November 28, 2016
Drag-along rights, or drag rights, which give the majority owner of a company the right to force minority owners to participate in a sale of the company, can be a fiercely negotiated provision in a company’s governing documents. These provisions implicate the rights a majority owner and minority owner will have in a future sale transaction, which could be years down the road and to an unknown buyer. From the perspective of a majority owner, these provisions are intended to ensure that the majority owner will be able to sell the entire company on terms and conditions, and at the time, desired by the majority owner. In negotiating these provisions, the minority owner seeks to ensure that such a sale will not disadvantage the minority. In light of what is at stake and the inherent uncertainty drag rights engender, parties are understandably cautious when approaching the negotiating table.
Many may view these provisions simply as a measure to get the parties to the negotiating table later in the event of a sale rather than as a measure to actually effect a sale, which means they are not troubled by the details or mechanics of drag-along provisions. While this view may have merit, the relative leverage of the parties at that subsequent negotiating table may hinge on the relative strength of each party’s rights under the drag provisions. As a result, it is important to pay careful attention to these provisions. This article outlines potential pitfalls, as well as best practices, that clients and practitioners should consider when negotiating drag rights.
A threshold issue in negotiating drag rights is determining when they can be invoked–that is, when a majority owner can force a minority owner to participate in a sale of the company. There are a number of potential issues to consider:
Another important issue in negotiating drag rights is determining the form and allocation of sale proceeds, or consideration, that the owners will receive in the drag sale. With respect to the form of the consideration, majority owners, on the one hand, will want as much flexibility as possible to maximize value in the sale–they will want to be able to negotiate with third party buyers to receive any type of consideration, including securities, in the drag sale. Minority owners, on the other hand, generally will not want to be forced to sell their ownership interests for illiquid securities and may seek to condition the drag sale on receipt of either cash or liquid securities. Moreover, if the minority owners are unaccredited investors, receipt of securities as consideration may not even be feasible in the absence of an exemption from Securities Act registration requirements.
With respect to the allocation of drag sale consideration, minority owners should typically receive the same amount per share or unit received by the majority owner, including proceeds received from any post-closing purchase price adjustment. If the company has multiple classes of shares or units, allocation of consideration is more complicated–generally, the consideration can be allocated such that each owner receives the amount that the owner would have received in a liquidation if the cash value of the company (as implied by the purchase price) was distributed in accordance with the company’s distribution waterfall. If the event of non-cash consideration, the parties may also consider specifying in the governing agreement how the non-cash consideration will be valued.
Language requiring that all sellers receive the same consideration can create issues if some owners receive consideration related to the sale, such as a consulting fee or an ongoing contractual relationship with the company or the buyer, that other owners do not receive. To avoid this problem, careful attention should be paid such that the "same consideration" language clearly applies only to the amounts actually payable in exchange for tendered securities or, in the case of a broad definition of consideration that would pick up ancillary items that all owners should not receive, there is a mechanic for valuing those ancillary items and allocating that value proportionately to all the sellers.
To reduce the uncertainty inherent in a future drag sale, parties frequently negotiate, up-front in the governing documents, the type and scope of obligations that a minority owner will be required to undertake in the drag sale. These obligations can be categorized broadly into (1) representations and warranties, (2) covenants and (3) and sale procedures.
Drag rights are not negotiated in a vacuum, and the parties should consider how the drag rights provisions included in a governing agreement interact with other provisions in the agreement. For example, if the company’s governing agreement includes a right of first refusal (ROFR) or right of first offer (ROFO) in favor of the minority owner, then, from the majority owner’s perspective, a drag sale should not trigger such provisions. Otherwise, the existence of the ROFR or ROFO would inject execution risk into a sale to a third party buyer, potentially making the company an unattractive target. A minority owner might make the counter argument that precluding exercise of the ROFR or ROFO in a drag sale is tantamount to deleting the ROFR or ROFO altogether, depending on whether the parties envision many scenarios where a third party sale transaction would not trigger the drag rights.
The governing documents’ general restrictions on transfer of ownership interests should also be reviewed to ensure that there is an appropriate carve-out for transfers of ownership interests required pursuant to the drag rights provisions.
In the event of a drag sale, majority owners should prepare for the contingency of an uncooperative minority owner that refuses or otherwise fails to comply with the drag sale procedures. The relationship of the parties may have soured or the minority owner may simply be difficult to reach or non-responsive to requests. To mitigate the risk that an uncooperative minority owner can, intentionally or unintentionally, thwart an otherwise valid drag sale, there are a number of provisions or remedies majority owners can seek to include in the drag rights provisions.
Perhaps the most controversial remedy is to ask the minority owner to grant an irrevocable proxy and/or a power of attorney allowing the majority owner to enforce its drag rights, essentially allowing the majority owner to act on behalf of the minority owner with respect to any vote, action by written consent or other action, including signing its name, required to effectuate the drag sale. If included, the parties should be aware that the irrevocable proxy and/or power of attorney may not be enforceable in all situations and, in any event, would need to comply with statutory requirements, which vary by jurisdiction. Moreover, depending on the parties’ relationship, asking a minority owner to grant an irrevocable proxy and/or power of attorney might be considered offensive when a minority owner wants to retain the ability to review and sign drag sale documents and otherwise be involved in the drag sale process.
Aside from the grant of an irrevocable proxy and/or power of attorney, a majority owner may request that the parties add customary provisions to the governing documents requiring the company to automatically update its books and records to reflect the transfer of ownership contemplated by the drag transaction. In the event of an uncooperative minority owner, the governing documents could also provide for the remedy of specific performance or require drag sales proceeds to be held in an escrow account until the minority owner tenders its shares or ownership interests to the third party buyer or otherwise complies with its drag sale obligations. Whatever the remedy, drafting precision and careful attention to the implications and possible outcomes of a drag sale will help mitigate some of the uncertainty inherent in the drag rights provisions of the governing documents.
Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these issues. For further information, please contact the Gibson Dunn lawyer with whom you usually work, or the authors in the firm’s Dallas office:
Please also feel free to contact any of the following leaders of the firm’s Mergers and Acquisitions practice group:
Barbara L. Becker – New York (+1 212-351-4062, [email protected])
Jeffrey A. Chapman – Dallas (+1 214-698-3120, [email protected])
Stephen I. Glover – Washington, D.C. (+1 202-955-8593, [email protected])
© 2016 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.