediately after the new round. In both circumstances, the shareholder receives more shares for their initial investment to ensure no dilution of stake in the company.

Weighted Average Ratchet: Under a weighted average ratchet anti-dilution clause, the shareholders are able to increase their shareholding at a weighted average of the new share issuance price. The agreement should contain a formula governing the calculation of the weighted average share price based on:

  • Capital raised before the additional round; and
  • The average price per share compared with the subsequent capital raise and lower share price.

Though the weighted average formula does not completely protect investors from dilution, it is considered favourable as it significantly mitigates the effect

Restrictions on share transfers protect shareholders from dilution of voting power and rights to dividends. Theoretically, shareholders benefit when the startup receives fair value for new shares because the value of existing shares will rise in proportion to the value received. However, the agreement safeguards the start up from sale and transfers done in bad faith or for inadequate consideration with specific clauses.