Schemes and offers where drags don't work

James Mee and David Wallis detail the statutory solutions available when drag-along rights are either ineffective or non-existent for the sale of private companies with a large employee shareholder base

In our previous article, we explained some of the issues that arise when the use of drag-along rights may be required.

However, there can be situations where the key shareholders in a company are looking to sell and there are too many of them to sign a sale and purchase agreement (SPA), but there are either no drag-along rights or there is a risk that the drag-along rights don't work. The latter is surprisingly common.

If drag-along rights might not work or don't exist, it will be necessary to try to achieve the sale using one of two statutory mechanisms – the first being a takeover offer and squeeze-out, the second being a scheme of arrangement.

Neither is easy, and either will increase the transaction costs well beyond those incurred when an SPA can be signed.

Takeover offer and squeeze-out

An offer can be made to acquire all of the shares of the company being sold. The documentation required on the sale of a private company by way of an offer is generally easier than when a listed company is being sold (as certain regulations won't apply), but is still complicated.

A few examples will illustrate this. The "offer document" will need to set out clearly the terms of the transaction, including pricing and any changes to price through completion accounts.
It will also need to set out details of any amounts held back by way of escrow or deductions from the purchase price for transaction fees and/or any premium for a warranty and indemnity policy.

Explaining a complicated transaction in a document to be sent to shareholders can take some doing. Warranties can be included. Where there are lots of shareholders, typically only key/management shareholders give warranties on the state of the business (all shareholders usually give warranties that they own the shares they are selling).

A buyer may want key sellers to sign a "transaction agreement" that will contain those business warranties – and it will also include other key terms such as restrictive covenants.
So, at a very basic level, the number of documents starts to increase. And how they fit together needs some care.

From a buyer's perspective – and when planning a sale on the sell-side – there is no substitute for having all key sellers sign up to the transaction agreement (which is akin to a SPA, but only signed by them), as the "squeeze-out" can't be used to impose terms such as restrictive covenants on sellers that don't accept them.

The document will also contain details of how to accept the offer (which is normally by the signing and return of a "form of acceptance" sent with the offer document). A form of acceptance can itself be complicated if there are different types of consideration.

This may be the case when certain shareholders are being required to "roll over" part of their investment in the company being sold into equity (or commonly convertible/exchangeable debt) in the acquirer/holding company. This is particularly common with a private equity-backed buyer, but we also see this where the acquirer is listed.

If the offer is structured correctly then the acquirer will, in broad terms, be entitled to buy out dissenting shareholders if the holders of 90 percent by value of the "shares to which the offer relates" have accepted the offer. This forced acquisition is referred to as the "squeeze-out".

It will by now be clear that using an offer is not simple. Sometimes the issues that arise when a drag provision may not work also surface when an offer is being planned.

If the reason the drag won't work is that a different consideration is being offered to different groups of shareholders (e.g. if certain shareholders are being required to "roll over"), then the structure of the offer becomes more complicated. Under the Companies Act, the offer must be on the same terms for all shareholders holding each class of share.

To treat different groups of shareholders differently, different "classes" of shareholder are required. In practice, new classes of share may need to be created through changes to the articles of association.

As with making changes to the articles of association when using a drag, that brings with it the risk of objecting shareholders going to court. And segmenting the shareholder base may make it more difficult to achieve the 90 percent threshold that will need to be achieved in respect of each class of share.

It is also important to factor in the wording of the rules of existing share option and incentive plans, and work out carefully how the offer will interact with those rules. They don't always dovetail neatly.

Scheme of arrangement

The second statutory mechanism is a scheme of arrangement. Schemes have been used to transfer insurance books of business (now usually under a "Part VII" transfer), but what we are considering here is a scheme between a company and its shareholders to sell the company to a buyer.

A scheme requires approval by shareholders and also by the court. Once approved, it binds all shareholders irrespective of whether they voted in favour.

Under a scheme, the shares in the company being sold are automatically transferred to the buyer in exchange for the buyer paying the agreed consideration directly to the selling shareholders.

One advantage of a scheme over a takeover offer or using a drag-along is that it can be easier to make changes to the articles and know that once the court has approved them shareholders are bound.

Also, the court can approve changes that "mop up" shares that come into being after the change in ownership (for example, following the exercise of options).

Care is, of course, needed in structuring a scheme and in making changes to articles of association, as the court has discretion to approve or reject a scheme.

As with structuring an offer, one has to look carefully at the number of "classes" required for scheme purposes. The approval of each scheme class is required by separate resolution (this is analogous to a takeover offer having to be accepted by the threshold percentage in each class).

As with an offer, different considerations being offered to different shareholders will – and sometimes different sell-side and/or buy-side incentives being offered to certain shareholders may – create a need for different scheme classes.

Whether a scheme or an offer makes sense will require a detailed analysis of the shareholder base, and the different classes needed for an offer or a scheme.

There is a dual approval threshold under a scheme: (1) 75 percent of those by value of those voting at the relevant class meeting; and (2) a majority by number of those shareholders voting at that class meeting. Thus, a long tail of minority shareholders in any class may be able to block a scheme.

As with an offer, if management hold a significant shareholding and receive a different "deal" to non-management employee shareholders, the non-management employee shareholders may have an effective veto; and care is needed around existing share options and incentives.

In summary then, if the chips are down there are statutory solutions available, but these are complex and costly. It is much better to have prepared earlier for a successful sale by checking and, if needed, amending drag-along provisions well in advance of that sale, when time and opportunity are on your side.

This article was first published in the Insider Quarterly.