Call options and put options in shareholders’ agreements: what they are and why they can ruin your company

In previous articles, we have analysed the key clauses of shareholders’ agreements as a fundamental instrument for preventing corporate disputes. However, there are certain mechanisms which, if included without due care, may become a genuine problem in shareholders’ agreements involving investors.

Without prejudice to the fact that there are other particularly critical clauses as well (such as set-off rights or the combination of drag-along rights and liquidation preference), we refer here to two profoundly asymmetrical mechanisms: call options and, above all, put options.

Call options: the right to acquire

A call option is based upon the right of one party (the option holder) to acquire, at a future date and subject to certain conditions, the shares or equity interests of another shareholder, who is thereby obliged to sell. At first sight, there appears to be no financial risk, since the obliged party will always receive a fixed or determinable amount (unlike a put option which, as we shall see, entails an obligation to make payment).

However, this mechanism is not without risk. In practice, call options are frequently linked to potential breaches that enable the investor to “force out” the defaulting shareholder from the company. When the alleged breach occurs and the call option is exercised, the exercise price is commonly symbolic, namely at nominal value or even one euro, thereby operating as a genuine penalty against the shareholder being expelled.

On paper, this is understandable, since a party committing a serious breach should bear the consequences of such breach. Nevertheless, it is precisely the punitive nature of the mechanism that makes it essential to regulate very carefully the grounds entitling the option holder to exercise the option. Accordingly, if the criteria enabling the call option to be exercised against the alleged defaulting shareholder are not drafted clearly, and the determination of whether a breach has occurred is left to the discretion of the option holder, the option may become a mechanism of exclusion and pressure.

Outside these disciplinary or punitive contexts, call options must be structured appropriately and respond to logical and symmetrical parameters in order to fulfil their intended purpose. A poorly calibrated call option may become financially punitive where the damage is channelled through a forced exit at a negligible valuation.

The key to this mechanism therefore lies in designing it appropriately in terms of its exercise mechanics, time period, price, valuation and symmetry.

Put options: when you are forced to buy

Notwithstanding the above, the real danger may lie in the put option, since in such cases the roles are reversed and it is the holder of the option (usually the investor) who has the power to compel the other party (typically the founding shareholders) to purchase its shares or equity interests. Accordingly, the obligation imposed is one to purchase, which inevitably entails a financial outlay.

Investors, particularly private equity and venture capital funds, commonly require this type of clause in order to establish clear exit windows if the investment does not develop as expected, if no liquidity event occurs within a specified period, where there is a management deadlock, or where continued compliance with the investor’s internal holding policy becomes impossible. In such cases, the sale price is often symbolic (nominal value or one euro), since the investor requires certainty of exit.

However, those are not the truly dangerous cases. The real problem arises where the put option is not symbolic but instead carries genuine economic substance. If the amount is fixed from the outset and assumed by the option grantor, the risk may be reduced. However, where the price is merely determinable and dependent upon future metrics, the result may be a payment obligation that becomes impossible to bear.

For example, the put option right may be linked to recovery of the investment, attainment of a minimum IRR (Internal Rate of Return), a multiple of the invested amount, or a value equivalent to the investor’s capital contribution. In such circumstances, the price of the put option may still be ascertainable in advance. However, if the valuation metrics are tied to the future performance of the company, the founders may ultimately face a payment obligation to the investor capable of causing irreparable decapitalisation. In reality, what is effectively being granted in such circumstances is a disguised liquidation preference right, which may constitute one of the most dangerous instruments within shareholders’ agreements involving investors.

Accordingly, where one acts as a founding shareholder, the sensible approach will always be to avoid any type of put option that is not symbolic in nature or whose price is not known in advance and reasonably affordable. Nevertheless, commercial reality may at times make this impossible where the investor holds a position of strength. In such circumstances, it becomes essential to introduce safeguards preventing the clause from becoming an existential threat (including, among others, a realistic valuation methodology, a maximum cap, a clearly defined time window and objective triggering conditions, instalment payments, etc.).

Call options and put options: achieving balance in shareholders’ agreements

Ultimately, both call options and put options are mechanisms which, if poorly calibrated, may entirely disrupt the balance of power between investors and founders. The key does not always lie in eliminating them altogether, but rather in anticipating the circumstances in which they may be exercised, objectifying the triggering events and aligning the pricing mechanisms with realistic and symmetrical parameters. Otherwise, a shareholders’ agreement that fails to contemplate fair exit mechanisms may ultimately become the very source of the conflict it was intended to prevent.

FAQ – Call options and put options in shareholders’ agreements with investors

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