Early stage companies face an uphill climb in growing their business and ensuring their viability going forward. Private equity firms can provide capital as well as significant operational and transactional expertise to aid in a company’s growth. However, private equity investors often intend to exit any investment within a defined time period. As a result, private equity investors frequently demand concessions prior to investment to avoid exposure to liquidity risk. Common liquidity mechanisms sought by private equity investors include drag-along rights, and registration rights.
Drag-along rights and tag-along rights
Private equity investors will frequently attempt to negotiate the inclusion of a drag-along provision in a shareholders’ agreement. A drag-along right allows shareholders (usually a majority) to force the remaining shareholders to accept an offer from a third party to purchase the company on the same terms. This allows liquidity and an exit route to the selling shareholders as most buyers want to acquire 100% of a company without potentially hostile or uncooperative minority shareholders. A drag-along provision can cause heartburn for founders who are wary about the potential that the company may be sold without their consent.
The flip side to drag-along rights are tag-along rights, which allow certain shareholders (usually a minority) to participate in a sale by the other shareholders on the same terms. Generally, a tag-along provision works to the benefit of smaller shareholders, to avoid being left behind when the larger investors liquidate their investment.
In a limited partnership structure, such rights would generally be included the limited partnership agreement.
A founder needs to be careful when negotiating drag-along provisions in particular, as such provisions can force the sale of a founder’s interests even when it is against such founder’s wishes. In addition, if ae founder is also an officer of the company, this may mean a termination of employment.
Registration rights are another right commonly sought by private equity investors. Registration rights can take the form of “demand” or “piggyback” registration rights.
Demand registration rights essentially grant the right to an investor to force the company to list its shares publicly so that they can be sold by the investor. If the company is private at the time, this would mean that the company would have to conduct an initial public offering, which can be expensive and time consuming for the company. There would also be additional costs associated with being a public company, such as compliance with continuous disclosure requirements and listing fees.
Piggyback registration rights grant the right to an investor to also list its shares when either the company or another investor initiates listing. In this instance, the investor cannot initiate the listing process. From the perspective of the investor, these rights are inferior to demand registration rights.
It is in the interests of a company to limit registration rights, as they can impose a significant cost on the company, divert employees from growing the business, or could lead to the company becoming public at an inopportune time.
While the world of private equity investments can create huge opportunities for early stage companies, in structuring a private equity deal, careful consideration must be given to the details of the investment to ensure that the liquidity concerns of the investor are balanced with the best interests of the company and the wishes of its founders. A fine balance must be struck to ensure that the deal is both appealing to private equity investors and adequately protects the company, its founders, and its existing shareholders.
The author would like to thank James Foy, articling student, for his assistance in preparing this legal update.