Issues and Best Practices in Drafting Drag-Along Provisions

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 post outlines potential pitfalls, as well as best practices, that clients and practitioners should consider when negotiating drag rights.

Triggering 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:

• What types of transactions will trigger the drag sale procedures? From a majority owner’s perspective, drag rights should be triggered by all types of sale transactions, such as mergers and sales of substantially all of the company’s assets, rather than simply a sale of shares or membership interests. Sometimes this is accomplished by tying the drag rights trigger to the definition of “Transfer” (e.g., a majority owner may invoke its drag rights in the event of a “Transfer” of a specified amount of its ownership interests) or a “Change of Control.” If the definition of “Transfer” is used, parties should ensure that the term is not broadly defined to include non-sale transactions, such as a pledge of ownership interests. In addition, if “Transfer” is broadly defined to include indirect transfers, parties should consider whether an indirect upstream transfer really is intended to trigger drag rights and if it is, how such a drag-along transaction would be accomplished mechanically. Because the same transfer concept is often used for both drag-along and tag-along provisions, these same issues should be considered in the tag-along context. Finally, if drag rights can be triggered by alternative types of sale transactions, the minority owner’s obligations should be expanded to encompass whatever is required to effect such transactions, such as voting in favor of the transaction and waiving appraisal rights, and should supersede any consent rights the minority owner may have with respect to such transactions.
• What minimum percentage ownership of the company (or what percentage of the sponsor’s ownership, if a sponsor is the party with the drag rights) should be required to be sold to trigger the drag rights? A sale of at least 50% of the company (or 50% of the sponsor’s ownership) is common, but the exact percentage may vary depending on the company’s ownership mix and the parties’ relative bargaining strength. The parties should also consider that the percentage used to trigger the drag-along is generally the same percentage used to trigger the tag-along. In other words, a majority owner that wants a low percentage threshold to trigger the drag-along should keep in mind that the same low percentage threshold generally will be the trigger for the minority owner to tag along.
• Minority owners may consider bargaining for additional restrictions on the ability of a majority owner to invoke drag rights. For example, minority owners may seek to impose a black-out period or require a guaranteed minimum price or rate of return over a given time period before the drag right can be exercised. In any event, minority owners should ensure that drag rights can only be triggered by a sale to a bona fide third party purchaser—in most cases a majority owner should not be able to trigger drag rights by transferring its ownership interests to an affiliate. Requiring board approval of a drag sale, which would require the board to consider its fiduciary duty to all of the company’s owners, is another way for minority owners to protect themselves from a non-bona fide drag sale or otherwise to better ensure that the sale is for at least fair market value. Of course, a majority owner should realize that subjecting the drag-along transaction to board approval may compromise its ability to effect a sale on terms of its choosing.
• What type of notice should the majority owner be required to give to the minority owners before invoking drag rights? This issue was the subject of a ruling from the Delaware Court of Chancery in Halpin v. Riverstone National, Inc., C.A. No. 9796-VCG (Del. Ch. Feb. 26, 2015). The court held that a majority owner’s drag rights were not enforceable because it did not comply with the drag sale notice provisions contained in the governing agreement. The governing agreement required the majority owner to provide advance notice of a drag sale transaction, but the majority owner did not give notice of the drag sale until after it had already occurred. In light of Halpin, majority owners should seek to preserve flexibility regarding when notice must be provided in the event that the sale is conducted on a fast or unpredictable time table. Due to language in the court’s opinion in Halpin, however, is unclear whether notice can be provided retrospectively after the closing of the drag sale, even if the company’s governing documents provide for retrospective notice. Specifically, in dicta, the Halpin court explained that a retrospective notice scheme would prevent a minority shareholder from petitioning the court to avoid an oppressive merger, casting doubt on whether a retrospective notice scheme is appropriate. In any event, regardless of when notice of the drag sale is required to be given, minority owners should seek specificity regarding the content of the notice. At a minimum, minority owners should request that the notice include a copy of the sale transaction agreement or a summary of the material terms and conditions of the transaction.

Sale Proceeds

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.

Sale Obligations

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.

• Representations and Warranties. Most commonly, the minority owner will agree to make customary representation and warranties regarding its ownership and will agree to bear, severally and not jointly, its pro rata portion of any indemnification obligations with respect to breaches of the representations and warranties made by the company. Alternatively, if the majority owner has a relatively strong bargaining position, it may ask the minority owner to agree to be jointly and severally liable for the company’s indemnification obligations and to enter into a contribution agreement providing for sharing of indemnification obligations. Minority owners often seek to cap their indemnification obligations so they do not exceed the net proceeds each owner will receive in the sale.
• Covenants. Generally, a majority owner requires minority owners to agree to make the same covenants made by the majority owner in the drag sale and to take any action reasonably required to effect the consummation of the drag sale. However, there are a number of specific covenants that minority owners may resist and carve-out from a general requirement to make the same covenants as the majority owner in the drag sale. These specific covenants include the following: non-competition, non-solicitation or similar restrictions (such restrictions are usually heavily negotiated and tailored to the transaction and the applicable seller); waivers of any rights or benefits to which the minority holder may be entitled pursuant to then-existing contractual rights to which the other owners are generally not entitled; covenants to which the majority owner is not subject in the drag sale; and covenants without “reasonableness” or “customary” qualifiers.
• Sale Procedures. The parties should consider how they would like the drag sale process to be conducted. Doing so will help to avoid surprise issues or disputes when the time comes to coordinate and effectuate the sale to a third party buyer. To ensure that post-closing matters are conducted in an orderly fashion, a majority owner may require the appointment of a single seller representative and an escrow fund to fund the seller representative’s expenses. A majority owner may also require sharing of drag sale transaction expenses pro rata based on the consideration received by each owner (otherwise, the majority owner, which is typically the party initiating and running the drag sale process, might be stuck with the bill). Even if transaction expenses are shared, the minority owner might stipulate that it will not be required to make out-of-pocket expenditures prior to the consummation of the drag sale and/or that transaction expenses incurred by the majority owner for its sole benefit will not be shared. Another approach is to require the company to bear transaction expenses.

Interaction with Other Provisions

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.

Remedies

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.