An institutional investor's ability to deliver a smooth and timely exit, and deliver 100% of an investee company to a willing buyer, sits at the heart of its business. An exit agreed by all shareholders (including any management sellers and any co-investors) will always be the preferred route, but any responsible institutional investor must be prepared for the worst. A key tool employed to allow it to force an exit is the "drag-along" provision (also known as the more subtle "come-along"), which compels minority shareholders to sell alongside the majority. However many drag-along provisions are defective in practice, giving a disgruntled minority seller an opportunity to resist being dragged. This month we focus on five of the most common mistakes.
1. Identical terms
The Achilles heel of a drag provision is drafting that states a dragged shareholder's shares must be purchased "on identical/the same terms (including as to price)". For example, where a PE house is selling, it is likely that the majority seller (the PE fund) and the minority sellers (likely to be key members of the management team) will be selling on different terms – so whose terms should be extended to the dragged shareholder?
Key members of the management team will likely be "paid" partly in shares and/or loan notes issued by the buyer's acquisition vehicle (known as roll-over), and the selling PE house may also be partly "paid" in vendor loan notes. The management team may also be offered an earn-out to incentivise them to drive performance in the business post-completion, whereas the PE house will typically prefer the certainty of cash up front.
The better approach is to specify that the dragged shareholder should be offered consideration of value equivalent to that received by the majority sellers, but even that requires careful drafting and some carve-outs. For example, what if the selling PE house is granted a right to re-invest into the buyer's structure – should that right be considered part of the consideration?
2. Payment terms and costs
Another frequent failing of drag clauses is to overlook the practicalities of completion funds flows.
Many drag provisions only contemplate cash payable on completion, whereas deferred consideration and (as mentioned above) earn-outs are relatively common. This leaves the majority selling shareholders with a conundrum; arrange for the dragged shareholders to receive payment faster than they do (which could also breach the "same terms" requirement), or allow the dragged shareholder scope to challenge the sale.
Just as painful can be the realisation that transaction costs cannot be deducted from a dragged shareholder's consideration. Typically such costs (lawyers, accountants, corporate finance advisers) would be taken off the cash consideration payable at completion, before the balance is paid on to the sellers – but the drafting will need to provide for this if dragged shareholders are to pay their pro rata share of sale costs.
A drag provision may compel a shareholder to transfer its shares, but can it compel a dragged shareholder to provide contractual reassurances such as warranties and indemnities? It is not unusual for drag provisions to be silent on the issue, in which case a dragged shareholder could argue that it cannot even be bound by standard title and capacity warranties.
The better approach is to specify within the drag provision which warranties (usually full title, capacity, authority) a dragged shareholder must give. One note of caution here though – if the minority seller is properly advised, it is very unlikely to agree drag wording which could compel it to give commercial (business) warranties; this will usually be excluded expressly.
4. SPAs and ancillary documents
A requirement to sign a stock transfer form is typical in a drag clause, but provisions compelling execution of a share purchase agreement and ancillary documents (such as an indemnity for a lost share certificate) are not always present.
This is significant because a stock transfer form is the effective instrument to transfer legal title under English law, but a share purchase agreement is effective to transfer beneficial title. The share purchase agreement is also the document that will carry the fundamental title, capacity and authority warranties, and can 'lock in' the dragged shareholder at an early stage where there has to be a gap between signing and completion.
Additionally, it is standard for a buyer to demand that either each seller's original share certificate be relinquished, or an indemnity be executed in favour of the buyer. Unless this is expressly provided for, a reluctant dragged shareholder could gain leverage and complicate a sale process by disputing this requirement.
5. Defaulting dragged shareholder
If a shareholder refuses to comply with the drag provision, the drafting should provide a method to effect a transfer on its behalf. This sometimes takes the form of a power of attorney in favour of a director of the target company, or another person. However, under English law, a power of attorney is only effective if executed as a deed, and the drag provision typically features in articles of association (which are adopted by shareholder resolution, not executed as a deed).
A typical solution is to state that the director (or any other person) acting on the dragged shareholder's behalf will in fact act as agent, rather than attorney. It is unclear whether this approach would be upheld if challenged, but to mitigate this risk the scope of the agent's authority to bind the dragged shareholder should be clear and limited. A wide authority runs greater risk of being considered an (unenforceable) power of attorney.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.