The appropriate approach to be taken in a shareholders’ agreement in relation to the transfer of shares and exit provisions will largely be dependent on each party’s rationale for entering into the joint venture arrangement in the first place. For instance:
- Are the shareholders coming together to establish a new business or project? If so, an initial lock-in period (where no shareholder can exit) may be necessary to enable the project to reach a critical mass.
- Is a shareholder investing in an existing, successful business for the purpose of providing finance and achieving a return? In that case, it will want to be able to achieve a smooth exit without onerous restrictions, but how concerned are its co-shareholders about the identity of any future transferee of the investor’s shares?
The transfer provisions will also need to be flexible enough to allow for future changes in circumstances, both of the shareholders and of the joint venture company.
Restrictions on transfer of shares
In a joint venture arrangement, it is usual for each shareholder to want some comfort as to who will be its co-shareholder going forward. There are a range of restrictions that may be appropriate, from a complete prohibition on transfers without consent, to no restrictions at all (except perhaps for a prohibition on transfers to certain categories of restricted persons, such as those subject to sanctions or incorporated in a country on the UN blacklist).
Most shareholders’ agreements will include provisions which fall between these two extremes. It is fairly common, particularly where the joint venture relates to a new project, for there to be an initial period – commonly known as a “lock-in period” – where no transfers of shares are permitted (perhaps subject to exceptions for example intra-group transfers).
If transfers of shares to a third party are permitted, there is clearly a tension between the desire of the selling shareholder to exit, and the concern of the remaining shareholder as to the identity of the new shareholder. This is commonly addressed by allowing the remaining shareholder the opportunity to acquire the selling shareholder’s shares, known as a “pre-emption right”.
ROFOs and ROFRs: What’s in a letter?
There are two types of pre-emption rights commonly seen in shareholders’ agreements, but the two approaches can have very different implications.
Under a “right of first offer” (ROFO), the selling shareholder must approach the remaining shareholder before seeking to sell to a third party. The remaining shareholder will be invited to make an offer for the selling shareholder’s shares, which the selling shareholder may accept or reject. If the selling shareholder rejects the offer, then it is free to seek a third-party buyer for its shares, but it can only sell to a third party on terms that are better than those offered by the remaining shareholder. If it unable to find such a third party, then the selling shareholder can decide not to sell, or to sell to the remaining shareholder on the terms originally offered.
By contrast, where there is a “right of first refusal” (ROFR) – also sometimes called a “right to match” – the selling shareholder must first agree terms with a third-party purchaser, and then give the remaining shareholder the opportunity to buy the shares on the same terms.
A ROFO is therefore usually more attractive for a selling shareholder – it can seek a buyer for its shares knowing that it has an offer in its pocket against which it can invite higher offers. Under a ROFR, by contrast, it must go to the time and expense of negotiating terms with a third party, only to face the possibility that this deal will be unwound by the remaining shareholder. The existence of the ROFR itself will make finding a third party to buy the shares harder (as the third party may be reluctant to enter into negotiations knowing it may lose the deal). For the remaining shareholder, a ROFR is usually preferable, as the price it pays will have been market tested by the selling shareholder.
Of course, at the outset, you may not know whether you will be the selling shareholder or the remaining shareholder. These provisions also assume that the remaining shareholder will have the financial capability to participate in the pre-emption process – if the remaining shareholder is weaker financially, or is a minority shareholder, a ROFR or ROFO may offer it no protection, and we address below what alternative mechanisms may be appropriate in such circumstances. An imbalance between the shareholders may not only be in monetary terms: if a shareholder has limited involvement in the business of the joint venture, and little access to information, it will find it difficult to provide adequate due diligence material to potential purchasers, or to provide a purchaser with adequate warranty protection. These disclosure issues should be contemplated in the shareholders’ agreement (including appropriate provisions as to confidentiality).
Drag along and tag along rights
Where shareholders have unequal percentage interests in the joint venture, the majority shareholder’s shares are likely to be more marketable if it is able to deliver 100 per cent of the joint venture to a buyer. Conversely, a minority shareholder may not be keen to be in a joint venture with a new majority shareholder that it does not know. “Drag along” and “tag along” (or “co-sale”) rights are the mechanisms frequently used in shareholders’ agreements to address these concerns.
Broadly, a drag along right gives a right to the majority shareholder to force the minority shareholder to sell its shares to a third-party buyer on the same “terms” (and we will consider what that means below) as the majority shareholder, whereas a tag along right gives the minority shareholder the right to force the third-party buyer to acquire its shares on the same terms as it buys out the majority. Drag / tag rights may be included in addition to or instead of pre-emption rights, and it is a matter of negotiation whether both drag and tag rights are included.
A minority shareholder should consider carefully how the shareholders’ agreement describes a sale “on the same terms”. Should this just be at the same price as the majority sells, or will it be required to be on exactly the same terms (including the provision of any warranties and indemnities) as offered by the majority? A minority shareholder may not be in a position to give the same contractual protection as its larger co-shareholder, and if this is the case then this should be made clear in the shareholders’ agreement (for example, that on a sale the minority will only give warranties as to its capacity to do the deal and its ownership of the relevant shares). The minority shareholder should also consider what will be an acceptable form of consideration: this is straightforward if the majority shareholder is selling for cash, but if the majority shareholder receives other forms of consideration (such as shares in the purchaser) this may be less attractive for the minority. The shareholders’ agreement could therefore provide, for example, that the drag along rights can only be enforced where the consideration is in cash, or that the minority shareholder must always receive the cash equivalent of any non-cash consideration.
Some shareholders will enter into a joint venture with a very clear goal in terms of achieving an exit in a specified time frame. The proposed manner of their exit may not be limited to a sale of their shares, but may include disposal of the business of the joint venture, a disposal of the entire issued share capital, or an IPO of the shares in the joint venture. Such a shareholder is likely to require a clear timeline of when the exit process will be initiated, and the obligations on the other shareholders to co-operate in that process. These obligations may extend to implementing any reorganisation of the share structure necessary or desirable for an IPO, the provision of information, and the acceptance of certain terms (such as restrictions on disposing of shares following the IPO, or warranties to be provided on a share sale) intended to facilitate the exit. For a minority shareholder in this scenario, it will be important to that they are treated fairly on an exit and benefit from the exit on terms equivalent to the shareholder that is driving the exit process.
The bigger picture
Although we have so far focused on the mechanisms for transferring shares, there are of course wider implications to be considered when a shareholder disposes of its interest in the joint venture.
The parties will need to consider whether it is likely that any conditions to the transfer will be required (for example, competition clearances or bank consents) and how the process of obtaining those consents, and the consequences of failing to obtain them, will affect the process for implementing the prescribed process under the shareholders’ agreement.
It also may not just be shares involved in the transaction. If a shareholder has advanced loans to the Company, it is usual for these to be “stapled” to the shares, so that shares and debt are transferred together (and in equal proportions on a disposal of part only of a shareholder’s interest). If there are commercial contracts in place between the joint venture and its shareholders (such as supply agreements, IP licences or secondment arrangements) then the impact of a shareholder’s departure on those arrangements will also need to contemplated (either in the shareholders’ agreement or in the contracts themselves).