In our fourth part of the funding round term sheet 101 series we take a closer look at transfer restrictions. It is standard in almost all financing rounds to agree that share transfers are only allowed if they are made in accordance with the shareholders' agreement.
The most common provisions are the right of first refusal, purchase option, drag along right, and tag along right. The idea behind these clauses is that on the one hand you want to have a certain control over the company's shareholder structure (right of first refusal and purchase option). On the other hand it ensures that the majority shareholder(s) cannot be blocked by minority shareholders in sales negotiations (drag along right) or that the minority shareholder can "tag along" with his/her/its shares when the majority is selling their stake (so that the minority is not left behind with new outside shareholders).
The right of first refusal is standard in any shareholders’ agreement. It means that if a shareholder wants to sell shares to a third party, the shareholder has to offer them first to all other shareholders for sale at the same terms and conditions. Only if the non selling shareholders do not exercise their right of first refusal (also-called pre-emption right) may the selling shareholder sell the shares to a third party, i.e., the other shareholders have a ‘right to refuse’ the sale by pre-empting it. It can be agreed that certain shareholders (e.g. investors) are entitled first and the remaining shareholders only have a right of first refusal in second priority, or that - if there is more than one shareholder willing to buy - a proportionate share can be purchased by each buying shareholder.
The detailed structure of the right of first refusal lies in the discretion of the parties and in particular the determination of the price can vary. With the so-called unlimited right of first refusal, the purchase price for the shares is the price that a third party is prepared to pay. This can be prone to circumvention - for example, by agreeing an excessive price with a third party who is then "indemnified" in another transaction. For this reason, the parties often agree by contract that the price should correspond to the fair market value of the share and, in case of disagreement, should be determined by an independent valuator.
Finally, attention should be paid to the provisions concerning notification of the pre-emption event and exercise of the pre-emption right: The selling shareholder must first inform the other shareholders about the essential contents of the sales contract and provide them with a reasonable period of time (typically 30-60 days) to exercise the pre-emption right. Also, the execution of the sale to a third party (incl. requirement of such third party to sign the shareholders’ agreement) and the mechanics if one or more of the existing shareholders exercise their right should be addressed .
The right of first refusal can also be structured as a so-called right of first option (Vorhandrecht). In this case, it is agreed that the shareholder intending to sell must first offer the shares to the other shareholders before they can be offered to third parties. Since in this case there is no offer from a third party to determine the price, it is important to agree on a price determination mechanism.
Although the parties can agree otherwise, it is important to note that, by law, inheritance in particular does not trigger the right of first refusal (see purchase option).
The purchase option has two functions: (1) penalize certain unwanted behaviour (e.g., criminal acts, ‘bad leaver’), and (2) prevent the transfer of shares to third party if something happens to a shareholder (e.g., death). As with the right of first refusal, this clause gives existing shareholders the possibility of controlling the shareholder structure.
Typically, all other shareholders have the right to buy the shares of a shareholder (usually on a pro rata basis), if that shareholder materially breaches the shareholders' agreement, commits a criminal act or leaves the company as a so-called bad leaver (e.g. a shareholder is dismissed without notice due to intolerable behaviour).
The same goes if a shareholder dies, becomes insolvent or gets divorced. In those instances, the other shareholders also have the right to protect the current shareholder structure since the shares might otherwise be transferred to someone else by operation of law.
The price the other shareholders have to pay usually depends on the event. In case of death, insolvency and divorce, the price is usually the fair market value. In case the option is triggered by unwanted behaviour, however, it can be agreed that the price is, e.g., only the nominal value, the subscription amount or a certain percentage of the subscription amount. That way, the misbehaving shareholder is penalized which gives an incentive to the shareholders to behave accordingly.
A well-drafted purchase option ensures that a co-founder cannot simply leave the company early on with a lot of shares (good leaver / bad leaver), and protects the shareholders from having to deal with heirs or bankruptcy offices. A professional investor will almost always request such a provision.
The drag along right protects the majority shareholder (or a group of shareholders) holding (typically) more than 50% if they want to sell their shares. The drag along provision gives them the right to oblige the other shareholders to also sell their shares to the acquirer. The drag along must always lead to a sale of 100% of the shares in the company. The rationale behind this clause is that it is usually easier to find a buyer for 100% of the company rather than e.g. 70% and that holding the majority shall give you the right to force a full exit.
A drag along clause may also include a certain minimum value of the exit so that a minority shareholder can not be forced to sell shares at a (too) low price. Furthermore, the obligations (such as warranties) that the minority shareholders are exposed to in case of a sale are usually limited.
The tag along right protects the minority shareholders. If a shareholder sells shares (surpassing a certain percentage threshold, e.g., 50% of all shares), the other shareholders have the right to request that the buyer also buys their shares for the same terms and conditions. If the buyer does not agree, the initial selling shareholder is also not allowed to sell any shares to the respective buyer. This protects the minority from being left behind with shares that are worth less (the buyer pays a premium for obtaining control) and with new outside majority shareholders.
There are variations when it comes to the threshold that triggers the tag along option. Usually the tag along right is only triggered if at least 50% of all shares of the company are being sold. In addition (or alternatively) to that, we often see that if a shareholder sells a portion of his shares that in total represents more than 10% of all shares of the company, the remaining shareholders may also sell pro rata. This means that if a shareholder sells 40% of his shares, which represent a total of 20% of all shares in the company, the other shareholders can also sell an equal portion, i.e., 40% of their stake.
Remember, in the first post of this series, we talked about valuation and price and looked at how many shares an investor gets for his investment. In the second post, we explained the antidilution protection and how it affects the stake of an investor as well as the value of the investment and in the last post, we looked at the concept of liquidation preference and how it affects the distribution of proceeds in case of a so-called liquidation event.