Investing in a company can often seem like navigating a minefield of unfamiliar parlance, specially with all the investment related jargon that is tossed around by lawyers and advisors! To understand the meaning of these terms that come up during the investment process, check out our series on De-mystifying Investment Jargon!
TAG-ALONG AND DRAG-ALONG
BY RASHI KAPOOR MEHTA
Tag-along Rights: Imagine you’ve been invited to a friend’s birthday party and your younger sibling insists on tagging along. That in short is what a tag along right is like. It is the right of your fellow shareholder to be that younger sibling and insist that you bring them along to the party (with the party being the sale of your shares to an outside buyer). So if a fellow shareholder has a tag along right, they can insist that the buyer you have found, purchase their shares at the same price and same terms as what you have negotiated for the sale of your own shares. While it may seem fairly straightforward, the downside is that if the buyer is unable or unwilling to purchase these additional shares, then you aren’t allowed to sell yours either. This way either everyone gets to enjoy the party or no one does!
Drag-along Rights: In keeping with the birthday party theme, have you ever seen that kid who has to be physically dragged away from a party, even as all the other guests have left, the tables and chairs are being dismantled and the clean-up crew is waiting in the wings? Well, if you have granted an investor a drag along right, you become that reluctant child and your investor becomes the parent telling you that the party is well and truly over. When a drag-along right is exercised against you, it allows the investor to force you to sell your shares along with theirs to a third-party buyer at the same price and on the same terms as them. An investor usually invokes his drag-along right when he believes the party is over (company is not performing well) or if a potential acquirer wants a larger, controlling interest in the company.
RIGHT OF FIRST REFUSAL V/S RIGHT OF FIRST OFFER
BY HENNA KAPADIA
Right of first refusal (“ROFR”) and right of first offer (“ROFO”) are contractual rights that provide the holder with an opportunity to purchase a certain asset before such asset is sold to a third party. A ROFR is essentially the right to have a ‘last look’ at an asset; whereas a ROFO is the right to have the ‘first look’.
ROFR: Mr. X wants to sell a box of 12 cupcakes. Mr. Y has a ROFR on such box. Mr. X scouts the neighbourhood for a few buyers. The best price offered to Mr. X for the box of cupcakes is INR 350. Since Mr. Y has a ROFR, before Mr. X can sell such box for INR 350 to a third party, he must first allow Mr. Y the opportunity to buy or ‘refuse’ to buy the box at INR 350. If Mr. Y refuses to make the purchase, Mr. X may sell the box to a third-party at INR 350 but not below that.
ROFO: Mr. X wants to sell a box of 12 cupcakes. Mr. Y has a ROFO on such box. Before Mr. X can scout the neighbourhood for other third-party buyers, he must first ‘offer’ to sell the box to Mr. Y. If Mr. Y offers to purchase the box at INR 300, Mr. X may either accept his offer or seek a higher price from third parties. If a third party offers to purchase the box at INR 350, Mr. X may make such sale. However, he may not sell the box for a price at or below the initial price of INR 300 that was offered by Mr. Y unless a clause to have a ‘second look’ was previously built into the agreement. A ‘second look’ clause will require Mr. X to first give Mr. Y the opportunity to purchase the box of cupcakes at the higher price that is offered to Mr. X. by a third-party.
The key difference in these arrangements lies in the fact that under a ROFR, the holder has the right to accept or refuse pre-determined terms whereas under a ROFO, the holder determines the terms.
CALL-OPTION AND PUT-OPTION
BY RASHI KAPOOR MEHTA
Call-option: Put simply, a call option is a right granted to a shareholder where they have the ability to compel you to sell your shares to them at a pre-determined price or formula under certain circumstances. A call option is usually proposed by an investor when they would like to have the option to slowly acquire incremental shares in a company while locking in the price upfront. It could also be requested by a founder if he/she would like to retain the right to increase his/her shareholding in the Company while locking in a return for an investor.
Put-option: A put option on the other hand is where a shareholder has a right to force you to buy their shares at a pre-determined price under certain circumstances. A put-option may be requested by an investor as a means to an assured exit from their investment.
AFFIRMATIVE RIGHTS
BY NEELKAMAL CHAUDHARY
You know how the youngest member of the family is often the one who has the loudest voice and the most say? Well, that’s often the nature of investors who despite being minority shareholders in a company retain the right to have a say on critical decisions of the company that may affect the value of their investment. The list of matters agreed upon between the parties to a contract on which consent from investors is required are known as affirmative right matters or veto matters or investor protection matters and generally include : changing the share capital structure of the company, amending the charter documents, issuing additional shares and terminating key employees.
Affirmative rights are particularly critical for an investor when the investor is a minority shareholder in the company. Although a company may ordinarily pass a resolution by simple or special majority votes from its shareholders, it may not be entitled to take decisions on affirmative rights matters without the consent of the investor having such affirmative rights, irrespective of the value of their shareholding. Both founders and investors should always endeavour to protect the investors without burdening the Company with a laundry list of affirmative rights since this could result in the hampering of day-to-day operations of the Company.
LIQUIDATION PREFERENCE
BY RASHI KAPOOR MEHTA
Liquidation preference is a right usually negotiated by investors that entitles them to stand at the front of queue and collect the return on their investment and then some before anybody else gets a turn. Liquidation preference rights are intended to be a downside protection for investors to ensure that their capital is protected. In any exit event, investors holding these rights have priority over all the other shareholders and are entitled to a guaranteed return before anybody else. So, if your investor has given you 100 Rupees and you have agreed to a 1.2X liquidation preference, the investor will first receive 120 Rs. before the sale proceeds are distributed to any other shareholders. An investor may agree to receive the higher of a multiple of the capital invested by such investor or their pro-rata share of what they would be entitled to based on their shareholding in the Company.
Sometimes however, you may see an investor wanting to double dip i.e. to get their liquidation preference and also a pro rata participation in the balance sale proceeds and this is something founders may wish to negotiate against.
PRE-EMPTION RIGHT
BY HENNA KAPADIA
A pre-emptive right is essentially a right (but not an obligation) of an existing shareholder to purchase additional shares of a company before such shares are sold to third parties. Pre-emptive rights serve as a safeguard against dilution in shareholding.
Imagine it’s your birthday and you invite 4 of your friends to share your birthday cake. The cake would be divided into 5 equal slices and each person would receive 20% of the cake. Now imagine if your brother and 4 of his friends join the party. The party now has 10 people is total and you would therefore receive only 10% of the cake. These additional 5 people have ‘diluted’ your cake quotient.
Similarly, when a company brings in additional shareholders, the promoters and the initial shareholders may get diluted. However, if such shareholders have a ‘pre-emptive right’, they would be able to purchase additional shares in the company and thereby maintain their percentage of ownership and control. If you own 10 shares out of 100 shares in company X, you are a 10% shareholder. However, if the company decides to increase the number of shares to 500 and you continue to hold 10 shares, you would become a 2% shareholder. A pre-emptive right would provide you the opportunity to purchase an additional 40 shares in company X and bring your shareholding up to 50 out of 500, thereby ensuring you still hold 10% of company X’s shares.