Even as they make their investment, private equity investors are focused on their exit. A standard feature of an exit strategy is the set of drag-along rights embedded in a stockholder or similar agreement executed among majority and minority investors at the time of investment. At their core, these rights vest in the controlling holders the decision of when to exit the investment and on what terms. In theory, it would be sufficient to simply require minority investors to each individually sell their equity to the buyer selected by the controlling investor, on the terms negotiated by the controller. In practice, controlling investors do not rely on an upfront agreement of the minority holders to sell their equity, out of concern that a minority investor might be unwilling to perform, or cannot be found, at the time of exit. Instead, especially when there is a large number of target equity holders, the exit is likely to take the form of a merger, whose approval is guaranteed by the majority vote of the controller.
With a merger, minority holders are generally swept along with the transaction, without any need for their vote or other affirmative action. The concern of the controlling investor shifts from effecting the transaction to avoiding post-completion challenges. Drag-along provisions therefore will invariably require minority equity holders to waive otherwise available rights to appraisal. These rights, if available, allow nonconsenting stockholders in a merger to challenge the fairness of the merger consideration. Standard drag-along rights also include other provisions to forestall challenges to the exit transaction.
A recent decision of the Delaware Chancery Court, Manti Holdings LLC v. Authentix Acquisition Co., Inc. (Del. Ch. August 14, 2019), suggests, but does not decide, that there may be limits in certain circumstances to the upfront waivers that a controlling investor may impose on the minority. The case dealt with the waiver of appraisal rights, which the court upheld in the circumstances, but its reservation on enforceability could require a different result on other facts. The court’s reservation might even be transposed to other rights that minority holders forfeit when they agree to standard drag-along rights.
The Introduction of Drag-Along Rights
Minority equity holders may be initial venture investors who from the outset are content to cede governance and exit control to the promoting majority holders. Alternatively, they may be the promoters themselves who at a subsequent time are required to enter into various equity holder arrangements as a condition to an infusion of new capital by investors in a subsequent financing round. Depending on the leverage that the new investors are able to exert, these subsequent investors may demand and receive rights to control the exit strategy for the enterprise.
Often, there will be a combination of these two fact patterns. In the initial round, the promoters of a venture will bring in minority investors, perhaps friends and family, without special attention to exit considerations. With the venture in need of capital, new financial investors are introduced, and, as a condition of investment, these investors insist on a full panoply of rights that include various elements of control on an exit. The arrangements with the new investors will typically be negotiated by the originally controlling equity holders, with little if any input from the minority.
The minority will typically follow the lead of the original majority in executing agreements required by the new investors. These agreements, which contain the drag-along rights, may variously be styled as voting agreements, stockholder agreements or investor rights agreements. The drag-along rights typically contain a covenant to take reasonably requested action in support of a majority-approved exit transaction, including to execute certain contractual arrangements; to refrain from exercising appraisal rights; to refrain from asserting any claim or commencing any legal action challenging the exit transaction; and to refrain from alleging that the controlling investors breached a duty, or aided and abetted the breach of a duty, in connection with the exit transaction. While the minority will be required to join as parties to these agreements, it is often the case that they will have had no participation in their negotiation.
Authentix is a company that provides authentication solutions to government and private industry. It was acquired by an investment group in 2008, with the original owners retaining a minority stake. As a condition to the acquisition, the original owners entered into a stockholders agreement, with drag-along rights that required the original owners to waive their appraisal rights on an exit. In 2017, the company was sold to an unaffiliated third party in a transaction approved by the controlling majority. The original owners challenged the enforceability of the waiver of appraisal rights. Initially, the petitioners challenged only the application of the waiver on a number of grounds that were rejected by the court (Del. Ch. October 1, 2018). On a motion for reargument, the petitioners sought to invalidate the waiver itself, arguing that statutory appraisal rights cannot be waived as a matter of law. The court disagreed, but with a reservation that may have implications for the enforceability of drag-along rights generally.
Rejecting the petitioners’ position on non-waivability as a matter of law, the court held that “waiver of appraisal rights is permitted under Delaware law, so long as the relevant contractual provisions are clear and unambiguous.” The court then stressed the sophistication of the parties:
Petitioners were [Authentix’s] sole stockholders. There is no record evidence that the Petitioners were not fully informed; to the contrary, there is evidence that the Petitioners are sophisticated investors who were fully informed and represented by counsel when they signed the [stockholders agreement], under which they obtained some rights and relinquished others, and then accepted the benefits of that contract for seven years.
The court then added, “I need not decide whether a waiver of appraisal would be upheld in other circumstances.”
The petitioners in Authentix were in the minority at the time of the exit transaction, but were the sole owners at the time the new investors arrived on the scene. Through their counsel, they negotiated with the new investors the drag-along rights to which they objected when the company was sold to a third party. In these circumstances, their challenge was hardly appealing. But what of “friends and family” or other investors who at all times were a minority and who did not participate in negotiating the drag-along provisions to which they are being subjected on exit? The reservation of the Authentix court seems directed at such investors.
The scope and rationale of the court’s reservation are open to interpretation. The court may have been registering uncertainty only regarding a contractual waiver of stockholder protective statutory rights expressly contained in the Delaware General Corporation Law. If so, the case would not have implications for other waivers and affirmative obligations typically found in the standard roster of drag-along rights.
Alternatively, the court’s reservation may be understood more broadly, as reflecting an uneasiness with the waiver of stockholder rights generally in circumstances in which the waiver is not fully knowing or consensual. This uneasiness could extend to the release of common law rights and might even inform a court’s willingness to enforce — or the scope of its enforcement of — provisions that seek to impose affirmative duties on stockholders that are the essential equivalent of a waiver of rights. This would include the waiver of common law claims for breach of fiduciary duty, or abetting such breach; the undertaking to desist from challenging the transaction; and the affirmative obligations under customary drag-along rights to take action such as the execution of documentation (which may contain indemnification obligations and restrictive covenants) to facilitate an exit transaction.
Protecting Enforcement of Drag-Along Rights
There do not appear to be any cases in which courts have declined to give effect to any of the assortment of rights found in commonly formulated drag-along provisions. Nevertheless, in light of the uncertainty injected by the Authentix case into enforcement of these rights, at least with respect to appraisal, private equity investors may wish to take steps to enhance the enforceability of these rights, and to fortify them against possible challenges at the time of exit by minority holders.
Private equity investors should therefore consider, at the time of their investment:
- Designating an equity holder representative to represent the interests of the minority holders, particularly if their interests may differ from those of the originally controlling equity holders with whom the new investors are negotiating.
- Expanding the contractual description of the drag-along rights, including particularly the types of agreements that selling holders may be required to execute in connection with an exit transaction. This could include indemnification obligations, restrictive covenants and the requirement to accept pro rata rollover equity (with the corresponding obligation to execute the new organizational documents and stockholder agreements with respect to a successor entity).
- Assuring that the minority holders receive full and timely written disclosure regarding the drag-along rights. This could include not just the documentation itself, but a plain-English explanation of its terms.
- Memorializing the opportunity given to minority equity holders to ask questions concerning the drag-along rights, together with other elements of the investment transaction.
- Including in the agreement that contains the drag-along rights some representations and/or acknowledgements that the equity holders executing the document are sophisticated investors and have read and understood the terms of these rights.
Financial investors in a private venture are understandably focused on their ability to engineer an economically attractive exit of their investment without disruption by minority holders. Drag-along rights are therefore a core feature of the package of investment terms on which these investors insist when making their investment. The Authentix case suggests that there could be circumstances in which at least certain of these drag-along rights might not be enforceable against passive minority equity holders. Depending on the circumstances, it might be prudent to consider implementation of some or all of the additional steps described above at the time of investment, which could deflect possible challenges to the drag-along rights at the time of exit.