In our previous article in our series on shareholders’ agreements, we looked at 5 key differences on pre-emptive rights found in 3 sets of model shareholder arrangement documents published by 3 venture capital (VC) associations.
To recap, these are the model shareholders’ agreements which we took a closer look at:
- the US based National Venture Capital Association,
- the British Private Equity & Venture Capital Association, and
- the Australian Private Equity & Venture Capital Association.
In this article, we take a closer look 5 key differences on drag-along rights between the 3 sets of VC model documents as well as the VC model shareholders’ agreement released in 2018 by the Singapore VC association and the Singapore Academy of Law.
Recap on drag-along rights
A drag-along right allows the shareholder with that right to sell up to 100% of the shares of the company by requiring all or some of the other shareholders to sell their shares to the buyer.
By allowing the dragging shareholder to deliver up to 100% of the company to the buyer, the right may be critical in securing an additional “control” premium in the sale price or securing a sale at all.
On the other hand, forcing a sale of shares at a price and time which is out of the dragged shareholder’s control is a serious matter.
Shareholders should not agree drag-along right terms without considering them carefully.
Difference 1 – What “sale percentage” triggers the drag-along rights?
The first key difference between the drag-along rights in the 4 model agreements is the percentage of shares that the buyer offers to buy before the drag-along is triggered. Should such rights apply when the offer involves an offer to purchase 100% of the company or a lesser percentage such as a sale of 51% of the shares?
In both cases, the drag-along sale price theoretically includes a ‘control’ premium, as a sale of more than 50% of the voting power of a Singapore company often passes control of the company on many matters.
However, with a “sub-100%” trigger, a dragged shareholder may worry that they will remain invested in a company with new controllers, even if some of their shares are sold in the transaction and they reap part of the ‘control’ premium.
Out of the 4 sets of model agreements, 2 provide for drag-along rights only where there is a sale of 100% of the shares, another for a sale of more than 50% of the shares, while the last leaves the threshold to be decided by the user.
Further, if the drag-along right is for less than 100% of the shares in the company, how will allocations of sales be made? Will sales of shares be proportionate or will some shareholders have a first right to sell their shares?
In 1 of the 2 model agreements providing for a “sub-100%” trigger, the specifics are not spelt out. For the other model agreement, the dragged shareholders are made to sell the same proportion of shares as is being sold by the dragging shareholders.
Difference 2 – Who has the benefit of the drag-along rights?
Out of the 4 model agreements:
- One stipulates that the drag-along rights may only be exercised by a selected majority of investors;
- Another stipulates that these rights may be exercised with a majority of all shareholders; and
- The other 2 provide for a combination – drag-along rights are exercisable by a shareholder majority which must include the investor majority.
This may not be an issue at the early stages when investors might hold a majority of the shares of the company such that extending the drag-along rights to all shareholders might appear to be a distinction with no difference. However, this may be more critical at later stages if the initial investors’ holdings are diluted with newer investors in the company and they may require the support of other shareholders.
Further, 1 of the 4 model agreements provides for an optional additional level of approval – the drag-along rights may only be exercised if the sale of shares has been approved by the board of directors of the company. As directors must act in the best interests of the company, this additional level of approval may put them in a difficult position.
There is a degree of deviation on this aspect among all 4 model agreements which warrants a deeper consideration by users of any of them. A compromise might involve additional limits on the drag-along triggers outside of the the approval process.
Difference 3 – What price do shareholders sell at?
Only 2 of the 4 model agreements stipulate that the sale proceeds are to be distributed in accordance with the liquidation preference provisions, while the other 2 provide that the sale of the dragged shareholders’ shares are to be on the same terms and conditions as the sale of the shares of the dragging shareholders.
This point is particularly critical in a situation where the company is performing poorly. Shareholders may have to choose between a fire sale price or a winding up. Without the liquidation preference provisions clearly applying to a drag-along transaction, preference shareholders may be incentivised to support a winding up instead, even if it results in a lower price for the business.
On the other hand, dragged shareholders may complain that this means they potentially end up with nothing for their shares after a forced sale if the liquidation preference waterfall applies to a drag-along too.
Another difference is that among the 4 model agreements, only 1 has special provision for where the sale involves non-cash consideration. It provides that the dragged shareholder will be paid an amount in cash equal to the fair value of the non-cash consideration (usually securities).
This specific provision is important to protect dragged shareholders from being forced to transfer their shares for illiquid consideration. It may also be important for dragging shareholders to seal the deal as buyers offering securities may not want the dragged shareholders joining their share register.
Difference 4 – Do all shareholders sell on the same terms?
Some model agreements specify that the dragged shareholders are not required to provide warranties as part of the drag-along sale, except as to ownership of and title to their shares.
This may be because the dragged shareholders are not privy to the discussions and negotiations between the purchaser and the dragging shareholders and haven’t had an opportunity to negotiate these representations and warranties.
On the other hand, the dragging shareholders may object to having to bear all the risks of a warranty claim for a portion only of the sale price.
Among all 4 model agreements, 3 include drafting on this. Notably, the outlier allows the dragging shareholders to specify the terms and conditions which binds all the dragged shareholders!
Difference 5 – What happens if dragged shareholders refuse to sign transfer documents?
Implementing a drag-along transaction is likely to require signature of transfer documents. However, there may be times when the dragged shareholders are uncooperative or uncontactable.
The dragging shareholders could head to court to enforce their drag-along rights. That can take time and involve legal costs. It may also introduce uncertainty into the drag-along transaction that results in a lower offer price or an aborted transaction.
Another solution is to have express provisions dealing with such situations. Only 2 out of the 4 model agreements do so.
Both provide that if a dragged shareholder fails to deliver the necessary transfer documents, an agent and attorney is appointed with authority to do all things necessary to effect the transfer. This authority is given at the time the shareholders agree to become parties to the shareholders’ agreement.
Powers of attorney always look like a technical point and overkill. On a drag along mechanism, it may actually have significant practical repercussions.
The 5 differences explored above are only the tip of the iceberg – there are other nuances in drag-along provisions which each party should look out for.
These nuances are not always the result of differences in the laws of the different jurisdictions but present options for meeting different priorities.
Read more on:
- our analysis of the differences in the provisions on board-related rights in shareholders’ agreements – 5 key options for board provisions in a SHA
- our analysis of the differences in the provisions on pre-emptive rights in shareholders’ agreements – 5 key options for pre-emptives on transfers in a SHA
- our analysis of provisions on transfer of shares in shareholders’ agreements – 5 key concepts on transferring shares under a SHA
- our analysis of board and shareholder control provisions in shareholders’ agreements – 3 key control concepts for a SHA
- choosing a template agreement – 6 tips for picking a template agreement
- our thoughts on the Singapore model documents – VC model documents for Singapore
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