Many private equity investors have not been including so-called "drag-along" or "bring-along" rights in their standard term sheets and investment documents. In light of the recent decision of the Delaware Supreme Court in the Omnicare case, investors have even more reason to consider adding such provisions. In addition, even if investors are currently including drag-along rights in their agreements, these rights should be reviewed to be sure they are up-to-date and effective.
Definition. "Drag-along rights" are provisions (most commonly found in shareholders’ agreements) that require all shareholders subject to the agreement to agree in advance to participate in a future acquisition of the company if a specified percentage of the shareholders or preferred shareholders support the acquisition. The shareholders agree to vote for a merger, or a sale of the target company’s assets, or to sell their stock directly to the prospective purchaser, and not to seek appraisal rights. Drag-along rights typically terminate upon a public offering.
Omnicare. The Delaware Supreme Court recently nullified the deal protection terms of a negotiated merger transaction in Omnicare, Inc. vs. NCS Healthcare, Inc. (See the TH&T client bulletin, "Delaware Supreme Court Nullifies Locked-Up Deal" on our website at www.tht.com for a fuller discussion of the Omnicare case and its potential effects on merger and acquisition transactions.) In Omnicare, the Court invalidated a combination of deal protection terms, including (1) an irrevocable agreement among the holders of 65% of the target’s outstanding stock to vote in favor of the deal; (2) an agreement to put the merger to a vote of the target’s shareholders even if the board of directors withdrew its recommendation of the deal; and (3) the lack of an effective "fiduciary out." The Court determined that this combination of defensive measures precluded the ability of the directors to exercise their fiduciary duties, and of shareholders to reject the transaction.
Buyers in today’s uncertain markets are likely to continue to want as much certainty as possible that a transaction will be completed before they will offer their best price to acquire a target. Buyers therefore may want to execute acquisition agreements that do not contain a fiduciary out and require the target to put the matter to the shareholders even if the directors withdraw their recommendation. If a buyer also enters into a lock-up agreement with shareholders representing a majority of the shares, the arrangement would run the risk of being invalidated under Omnicare. However, with drag-along rights, the buyer and target investors in favor of the transaction could be reasonably assured that the required votes to complete the transaction will be available without having an impermissible lock-up.
It is important that any agreement to sell a majority of the stock of a target company be carefully structured and negotiated to differentiate it from Omnicare. A key factor would be the negotiation of these drag-along rights at the time of the preferred investors’ investment in the target, not at the time of the acquisition in question. Further support would come from the well-settled principle of Delaware law that, absent board involvement such as that in Omnicare, agreements between shareholders and third parties regarding the disposition of their shares are valid and enforceable.
Other Uses for Drag-Along Rights. Private equity investors also find that drag-along rights can be useful even if a lock-up is not a primary concern, such as when the private equity investors are not in a majority position or there are sizable numbers of shareholders (such as friends and family of the founders or "angel investors") who may not have the same interests in a particular transaction as the private equity investors. These other shareholders may not agree with the private equity investors on the price or other terms of a proposed sale of the company, particularly if the private equity investors will receive a disproportionate share of the proceeds because of their liquidation preferences. The drag-along rights can also lower the percentage of the shares that can oppose the transaction and seek appraisal rights. In some instances, the mere existence of the drag-along rights is enough to persuade shareholders to agree to a sale or merger.
Drafting and Negotiating Issues. Although drag-along rights are a commonly known term in private equity investing, there are a number of issues that may be negotiated. One issue is the percentage of the group of investors or class of shareholders that is required to trigger the rights. A related issue is whether there are any conditions to a transaction (e.g., minimum price) that are required to trigger those rights.
Drag-along rights are usually included in a shareholders’ agreement, and each shareholder to be subject to the rights must become a party to that agreement. Private equity investors often insist that, as a condition to their investment, all or a specified percentage of current shareholders agree to the drag-along rights, and that the company agree not to issue additional shares of stock unless the purchaser becomes a party to the shareholders’ agreement.
Investors will also want to be sure that the drag-along rights specifically provide that the rights are effective in a transaction in which the consideration received by the shareholders is determined in accordance with the liquidation preference provisions of the charter. This will make it clear that all shareholders do not necessarily have a right to the same consideration as will be provided to the investors triggering the rights.
Acquisition Considerations. An acquisition involving drag-along rights should be negotiated and structured in a manner that maximizes the effectiveness of the rights as a means to provide lock-up protection to a buyer. Since the Omnicare Court emphasized the role of the target’s directors and their relationship with the majority shareholders, the role of the directors affiliated with key shareholders should be limited in negotiating any contemporaneous lock-up of the shareholders. The target’s involvement in the transaction should be carefully examined as well. These issues need to be identified and dealt with as early as possible in any negotiation. Merger and acquisition practice under Delaware law and Omnicare is likely to continue to evolve, and private equity investors will need to be sure to get current advice when planning a transaction.
Conclusion. When structured and implemented properly, drag-along rights can provide important protection for private equity investors when it comes time to exit a portfolio company investment.
The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.