Fast growing companies that reach exit velocity in record time are particularly attractive to PE investors. However, buyer beware! These companies may have received investment from a number of different sources and have a wide shareholder base. In a number of high-growth tech or IP heavy companies, the original developers of key IP may feel that they have not been appropriately compensated for their work. When an acquirer comes along, they may consider holding out for better terms, leaving investors with additional hurdles to overcome to successfully complete the transaction.
Drag along provisions are one way of circumventing this issue in the UK. In this article, we consider the practical steps required to enforce a typical drag along provision.
This article is the first of a two part series. Also read the second part, “Getting PE Deals in the UK Across the Line: Alternative Approaches”.
Drag Along – Two Approaches
There can be both an informal and formal procedure to be followed when seeking to drag minority shareholders.
Informal Approach
Buyers will expect the sellers to resolve any potential issues amongst a target’s shareholder base. They may make suggestions as to the approach to be taken, but will be keen to maintain some distance from the process.
Informally, a seller might remind potentially difficult minority shareholders that there is a drag along provision that could be used to force them to sell their shares. A seller might suggest that, to save time, cost and unnecessary paperwork, it would be better for those shareholders to agree to sell their shares under the terms of pre-prepared transaction documents instead. In some cases, where this is not at first acceptable to a minority shareholder, some form of consideration, together with a settlement agreement, might help tip the balance.
Formal Approach
If an informal approach fails, or if it is impractical due to the sheer number of minority shareholders, then a formal procedure, dictated by the drag along provision, will need to be followed. A written notice will need to be sent to the minority shareholders to be dragged. To enforce the drag along provision, there is also often a requirement that there is a bona fide third-party purchaser seeking to purchase 100% of the shares, so as to prevent existing shareholders from abusing the provision to force out minority shareholders.
In all cases, where there are potential hold-out shareholders, the target company (together with its majority shareholders) will want to determine the likelihood of the relevant minority shareholders actually signing the required transfer documents. It is therefore very important that up-to-date records of shareholders and their contact details are maintained in the run up to any relevant transaction.
Proceed with Caution
A cautious approach should be taken when seeking to enforce a drag along provision, even if it is the only option available. Enforcement of the provision may jeopardise a share transfer, and even the wider transaction, if aspects of the procedure are contested. In addition, the provision itself may not be entirely enforceable and amending the existing provision to correct any errors or ambiguity can lead to claims of unfair prejudice (under section 994 of the UK Companies Act 2006 (“CA 2006”)) or challenges to enforcement.
Some of the practical difficulties parties may encounter when enforcing a drag along provision in respect of a UK target company’s shareholders are set out below.
Process
Some drag along provisions will require an “offer” for 100% of the target. If this is the case, the transaction needs to be structured (or restructured) this way. Failure to follow the precise language of the provision is likely to lead to claims from aggrieved parties and resultant delays. There is also a risk that the buyer might walk away from a transaction (having agreed only to purchase 100% of a target‘s issued shares).
Communication
Some minority shareholders may not be contactable during the course of a transaction. Where this is the case and the target company has sought to exercise the drag along right, a shareholder might claim that their position has been undermined and seek damages. Proceeds will need to be held on trust for the relevant minority shareholders in separate accounts in any event, but even where this has been done, those minority shareholders might not have agreed to the sale and may call into question the transfer.
Timing
There is often little time to ensure that minority shareholders can be dragged. Parties are reluctant to enforce drag along provisions without knowing for certain when a transaction is scheduled to close. This might cause some minority shareholders to feel aggrieved and subsequently look for reasons to protest the transfer, even if the drag along notice was given in line with the requirements of the drag along provision.
Aggrieved Shareholders
Some minority shareholders may simply feel that they are receiving a bad deal. Possibly because the markets have turned, perhaps because the majority shareholder is in financial difficulty itself, or, as mentioned above, where the hold-out shareholders were key to developing the intellectual property in the target. If minority shareholders believe that the price they are receiving for their shares is too low, they will likely refuse to sign the transfer documents.
Required Documents Not Received
Minority shareholders might not return the documents required to effect the relevant transfer. If this happens then the seller and buyer will need to work with the target company to decide to either: i) negotiate with the relevant minority shareholder(s) or ii) seek to enforce the drag along provisions by executing relevant transfers on behalf of the dragged shareholders.
Enforcing Against a Shareholder’s Wishes
To ensure that all shares are transferred without risk of litigation, a target company may seek to delay completion and negotiate with the relevant parties. Although PE buyers look to deploy their dry powder as quickly as possible, they will not want to assume unnecessary risk and often favour this approach. The sellers will usually bear any associated costs such as additional compensation.
If negotiations fail and shares need to be transferred (under a drag along provision) on behalf of a minority shareholder, it may be possible to do so using either the target company’s articles or a power of attorney granted in a shareholders’ agreement to which the dragged shareholder is party. The power of attorney involves less risk of future dispute, being, by its very nature, a strong authorisation to make the necessary transfer given by way of English law deed.
To ensure certainty, a buyer in a strong negotiating position may include a walk-away right in the main SPA, capable of being invoked if more than a few minority shareholders refuse to sign the relevant transfer documents and have to be dragged.
Key Takeaways
For a buyer looking to acquire a company in the UK, particularly any company that has recently experienced very high growth, it is important to keep in mind potential problems associated with a large shareholder base and how to deal with that. In summary:
- Determining whether there are likely to be hold-out shareholders will go a long way to smoothing out the acquisition process, which is key for an efficient deployment of newly raised fund capital.
- Engaging with those shareholders early will help with any feelings of hostility towards a potential acquisition and may reduce the need to rely on drag along provisions.
- Proceed with caution in using drag along rights and ensure deal certainty at the earliest stage.
This article is the first in a two part series. Read the second part, “Getting PE Deals in the UK Across the Line, Part 2: Alternative Approaches”.
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