An IPO is normally the preferred exit strategy for private equity investments as it generally yields the highest returns. However, since launching a successful IPO depends on favorable market conditions, among other factors, investors must always plan ahead alternative exit routes. That's where trade sales come in.
In a trade sale, a buyer purchases the target company's shares. In some cases, such as when the buyer is a strategic player in the target company's business (e.g., a competitor, customer or supplier), the buyer will only go through the purchase if it is able to buy all of the target company's shares (or at least a number of shares that will secure absolute control over the target company).
If the other shareholders of the target company are at the time willing to sell their shares to the strategic buyer, the problem is solved. Everyone sells their shares and the private equity investor has its desired exit. But what happens when only the private equity fund wants (or needs) to sell shares? How does it make sure that a trade sale exit will be feasible? The typical solution to this challenge is the provision of a drag along clause in the target company's shareholders' agreement.
Notwithstanding variations from one agreement to the other, the drag along clause usually has the following basic structure: it empowers the shareholder who wants to sell its interest in the company and has found a buyer willing to acquire the shares to drag and force the other shareholders to also sell their interests to the same buyer and under the same conditions. The private equity vehicle holding such drag along right is thus able to exit the company even where the buyer only has interest in acquiring all of the company's shares.
Drag along rights are more commonly ascribed to the majority shareholder (or alternatively to all shareholders subject to the rule that such rights can only be exercised jointly by a group of shareholders representing the majority of the voting rights attributed to the company's shares). But, especially in seed and venture capital investments, it can also be granted to minority shareholders, especially private equity funds, which are thus allowed to compel the majority shareholder to also sell its shares.
In this case, the provision is known as a reverse drag along clause.
The drag along right also brings another benefit to the private equity fund, notably when it is a minority shareholder. In addition to facilitating an exit the drag along also enables the fund to share the added value that a buyer would otherwise pay only for the controlling shares. Since the sale of shares by all shareholders must be consummated under the same terms and conditions, the added value (control premium) is divided proportionally among all sellers. In short, the drag along right increases liquidity and value. Drag along rights are not necessarily attributed to all shareholders. Private equity vehicles may request to have drag along rights but will want to avoid being dragged out of their investment for a value below their expectations.
Naturally, the other shareholders may also have similar concerns. Even though the drag along clause usually aligns the interests of the private equity fund and those of the other shareholders – after all, both will want to obtain the highest sale price possible for their shares – in some cases misalignments can occur. The other shareholders may be unwilling to sell their shares at a certain moment because they believe the company's prospects will increase in the long run or are emotionally attached to it. They may also be concerned that they will be forced to sell for a price lower than the company's fair value if the private equity fund is under a deadline to be liquidated.
Some of the shareholders' apprehensions about being dragged can be addressed. A typical protective provision is the right of first refusal (ROFR) or the right of first offer (ROFO), which allows them to acquire the shares being sold and thus continue in the company. The ability to exercise a ROFR or ROFO, though, may not provide sufficient comfort. Even if the shareholders believe the offered shares are underpriced, they may not have readily available funds to acquire them. Or due to circumstantial economic conditions, such shareholders may not be able to raise funds in the market to buy the offered shares.
The agreement can also establish a general lock-up period or that the drag along rights may only be exercised after a certain time period has elapsed. Concerns about underselling in many cases can be addressed if the agreement sets forth a minimum price for the shares subject to the drag along rights. This minimum price can be pre-determined upon the execution of the agreement or be established at the time of the sale based on an appraisal of the company's fair value or some other criteria.
Carefully and creatively drafted, drag along provisions can provide a potential way out of an investment for private equity vehicles, while addressing concerns that the other shareholders may have about being dragged out of the company.
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