Navigating Restriction on the Transfer of Promoters Shares

Safeguarding Investments: Navigating Restriction on the Transfer of Promoters Shares

Safeguarding Investments: Navigating Restriction on the Transfer of Promoters Shares

In the dynamic landscape of investments and corporate governance, the ownership of shares by a company’s promoters holds significant sway over business trajectories. Investors keen on ensuring stability and long-term growth must carefully navigate the intricacies of promoter stability and share transferability concerns.

Unrestricted transferability provides promoters with an easy exit strategy from the company at any time. When promoters can freely sell or transfer their shares without being bound by specific conditions or timelines, they have the flexibility to divest their ownership swiftly. While this may seem advantageous for promoters seeking liquidity or wanting to exit for personal reasons, it can be detrimental to the stability and continuity of the business. Promoters, being key figures in a company, play a crucial role in its strategic direction and day-to-day operations. Unrestricted share transferability may lead to abrupt changes in leadership, potentially disrupting the company’s operations and causing uncertainty among investors and other stakeholders.

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In line of the foregoing, transactional documents (such as shareholders’ agreement), provides for the several restrictive clauses which imposes transfer restriction on promoters which are provided below:

1. Lock in Period

In a Shareholders’ Agreement (“SHA”), promoters’ lock-in, essentially means that the promoters or promoter group cannot sell their shares for a specified period without the prior written consent of the investors. During such lock-in period, promoters are restricted from selling their or transferring their shareholding. The lock-in period could be as short as 1 (one) year or continue for such time period till the investors hold securities in the company, which completely is dependent upon the negotiation between the promoters and the investors.

The lock-in period acts as the primary restriction on promoters transferring their shares. After this period expires, additional restrictions such as the Right of First Refusal (ROFR) and vesting (as provided below) (if vesting period is beyond the lock-in period) still remain in place to safeguard investors’ interest in the company.

2. Vesting of Shares

Adding a vesting schedule in the SHA for the promoters is a key method for investors (as well as shareholders) of the company to ensure that their interests are protected. The vesting schedule ordinarily lasts between 3 (three) to 5 (five) years and further helps in preventing the promoters from quitting the investee company before the vesting of shares takes place. This ensures the continued association of the promoters with the investee company.

The drafting of the vesting clause must be meticulous, considering various scenarios that may arise during the promoters’ tenure, including permanent disability, death, or termination for reasons attributable to the promoters—referred to as ’cause’ events, and ‘non-cause’ events. Addressing these situations is vital, as no investor would desire the immediate vesting of all promoters’ shares. Crafting the vesting clause with foresight and precision is essential for maintaining a fair and equitable balance between investors’ protection and promoters’ circumstances.

3. Right of First Refusal (“ROFR”)

This provision favours the investors by providing them with an option to buy out the shares of the selling promoters at first instance before the promoters sells those shares to any third party. This not only enables investors to maintain their shareholding but also serves as a defensive mechanism against unwanted third-party involvement. In the instance where the promoters on whom this restriction operates (“Transferring Party”), wishes to transfer their shareholding to any third-party purchaser, then this restriction would mandate him to offer the shares up for transfer first to the holder of the ROFR on same terms as are offered by the third-party purchaser. The Transferring Party may proceed to transfer his shareholding to the third-party purchaser only if the ROFR holder rejects the offer first, and subsequently such a transfer to the third-party purchaser can be carried out by the promoters subject to the same being carried at the same price, terms and conditions which were offered to the holder to ROFR.

Transfer to Competitor(s)

This clause puts forward a complete restriction on the promoters to transfer any security/shareholding held by them to any competitor of the company. This restriction is often exercised by way of a general definition referring to companies operating in the same business as the investee company. This restriction is often an absolute restriction and remains applicable even if the other transfer restrictions remain applicable on promoter or not.

5. Free Transferability of Promoters’ Shares

Since, it is crucial to have the promoters’ skin in the game, the above transfer restrictions become quintessential. However, since to have a fair play, the parties does agree to provide some sort of free liquidity on promoters’ shares. Accordingly, the promoters are often provided with some percentage shareholding which is kept free from any and all transfer restrictions, except to transfer to competitor. At times, if the major investors insist, the free liquidity also includes ROFR or right of first offer restriction on the free transferability of such promoters’ liquidity shares.

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