Introduction
In the rapidly expanding startup ecosystem, founders must closely focus on product-market fit, fundraising, and efficient scaling. Amidst these pressures, one foundational document is frequently undervalued and reduced to mere formality: the Shareholders Agreement (“SHA”). In reality, a well-drafted SHA is a startup’s blueprint for long-term stability. It provides for governing rights, responsibilities, and remedies in times of difficulty.
Whether it’s a co-founder exit, an investor seeking liquidity, or a deadlock at the board, most early-stage disputes are not due to bad faith of the parties. Rather, they occur due to of vague or incomplete shareholder arrangements. For founders, this is more than a legal issue, it is a business continuity issue. This article looks at the most critical clauses that startups should negotiate in their SHAs.
Harmonizing SHA and AOA
After the basic terms are decided through a non-binding term sheet,[i] a binding SHA is signed. It is a private agreement that outlines the rights and obligations of shareholders amongst them and within the company. Meanwhile, Articles of Association (“AoA”) is a public document concerning the internal affairs of the company that every company must adopt upon its incorporation.[ii] The key difference is that AoA is a publicly available document governing the company,[iii] while SHA is a confidential agreement that governs relations between shareholders.
Given the overlap between these two documents, it is essential to harmonize them to ensure that the terms take full effect. In a landmark case, the Supreme Court held that any restriction on the transfer of shares that contradicts the AoA does not bind the company.[iv] The AoA must authorize these restrictions to make them enforceable. But in this case, the restriction was a general, so it couldn’t be enforced through a private agreement. Later, the Supreme Court clarified that if the restriction applies only to specific shares held by specific members, it doesn’t count as a general ban on transferability and that kind of restriction can be enforced privately.[v] Therefore, the terms of SHA must be specific to the parties signing it and ensure its nature as a private agreement to preserve its sanctity. This is where the strategic legal input, not generic templates, can safeguard a startup’s journey from seed to scale. Additionally, AoA framework should be harmonized with the agreement to include relevant rights and obligations to ensure their enforceability and prevent potential litigation.
Another key insight is to make the company a party to the SHA. In some instances, courts found that provisions did not bind the company because it was not a party to the SHA.[vi] Delhi High Court observed that the terms of a private agreement, despite not being included in AoA, would bind the company as it was made a party to the agreement.[vii]
Share Transfer Restrictions
Share transfer restrictions require shareholders intending to sell their shares to adhere to specific regulations. These clauses are particularly crucial for startups as equity dynamics are sensitive, and long-term strategic alignment is crucial. Two widely used mechanisms to regulate such transfers are the Right of First Offer (“ROFO”) and the Right of First Refusal (“ROFR”).
A ROFO requires the selling shareholder to first offer their shares to existing shareholders which is the right to make an offer for the selling shareholder’s shares before they can approach any third party.[viii] If the existing shareholders decline the offer, the seller is free to negotiate with external buyers on terms that are no less favorable than the ones offered or negotiated with existing shareholders. This mechanism favors sellers, especially those looking for an exit, as it gives them more control over the timing and pricing of the sale.
Conversely, a ROFR allows the selling shareholder to first negotiate with a third party and then empowers existing shareholders to match the offer.[ix] It provides strong protection for continuing shareholders. But this disincentivizes third-party buyers, since they won’t want to spend time and money on due diligence if existing shareholders can step in and acquire the shares on identical terms. Because of that, it’s hard for the selling shareholder to get the full value of their shares.
From a practical standpoint, ROFRs work best in companies where shareholder continuity and control are paramount, like long-term venture-backed startups. Meanwhile, ROFOs are more suitable in situations where investors are actively interested in the exits. While ROFR clauses favor promoters, they might be less attractive to potential investors, and the incorporation of such a clause might require conceding in other terms during negotiations. Poorly structured transfer restrictions often result in legal disputes or failed exits, so startups must choose wisely, ideally in consultation with legal counsel, to account for shareholder interests and company needs.
Exit Rights
Exit rights are clauses within the SHA that grant investors certain rights regarding the disposal of their securities when they wish to sell their investment in the company, usually to realize a higher value. Although typically enforceable without changes to the AoA, these clauses must still be included to create blanket obligation on all shareholders.[x]
Exit clauses are typically structured to mandatorily provide an exit to existing investors, usually within a specified timeframe. To give effect to such provisions, some clauses have waterfall mechanisms where a set order laid out in the SHA that needs to be followed when carrying out an exit.[xi] The waterfall clause may require the company to first attempt an Initial Public Offering (“IPO”), if that fails, which a third-party sale, and triggering drag-along rights is usually at the end. A waterfall clause is usually beneficial to both parties, as it provides greater clarity. However, it is particularly useful for promoters as they have a clear order to discharge their obligations before the drag-along rights are triggered.
There are 3 most common Exit Rights used by the investors:
- IPO: IPO involves the sale of securities in the primary market for the first time, allowing a company to raise equity capital from public investors.[xii] Existing shareholders can exit their investment through the secondary market. While negotiated as a first mode of exit due to mutual benefits to investors and promoters, this decision remains heavily dependent on market forces and externalities. Therefore, clauses usually have terms like “best efforts” or “reasonable efforts”, which need to be chosen carefully to reflect the commercial intent. Calcutta HC referred to an English case[xiii] and interpreted “best efforts” as similar to “every effort”, requiring obligated party to exhaust all available reasonable means, while “reasonable efforts” requires undertaking one reasonable course of action.[xiv] While there are many variations across jurisdictions, it is clear that the standard imposed by best efforts is higher than reasonable efforts, and while the standard of “reasonable best efforts” is unclear, it is likely to be higher due to the presence of the term “best”.[xv] Parties need to implement the efforts standard based on the stringency requirement of going public, while also considering impact of market conditions in this decision.
- Third Party/Trade/Strategic Sale: Sale of investors’ securities to a third party is a common option in SHA, and it allows existing shareholders to retain their respective shares in the company. Meanwhile, strategic sale is more contentious as it requires sale of the entire share capital of the company to a strategic buyer (usually in the same industry). Trade Sale involves the sale of substantially all assets and businesses of the company to a third party. Third-party sales are more favorable to promoters as they are not forced to sell their share in the company.
- Drag Along Right: Drag-along right provides the holder the right to require another shareholder to also sell their shares at the same terms as the right holder.[xvi] This right is intended to protect the majority shareholders from minority shareholders obstructing their exit, as the third-party shareholder may wish to acquire the entire company for strategic purposes. Companies typically use this as a last resort in an exit waterfall. Courts have not extensively tested their enforceability, and specific performance is usually the only remedy.[xvii]
Conflict Resolution
Deadlock occurs when the parties are unable to reach resolution on a particular matter, especially when a shareholder with reserve matter rights[xviii] blocks a resolution. Deadlock resolution mechanisms in SHA ensure that this paralysis of decision making does not compromise the business. These mechanisms can range from friendly consultations to forced exits or liquidation. Each has different implications for shareholders and the company.
The most constructive starting point is the escalation mechanism, where disputes are referred to senior representatives of the shareholders for resolution. While this encourages dialogue and preserves relationships, it may not be useful if commercial interests are deeply misaligned. However, it is quite effective for minor deadlocks. Beyond that, mechanisms like mediation and arbitration offer structured resolution through neutral third parties. Mediation fosters negotiated outcomes, maintaining relationships. However, it lacks enforceability. Arbitration ensures a binding outcome but can be as costly and adversarial as litigation, especially when commercial stakes are high. Mediation and arbitration agreements must be in writing in order to be enforceable.[xix]
A common mechanism to resolve a deadlock is the Russian Roulette clause, wherein a shareholder issues notice to other shareholders of a specific price, at which he offers to either buy out the others or require others to buy his stake at the same price. This requires the initiating shareholder to ensure a fair price is proposed, as if the price is too low, they risk having to sell their own shares at an undervalued price. Another approach to resolution is the Texas Shootout or the sealed auction clause. Each shareholder submits a secret bid to an independent party, offering to buy out other shareholders at a specified price.[xx] The independent party simultaneously opens the bids, and the highest bidder must buy out others at his specified price. Russian Roulette ensures that a fair price is put forward, since the party could be either the buyer or the seller. However, this discounts the resource imbalance of various shareholders, and shareholders with greater financial resources can offer a lower price since other shareholders will be unable to fund an offer to buy and thus be forced to sell.[xxi] The Texas shootout, on the other hand, is rapid and decisive. However, since it is a competitive bidding process, it may lead to a premium price being offered for the shares.[xxii]
Conclusion
References:
[i] Startup India, Term Sheet (Equity) Template (India) (OS v.1, November 2016) accessed 4 June 2025.
[ii] Companies Act 2013, s 5.
[iii] A Ramaiya, Guide to the Companies Act (19th edn, vol 1, LexisNexis 2021).
[iv] V.B. Rangaraj v V.B. Gopalakrishnan AIR 1992 SC 453.
[v] M.S. Madhusoodhanan v Kerala Kaumudi Pvt Ltd (2004) 9 SCC 204; Messer Holdings Ltd v Shyam Madanmohan Ruia & Ors AIR 2016 SC 1948.
[vi] World Phone India Pvt Ltd v WPI Group Inc USA (2013) 178 Comp Cas 173 (Del).
[vii] Premier Hockey Development Private Ltd v Indian Hockey Federation (2011) 5 SCC OnLine Del 2621.
[viii] Practical Law, ‘Rights of First Offer (ROFO)’ (Thomson Reuters, 2025) accessed 4 June 2025.
[ix] Practical Law, ‘Right of First Refusal (ROFR)’ (Thomson Reuters, 2025) accessed 4 June 2025.
[x] Nishith Desai Associates, ‘Right of First Refusal: Is It Valid in Law?’ (Corpsec Hotline, 29 September 2010) accessed 4 June 2025.
[xi] Sahil Lathwal and Agrim Mor, ‘IPO Exits Demystified: The Legal Architecture and Strategic Considerations’ (Centre for Business and Financial Laws, National Law University Delhi, 1 March 2025) accessed 4 June 2025.
[xii] Practical Law, ‘Initial Public Offerings (IPOs): Overview’ (Thomson Reuters, 2025) accessed 4 June 2025.
[xiii] Rhodia International Holdings Ltd & Rhodia UK Ltd v Huntsman International LLC [2007] EWHC 292 (Comm).
[xiv] Smt. Manika Seth v Sett Iron Foundry (2022) Arbitration Petition No. 80 of 2020 (Calcutta High Court).
[xv] Parina Muchhala, Arjun Gupta and Harshita Srivastava, ‘Disputes in Private Equity: Assessing the Enforceability of Investor Exit Rights in India’ (Nishith Desai Associates, 30 January 2024) accessed 4 June 2025.
[xvi] Practical Law, ‘Drag Along Rights’ (Thomson Reuters, 2025) accessed 4 June 2025.
[xvii] Parina Muchhala, Arjun Gupta and Harshita Srivastava, ‘Disputes in Private Equity: Assessing the Enforceability of Investor Exit Rights in India’ (Nishith Desai Associates, 30 January 2024) accessed 4 June 2025.
[xviii] Net Lawman, ‘Reserved Matters in a Shareholders Agreement’ (September 2022) accessed 4 June 2025.
[xix] Mediation Act 2023, s 4(1); Arbitration and Conciliation Act 1996, s 7(3).
[xx] Practical Law, ‘Texas Shoot-Out’ (Thomson Reuters, 2025) accessed 4 June 2025.
[xxi] Chamberlains Law Firm, ‘Resolving Deadlocks – Russian Roulette and Texas Shootout’ (Lexology, 27 March 2023) accessed 4 June 2025.
[xxii] Ibid.
