What happens when a minority of shareholders don’t agree to the terms to acquire or merge their company? The terms could change drastically… or the deal could fall apart completely.
But, says Nate Gallon, managing partner of the Silicon Valley office of Hogan Lovells, there’s a way to avoid that fate… because the shareholders will be contractually obligated to vote “yes” on the sale. This provision is well-known in the world of Private Equity and Venture Capital but not elsewhere.
Nate talks about how to lay the legal groundwork to make this strategy work, as well as…
- Why you have to look at the Liquidation Waterfall
- How to ensure that small shareholders don’t sabotage a closing
- The best person to provide you with this provision (if you don’t have it already and don’t even know)
- The dangers of appraisal rights claims
- And more
Mentioned in This Episode: www.hoganlovells.com
Patrick Stroth: Hello there. I’m Patrick Stroth. Welcome to M&A Masters, where I speak with the leading experts in mergers and acquisitions. And we’re all about one thing here, that’s a clean exit for owners, founders, and their investors.
Today I’m joined by Nate Gallon, office managing partner of the law firm Hogan Lovells, in Silicon Valley. Nate has spent his entire career here in the Valley working with the tech community, representing all flavors of entrepreneurs, from startups to the major corporations we know of every day. We hear about them every day in the media. As well as the entire ecosystem of the investor community that funds and supports these innovators. Nate, welcome to M&A Masters, and thanks for joining me today.
Nate Gallon: Thanks for having me, Patrick. It’s a pleasure to be here.
Patrick Stroth: There’s a lot of legal groundwork that needs to be laid way before owners and founders can even start thinking about an exit. And Nate, you were featured as a speaker in the latest Silicon Valley M&A forum, where you presented an informative briefing on the topic that needs to be brought to the attention of owners and founders planning an exit. And that’s drag along rights. Now, so the audience, I’ll let Nate explain this provision, which is routine in the venture capital and private equity worlds, but it may not be top of mind elsewhere. And that’s why he was highlighted recently, and why I wanted him to come on and share his knowledge with you on this. But before we drag Nate into that conversation, let’s start here with, Nate, why don’t you give everybody a little bit of context as, how did you get to this point in your career? Why did you pick tech, the law, and then tech law, and then ended up here in Silicon Valley?
Nate Gallon: Yeah. So yeah, I’ve been here in Silicon Valley my entire legal career, which is about 20 years. It’ll be 20 years this summer. Prior to my time at Hogan Lovells, I spent 15 years at another local Silicon Valley law firm. But my whole career has been focused on working with technology companies and investors, and to a lesser extent, life sciences companies and investors, because I wanted to be part of the economy that was creating new ideas, creating jobs, and was really helping to expand the economy and provide novel products and services and other items to the community at large. I didn’t want to work in traditional industries. I wanted to work with entrepreneurs and wanted to understand and be a part of the new technologies that were coming into existence.
And that hasn’t changed in my 20 years. I look back on what I’ve experienced, and it’s truly astonishing, the technologies and the platforms that we’ve seen come out of not just Silicon Valley, but the technology and life sciences community throughout the United States and in other parts of the world. So that’s really what attracted me.
And in M&A, and my focus is on both M&A, and equity transactions, and venture capital, and strategic investments, as well as representing entrepreneurs. And that really gives me a firsthand look at the companies, working with entrepreneurs, working with major corporations to buy companies from entrepreneurs, and really get your feet wet and get to understand everything that’s happening within the community, while also being able to act as a business advisor and help from a financial perspective for both buyers and sellers in M&A to achieve their goals. And in venture capital to help investors achieve their financial goals when they invest in new technologies and platforms.
Patrick Stroth: Well Nate, you and I share a common passion, and that is we have an affinity for people out there, the entrepreneurs that start with nothing and create something. And go from zero, to one, to two and help marry them with other parties that will get them from two to 10. And so it’s a great, great place to be in, and there’s no better place in the world than right here in Silicon Valley, while it is spreading elsewhere.
But let’s get to the topic here. What are drag along rights, and why are they so important?
Nate Gallon: Yeah. So drag along rights are something that’s been in the venture capital and the private equity community for certainly as long as I’ve been practicing, and I’m certain before that. A drag along provision, it’s a provision that’s usually located in stockholder’s agreements, occasionally in the bylaws, whereby the stock holders of a target company agree to vote in favor of, and not oppose or hinder a sale of the company. And to take any other action that’s reasonably required to consummate a sale transaction, including, if it’s structured as a share purchase, to sell their shares to the third party in the transaction.
So in other words, at the time that the venture investors make their investment in a company, well in advance of, sometimes years in advance of an M&A transaction or exit, the venture investors will often require that the parties to the stockholder’s agreement, essentially all the preferred stock holders, and typically most if not all the common holders sign on to an agreement. A stockholder’s agreement that says, if in the future, the board … and so either majority or super majority of the stockholders vote in favor of a sale of a company, to sell the company to a third party, then the other investors that are parties to that agreement, whether or not they agree with that sale transaction are bound, contractually, to vote in favor of the transaction, not oppose a transaction, and if required to tender their shares or take other action to ensure that the sale transaction takes place.
So it’s a way of ensuring that potential dissenters, or those who would challenge or oppose an M&A transaction will be contractually bound to vote in favor of, and go along with the transaction.
Patrick Stroth: So you can’t have the tail wagging the dog if one, lone dissenter wants to hold up … one dissenter can’t gum up the deal.
Nate Gallon: Exactly. Exactly. And that gets into kind of the priorities, and why would investors, or why would companies agree to such a transaction? And if you think … or a such a provision. If you think about it, there are reasons why the investor would want it, and there are reasons why a company founder might want it. Especially if you have a dispersed shareholder base, or you expect that you’ll have a dispersed shareholder base, there are oftentimes competing interests that look differently on a sale of the company depending on the liquidation waterfall. And by that I mean the, the capital structure, and which series and classes of shareholders get paid first versus last in a sale transaction. There may be competing interests and competing visions as to whether a particular M&A transaction is in the best interest of the shareholders.
So what this does, is it ensures that that kind of debate doesn’t happen at the time that the sale transaction’s in front of you. Essentially, it forecloses that debate, subject to the parameters that are actually negotiated in the drag along. And that’s often where the devil meets the detail.
Patrick Stroth: Yeah. So the benefits really on this are, this will make the decision a lot cleaner with the major shareholders. And you can’t have one party who may have an opposing viewpoint, or see things differently for whatever reason, they’re not going to slow this down. Are there any other benefits along with that?
Nate Gallon: Correct. Correct. So if you think about, let’s take the merger structure, which is one of several different acquisition structures we use when buyers are acquiring a company. The merger agreements will have a condition that the stockholders approve, some specific percentage of the stockholders approve the transaction as a signing condition. And as a closing condition, so in order to actually close the transaction, there will typically be a condition that no more than a small number or small percentage of stock holders have dissenters or appraisal rights under law. And those are, depending on the state, whether California, Delaware, or otherwise, dissenters or appraisal rights are creatures of state law that provide a judicial mechanism whereby shareholders who do not believe that they are getting fair value in the transaction in a merger can … if they adhere to a very specific time schedule that’s prescribed by state law, can have their shares valued in a court hearing, can have them valued as to whether or not the shares are more valuable or less, potentially, than the deal value.
And there are a number of headaches associated with that, because that is something that can happen following the closing the transaction. So buyers want to know that there are very few, usually under 5% of the shareholders of the outstanding shares, are eligible to have dissenter’s claims. If you have a drag along, it allows the sellers to much more easily, the target company, to more easily satisfy that closing condition. And that’s something that, for a founder that wants a deal done, or that venture capital investor, or strategic investor that is a preferred holder that wants a deal done, it allows those who are in favor of the deal to ensure that those small holders can’t gum up the closing by having the company fail to satisfy that minimum appraisal rights closing condition.
Patrick Stroth: You could actually …
Nate Gallon: Go on.
Patrick Stroth: I’m sorry to interrupt. You could have a situation then, if you don’t have drag along rights, where a small minority could really harm the deal post-closing, which now everybody gets harmed.
Nate Gallon: Right. Right. And what happens is if there are post-closing appraisal claims, typically a buyer will require that the company shareholders, former shareholders, the target’s former shareholders have to indemnify the buyer for any claims arising out of those dissenter’s claims. So to the extent that the buyer has to hire counsel to litigate an appraisal rights claim in Delaware court, those costs would ultimately be borne by the former target shareholders. And so through the indemnification process, and those former target shareholders will ultimately receive less deal consideration because essentially they are funding the legal fees of the buyer’s counsel in defending that appraisal rights claim.
Patrick Stroth: So that’s insult to injury. You’re the seller, you want to sell, you have a buyer that wants to buy, you’ve got these small percentage of dissenters that are going to hold this up. And if they’re successful in slowing this down and causing legal action, then you, the seller get to pay for all this, whichever way it goes. So that’s a real negative. That’s a real negative out there.
Nate Gallon: And that’s the outcome. If the buyer ultimately chooses to close in spite of there being a significant number of potential … or I should say, of shares available to press appraisal claims at the closing.
The other is, if the closing condition is not satisfied. So for instance, if the closing condition says, no more than 5% of outstanding shares of the target are eligible to bring appraisal claims at or after the closing. If that closing condition’s not satisfied, the buyer can walk away from the deal. So it’s not just if the buyer closes the deal, there’s an indemnification risk where the seller’s ultimately receive less total consideration because of indemnification claims. It actually can be a deal risk where the buyer could walk away. Hopefully that wouldn’t happen, but that is always a risk. So you have not just financial risk, but actually risk of getting the deal done if the closing condition’s not satisfied.
Patrick Stroth: Yeah, that’s Armageddon for sellers, is getting a deal … getting it signed and then not … and failing to get a close, and failing to get across the goal line. Then you have to go after all that time, energy, and passion has been used up, you’ve got to go back to the marker, back out. That’s just worst case scenario on the sales side.
Are there any limitations to drag along rights?
Nate Gallon: Yes, that’s a good question.
Patrick Stroth: Or is this is just a great magic bullet?
Nate Gallon: No, that’s a very good question. Typically the standard negotiated drag along rights usually have exceptions. So the drag along can be triggered by a vote of some majority or super majority of the stock holders, but they are usually conditions to enforcement. And the conditions vary depending on the deal you’re negotiating, but typically there are a number that you see, and I would say are generally customary in venture capital transactions. And you can actually find a lot of these … you can find all of them in the National Venture Capital Association forums, which are available online at NVCA.org. The NVCA has model venture capital investment documents for the entire suite of documents you’d use, including the … what we call a voting agreement. Which is a form of stockholder agreement that typically include the drag along.
And the types of conditions are, for instance, that the proceeds in an acquisition are allocated to the stockholders of target in accordance with the liquidation waterfall in the target certificate incorporation. That there are limitations on the scope of representations and warranties that a target shareholders must personally give in the acquisition agreement. And if the scope of the reps and warranties goes beyond that, then essentially that can frustrate or negate the ability to enforce the drag along.
There are other provisions around caps on liabilities for … on the liability of a stock holder of a target. And depending on the type of transaction, when and if at all a particular target stockholder can be liable for fraud or other claims by another stockholder. So it’s a fairly detailed set of exceptions, and you really have to look through them and navigate them closely to make sure that the exceptions do not frustrate … the exceptions, when you compare them to the deal you’re negotiating, do not invalidate the ability to enforce the drag along.
Patrick Stroth: All right. Now, in a practical sense, how do the drag along rights … how do they work, or how are they triggered? Is it just … if you have them set up, if you’ve got a competent attorney that helps you get your bylaws set up, you’ve got them in your agreement, and everybody’s aware of them, but they’re in there as you go forward on an acquisition. Who can trigger the drag along rights, or is it an automatic provision that just … they’re here, they work, move forward. How does it, in a practical sense, work?
Nate Gallon: Right. So the drag along would be in the voting agreements that I just mentioned. And you would have all of the preferred investors typically, and many, if not most, of the common investors signing on as parties to the agreement. As the company goes through successive rounds of financing, round series A, series B, you would continue to add parties to that agreement to make sure that you’re capturing the universe, so that you have 100% or close to … as close as possible, hundred percent drag along coverage.
When there’s an actual sale transaction before you, there are different ways it plays out. But usually the company has a good sense either through normal communications, regular communications or otherwise over whether stockholders have been on board with the company, whether they’re friendly, whether or not they’re not friendly. So that’s kind of just, know your stockholder base.
Second is, typically you have the major investors sitting around the board table. And oftentimes they are, or some subset of them, is sufficient to trigger a drag along. So if you’ve gone through successive rounds of financing, you may have three, or two or three, or maybe even more venture capital firms or strategics on there that collectively can trigger the drag along. So what you would do is you would have the board approve a transaction. You’d have the specified or required shareholders approve the transaction that triggers the drag along. And then between signing and closing, you would go out, reach out to the other stockholders with an information statement, with disclosure of the transaction, solicit their consent to approve the transaction. And it’s through that solicitation process, is usually where … that interim period between signing and closing, is where you would really start to shake out those who are in favor versus those who are not.
And oftentimes, if it’s a deal where people are making a relatively good return on their investment, it’s not so much people opposed to it as it is logistics. You often have people who are out in a boat for a month and you can’t reach them. That can often be a problem. Where the brass tacks are is when it’s a deal where not everybody’s making money, or not everybody’s getting the return that they expect to get. And that’s where you start to have challenges. And where, between that … you want to know before you do the solicitation, how enforceable is the drag along relative to the deal that you’ve cut with the buyer? But once you go out and do the solicitation, then you really have to kind of look at your drag along and figure out against whom you need to enforce it.
And a drag along is enforced because one of the key practice points is, a drag along has to have … should have a proxy and a power of attorney whereby the proxy in the agreement will state that if a shareholder opposes a transaction but is subject to the drag along, that shareholder … if that shareholder is obligated under the drag along to vote in favor of transaction, even if he opposes it, the proxy is granted typically to the company CEO or a member of the board. The proxy holder, the CEO, can vote that reluctant shareholder’s shares in his place and in favor of the transaction. So you’d have a proxy, and it would be coupled with a power of attorney that which grants that CEO, the proxy holder, the ability to sign a consent on behalf of the reluctant shareholder to approve the transaction.
So that’s the teeth of enforcement. And if there’s no proxy or power of attorney, enforcement’s much harder because you’d have to sue the reluctant shareholder in court to enforce the drag along provisions, which is a much more cumbersome process rather than relying on a proxy and a power of attorney.
Patrick Stroth: Yeah, and it speeds it up too because if somebody just decides, well I’m just not going to vote. I won’t dissent, I just won’t vote, and I’ll try to slow you down there. They’ve got the proxies in place, and it’s been signed off on with power of attorney. So it’s well supported. Very well buttressed provision.
Is there … I mean, is there a reason not to have drag along rights? The only thing I could ever picture is if you got a sole shareholder with one investor, and they’re both equal investors or something. But is there any situation where drag along rights shouldn’t be there?
Nate Gallon: The only instance is if … the term I use is the dragger or the dragged. If you are likely to be the dragged, it obviously does not make sense for you to put a drag along in place. It’s often hard to determine, especially if it’s a later stage company, based on the capitalization table, whether you will be the dragged or the dragger. But typically the … it’s lead investors that want the drag along, and especially if you are a follow on investor, or maybe more likely a small investor as part of a larger syndicate, it’s more likely that you would be dragged rather than dragging. But it’s hard to say.
And I would say, as a general matter, and as a general practice point, having a drag along in place is a good thing to have. I’d say nine times out of 10, the scenarios I see, whether I’m representing an entrepreneur or representing a venture fund, a drag along is a good thing to have in place.
Patrick Stroth: Well, now in cases where a company … and this would happen with companies that probably haven’t had initial funding, they haven’t had a seed round, they’ve just pretty much opened up and been self-sustaining their entire duration, and maybe haven’t needed to look at their bylaws that often. They may not have the drag along rights provision in there. What can you do? They can be added on. How does that work?
Nate Gallon: Yeah, so if it’s a non-institutionally backed company, if it’s self-funded or bootstrapped, we do see those a fair amount. And a lot of times it’s friends and family, so you’ve got a lot of investors, or you have a number of investors that may or may not be well versed in venture capital investing. That can present its own challenges from just an expectations perspective. But you can always put a drag along in place later on, after you have a stockholder base in place. The challenge is, you won’t be able to get anybody to sign up to … you can’t enforce a drag along on somebody who hasn’t consented to be parties to that agreement, or to be bound by those provisions.
So if you don’t realize until after you have 30 investors that you need a drag along, well, you need to get each one of those 30 investors to sign up to an agreement that includes a drag along. You can’t force it on an investor without his or her consent.
Patrick Stroth: Well it may be easier to do that if there’s nothing on the horizon, right then. So if you notice that you don’t have it, you think you should get it, and there’s no deal on the horizon. Might be easier to get agreement, to get all those bases covered. It’s just one of those things that you really don’t want to have to start chasing down when you’re on the clock to try to stage up your company for an acquisition. So that’s why I think it’s … this is just one of those issues where, again, it’s like if you’re building a house, and now thinking about where the rain gutters go. It’s a minor thing, because everybody’s thinking about kitchens, and roofs, and windows, and garages, and stuff.
These are the types of things that, while they’re not right top of mind, they’re easy to address, I think, with a professional that can fast track you through the process, to check and see if you’ve got them. And if you don’t, get them in there. I think it just pays dividends down the road. If not in dollars, it does in time and quality of life because you’re not stressed out with one of these things that’s easy to overlook if you don’t have an expert looking at this.
Nate, if we’ve got a lot of listeners out there that want to look more into this, and maybe just to see for themselves if they’ve got it, or what it would take to get it, you’re the guy to go to. How can our listeners reach you?
Nate Gallon: Yeah, Patrick, the best way to reach me is, you can email me. And my email address is ngallon. That’s N-G-A-L-L-O-N@hoganlovells.com. And you can also contact me through phone. You have … my bio’s on the web. You can always find my bio and contact information on the web. I am the managing partner at Hogan Lovells in Silicon Valley, and you can reach me here in the office here. You can come by anytime. We’re here in Menlo Park, and we are embedded in the venture capital and the M&A communities, and would certainly love to hear from anybody that has questions or would like to discuss this further.
Patrick Stroth: Very helpful, Nate. Again, you took a real technical, legal issue and brought some life to it, which is what you did at the forum. That’s why I thought it’s great value to our audience. So thank you very much.
Nate Gallon: It was my pleasure. Thanks for talking.