Abhishek Goel

10/4/202310 min read


Most of the fund-raising exercise starts with issuance of a term sheet which ultimately culminates into a shareholders and share subscription agreement between the investors, the company and the co-founders. The shareholders agreement typically forms the basis of the internal functioning of the company, and it significantly amends the articles of the company.

While most of the valuers typically valuing the equity shares of a company disregard the role and impact of the shareholders agreement, however, it places a significant influence on the valuation of any type of financial instruments issued by the company.

Shareholders' agreements are essential documents that govern the rights and responsibilities of individuals or entities holding equity in a company. While they serve various purposes, one often overlooked aspect of these agreements is their significant influence on equity valuation. Equity valuation is the process of determining the worth of a company's ownership stakes, and it plays a pivotal role in investment decisions, mergers, acquisitions, and other financial transactions. In this comprehensive article, we will delve deeply into how shareholders' agreements impact equity valuation and explore the various facets and considerations involved in this critical aspect of corporate finance.


2.1 What is a Shareholders' Agreement?

A shareholders' agreement is a legally binding contract that outlines the rights and obligations of shareholders in a company. It typically covers a wide range of matters, including the management of the company, the distribution of profits, restrictions on the transfer of shares, and dispute resolution mechanisms. These agreements are particularly important in closely held businesses, startups, and companies with multiple shareholders.

2.2 Key Components of a Shareholders' Agreement

This section will break down the essential elements of a shareholders' agreement, including:

· Governance and management rights.

· Ownership percentages and equity classes.

· Share transfer restrictions.

· Pre-emptive rights.

· Exit mechanisms.

· Dispute resolution mechanisms.

· Non-compete and non-disclosure clauses.


Various types of shareholders’ agreements are as follows: -

i. Founders' Agreement

Purpose: Founders' agreements are typically used in startups and early-stage companies.

Key Provisions: They often address issues such as the allocation of equity among co-founders, decision-making authority, vesting schedules for shares, and what happens in the event of a founder's departure or death.

ii. Investor Agreement:

Purpose: These agreements are between the company's founders and external investors.

Key Provisions: Investor agreements focus on the terms and conditions of investment, including the valuation of the company, the rights and preferences of investors' shares, and provisions for future funding rounds.

iii. Buy-Sell Agreement (or Buyout Agreement):

Purpose: Buy-sell agreements establish a mechanism for shareholders to buy or sell their shares under certain circumstances.

Key Provisions: They outline the triggering events (e.g., death, disability, divorce, or voluntary sale), the valuation method for shares, and the process for executing the buy-sell.

iv. Joint Venture Agreement:

Purpose: These agreements are used when two or more parties enter into a business partnership or joint venture.

Key Provisions: Joint venture agreements define each party's roles and responsibilities, profit-sharing arrangements, dispute resolution mechanisms, and exit strategies.

v. Shareholders' Agreement for Closely Held Companies:

Purpose: In closely held companies where there may be a limited number of shareholders or family members involved, these agreements are crucial.

Key Provisions: Such agreements often address management and control issues, dividend policies, and restrictions on the transfer of shares to outsiders.

vi. Drag-Along and Tag-Along Agreements:

Purpose: These agreements protect the interests of majority and minority shareholders in the event of a sale of the company.

Key Provisions: Drag-along provisions allow majority shareholders to force minority shareholders to join in the sale of the company, while tag-along provisions enable minority shareholders to join the sale on the same terms as the majority.

vii. Shotgun Clause (or Russian Roulette Agreement):

Purpose: This agreement is a mechanism for resolving disputes between shareholders who disagree on the value of their shares or the direction of the company.

Key Provisions: It allows one shareholder to offer to buy the other shareholder's shares at a specified price, or the other shareholder can counter-offer to buy at the same price. The first shareholder then has the choice to sell or buy at that price.

viii. Employee Stock Option Plan (ESOP) Agreement:

Purpose: ESOP agreements are used to grant employees stock options as part of their compensation package.

Key Provisions: These agreements define the terms, vesting schedules, exercise prices, and conditions for employees to exercise their stock options.

ix. Rights of First Refusal (ROFR) Agreement:

Purpose: ROFR agreements give existing shareholders the first opportunity to purchase additional shares before the shares are offered to external parties.

Key Provisions: They outline the procedure for invoking the right of first refusal and the terms under which the purchase would occur.

x. Shareholders' Agreement for Publicly Traded Companies:

Purpose: In publicly traded companies, shareholders may enter into agreements that address specific issues not covered by the company's bylaws.

Key Provisions: These agreements might include rules for proxy voting, information-sharing, and the management of large blocks of shares.

These are just some of the common types of shareholders' agreements, and the specific terms and conditions within each agreement can vary widely based on the needs and objectives of the parties involved. The creation and negotiation of a shareholders' agreement are essential steps in establishing clear expectations and governance for a company's shareholders.


4.1 Control and Governance Rights

Control and governance rights in a shareholder agreement are crucial components that define how a company is managed and how decisions are made among its shareholders. These provisions are essential to maintain order, protect shareholder interests, and ensure that the company operates smoothly.

Various kinds of Control rights are as follows:-

1. Board Representation: A shareholder agreement often specifies how the company's board of directors is composed. It may allocate seats on the board to specific shareholders or classes of shares. For example, certain investors or founders may have the right to appoint a certain number of directors.

2. Voting Rights: The agreement may outline the voting rights of each shareholder, which can vary based on the class of shares held. Some shareholders may have special voting rights, such as veto power over significant decisions.

3. Majority vs. Minority Rights: The agreement may address the balance of power between majority and minority shareholders. For example, minority shareholders might have protections against actions that could harm their interests, such as dilution or significant changes to the company's business.

4. Quorum Requirements: Control rights can include provisions regarding the minimum number of shareholders required to hold a valid meeting or make decisions. This helps ensure that important decisions involve sufficient shareholder participation.

5. Consent Mechanisms: The agreement might require the consent of specific shareholders or classes of shares for certain actions, such as selling the company, taking on significant debt, or making substantial changes to the business plan.

6. Exit Rights: Control rights can extend to exit strategies. For example, the agreement might specify under what conditions the company can be sold and who has the authority to approve or veto such a sale.

Various kinds of Governance rights are as follows:-

1. Management Roles: Shareholder agreements often define the roles and responsibilities of key executives, including the CEO and other top managers. This can include appointment and removal procedures.

2. Access to Information: Shareholders typically have the right to access certain company information, financial statements, and records. The agreement may outline the process for requesting and receiving this information.

3. Dividend Policies: Governance rights may touch on how dividends are declared and distributed, which can be crucial for shareholders who rely on dividend income.

4. Operating and Business Restrictions: The agreement may impose restrictions on the company's operations, such as limits on borrowing, capital expenditures, or entering into certain contracts. These restrictions can protect the interests of shareholders.

5. Dispute Resolution: Governance rights often include mechanisms for resolving disputes among shareholders or between shareholders and the company. This may involve mediation, arbitration, or other methods to avoid costly litigation.

6. Confidentiality and Non-Compete: Shareholder agreements can contain provisions that restrict shareholders from disclosing sensitive company information or engaging in competitive activities that could harm the business.

In summary, control and governance rights in a shareholder agreement are vital for defining how a company is managed, how decisions are made, and how shareholder interests are protected. These provisions play a critical role in shaping the governance structure and operational framework of a company.

4.2 Liquidity Preference

Liquidity preference is a concept in finance that reflects the tendency of investors to value assets that are more liquid (i.e., can be easily converted to cash) more highly than those that are less liquid. It plays a crucial role in various financial decisions and market dynamics.

Most of the shareholders agreement being entered into in the present times have a clause wherein one or more shareholders get the preference to get their shares liquidated before any other shareholder receives the money in case of liquidation. This allow the investor to receive the funds before any previous shareholder or founder receives any money from the company in case of liquidation.

Factors that affect liquidity preference are as follows:-

1. Time Horizon: Investors with shorter time horizons tend to prefer more liquid assets because they may need to access their funds sooner. Long-term investors may be more willing to accept less liquid investments in exchange for potentially higher returns.

2. Risk Tolerance: Risk-averse investors often demand greater liquidity because they want to be able to quickly exit an investment in case of adverse developments. Conversely, risk-tolerant investors may accept less liquid investments to pursue potentially higher yields.

3. Economic Conditions: Economic stability or uncertainty can impact liquidity preference. In times of economic uncertainty, investors may favour highly liquid assets to maintain flexibility and reduce exposure to market volatility.

4. Investment Goals: Different investment goals, such as capital preservation, income generation, or capital growth, can influence liquidity preferences. Income-oriented investors may favour liquid investments that provide regular cash flows, while growth-oriented investors may accept lower liquidity for the potential of higher returns.

4.3 Transfer Restrictions

Discuss how many shareholders' agreements include restrictions on the transfer of shares and how these restrictions can affect the liquidity and valuation of shares. Explore various types of transfer restrictions and their implications for equity valuation.

4.4 Pre-emptive Rights

Pre-emptive rights, also known as "rights of first refusal" or "rights of pre-emption," are a common provision in shareholders' agreements. They grant existing shareholders the opportunity to purchase additional shares of the company's stock before those shares are offered to external parties. Pre-emptive rights are designed to protect the interests of existing shareholders by allowing them to maintain their proportional ownership and prevent dilution. Exit Mechanisms.


The valuation of various rights & obligations provided under the shareholder’s agreement requires application of adequate value to each right in order to determine the value of different types of instruments of the company. The valuation in case where the business have multiple instruments arising out of the shareholders agreement is done by applying Waterfall Valuation methodology or OPM Backsolve.

5.1 Waterfall Valuation

Waterfall valuation methodology is a fundamental financial analysis technique used to distribute profits and proceeds among various stakeholders in a business or investment venture. It provides a structured approach to allocating returns based on predefined priorities and criteria. In this article, we will explore the concept of waterfall valuation methodology, its key components, and how it is applied in different financial scenarios.

Waterfall valuation is a financial model used to allocate profits or proceeds from an investment or business venture in a hierarchical manner, ensuring that various stakeholders receive their share of returns according to predefined rules and priorities.

Waterfall distribution involves following steps:-

1. Identify the value of the business;

2. Identify various rights and obligations for different type of instruments i.e. equity shares, ESOPS, Preference Shares, OCDs etc.;

3. Calculate the break points which are essentially the valuation iterations which reflect exercise of various rights;

4. Attribute the value in the order of preferences and the rights of each type of instrument; &

5. Calculate the per unit valuation for each instrument.

5.2 OPM Backsolve

OPM (Other People's Money) backsolve is a financial term and strategy used in corporate finance and valuation. It involves solving for a variable (typically the required rate of return or discount rate) in a financial model or valuation equation when all other variables are known. This approach is used to determine what rate of return an investor would require in order to achieve a specific financial outcome, such as a target valuation or return on investment. Here's how OPM backsolve works:

Scenario: Imagine you are valuing a company, and you know all the other variables in your valuation model, including the expected future cash flows, the time horizon, and the current market price of the company's shares. However, you want to determine what rate of return an investor would need to achieve a certain valuation based on these inputs.

Steps in OPM Backsolve:

· Input Known Variables: Begin by inputting all the known variables into your financial model. These may include the projected cash flows, the time period for the analysis, and the current market price of the company's shares.

· Set Up the Valuation Equation: Use a standard valuation model, such as the discounted cash flow (DCF) model, to calculate the valuation based on the known variables. The DCF model, for example, calculates the present value of future cash flows, discounted at a certain rate.

· Isolate the Unknown Variable: In the case of OPM backsolve, the unknown variable is typically the discount rate or required rate of return. Rearrange the valuation equation to isolate this variable on one side of the equation.

· Solve for the Unknown Variable: Use algebraic techniques to solve for the unknown variable (the required rate of return) based on the known variables and the target valuation or financial outcome you want to achieve. This may involve rearranging the equation and applying algebraic principles.

· Interpret the Result: Once you have solved for the required rate of return, you can interpret the result. This rate represents the return an investor would need to achieve in order for the known variables and the target valuation to be consistent. It provides insights into the attractiveness of the investment based on the investor's required rate of return.

Example: Let's say you have projected that a company will generate $1 million in cash flows per year for the next five years. The current market price of the company's shares is $3 million, and you want to determine what rate of return an investor would require to justify this valuation. You set up a DCF model with these inputs and isolate the required rate of return as the unknown variable. By solving for this rate, you find that the investor would require a 10% annual rate of return to justify the current market price.

OPM backsolve is a valuable tool for financial analysts and investors when they need to assess the required rate of return or discount rate that aligns with a specific financial objective or valuation. It allows them to work backward from a target valuation or outcome to determine what rate of return is implied by the known financial inputs.


In conclusion, shareholders' agreements are intricate legal documents with far-reaching consequences for equity valuation. By understanding their components and implications, stakeholders can make more informed decisions, promote transparency, and ensure fair valuations in the ever-evolving landscape of corporate finance.

For the valuers, shareholders agreement requires special emphasis while determining the value to be attributable to each instrument in the shareholder structure of the business. Ignorance of shareholders’ agreement may result in valuer determining a significantly different valuation of the instrument than what it should be after attributing various rights. Valuers while accepting the valuation engagement should refer to the existing as well as the previous shareholder agreement to chart out the economic rights of various instruments and then providing adequate value to each such instrument.