Joint Venture Series: Shareholder Exit Rights (Part 1 of 3)

Winston WONG (28 February 2024): Joint Venture Series (Part one of three)

The objective of a founding or investing in a business is to exit with profit. Outside trading on the stock exchange, it is key to ensure your Shareholders Agreement (in the case of Ordinary Shares) and/or Constitutional rights (in the case of Preference Shares) guarantee your right to profit. Where the court system is efficient and corruption-free, where a duly signed the Shareholders Agreement and Constitutional rights will be enforced in a court of law, the certainty of result of litigation and hazard of being awarded costs against you, will discourage parties from protracted litigation in favour of settlement. This will be augmented by an appropriately worded indemnity that would protect JV partners against strategy centered around oppressive majority behavior, bully tactics, frivolous litigation.

We set out some notes to equip you with the crucial legal knowledge to prospective founders, investors, and Ordinary and Preference Shareholders to navigate Shareholders Agreements and Constitutions.

PART ONE OF THREE

For this first part, we cover the exit clauses. The exit clauses comprise of the pre-emption clause, termination for convenience clause, drag-along, tag-along clauses, termination for default, and pre-determined cash out event. The first segment of this article is about the exit clauses and their variations. The second segment of this article is a discussion about what may reduce the effectiveness of exit clauses.

This article addresses exit clauses in the context of a profit-driven joint venture. Hence, the key purpose of such clauses is to exit the investment at a profit. Although a private investor accepts the risk that a private investment is illiquid as compared with buying shares on a publicly traded stock exchange, there is a spectrum of the degree of liquidity depending on the specific terms negotiated in these agreements.

Segment One: Exit clauses and their variations

1. Cash out for convenience:

a. Cash out to third party: A key decision to make in any joint venture is whether one or all shareholders have an unrestricted right to sell to a third party, and if not, what are the pre-conditions.

The most common options here are (i) no right to sell to a third party unless all shareholders reject your offer to sell to them (i.e. the Right of First Offer); and (ii) there is a right to sell to a third party unless one or more of the shareholders offer to purchase your shares (i.e., the Right of First Refusal). The further variation to the foregoing is how long the reaction period is: 7-14 days is typically considered short, and 3 months is ordinarily the extreme end of a long period. These provisions typically affect the non-founder / non-management shareholders more as they typically have a shorter-term view of their investment.

Under the SAFE and CARE standard investment terms, there is effectively no right to cash out to third parties.

b. Cash out to existing shareholders:

  • Put option: Right to sell one’s shares to existing shareholders. This is suitable for small investors who want a guaranteed cash out.
  • Call option: Right to compulsorily buy the other shareholder’s shares by issuing a notice to shareholders. This is suitable for either founders or PE funds. As this is in effect similar to a redeemable preference share, it is important to consider the use of the preference shares mechanism instead.

Under the SAFE and CARE standard investment terms, there is effectively no right to cash out to existing shareholders, nor do they have the right to redeem their investment.

2. Pre-defined cash out event: It is common for modern startups to pre-define trade sale or IPO as a pre-determined cash out event. They can include “liquidity event”, “equity financing event”, “dissolution event” or any other customised event as defined in the relevant agreements. It is key here to define the liquidity event and the Goldilocks principle applies here: not too precise, not too vague. Both extremes may result in undesirable loopholes.

Under the SAFE and CARE, “Equity Financing” results in the compulsory issuance of shares to the investor. The company is not obliged to negotiate the shareholder agreement terms (if any) with the investor, and a major risk remains that the shareholder’s agreement is one-sided and detrimental to the investor, and effectively is a loophole allowing incoming financiers to dispose of existing investors.

3. Drag-along: This is similar to a call option (or the right to buy) granted to the intended buyer of shares instead of existing shareholders. This typically kicks in when there is an exit opportunity (e.g., IPO, trade sale, etc.). The drag-along is a clause allowing a party to control the exit path by compulsorily requiring all other shareholders to sell and cash out at the same time as himself. The absence of a drag-along is a red flag for an investor as it unfairly grants shareholders (especially the minority) a veto power over the intended sale.

4. Tag-along: This is similar to a put option (or the right to sell) granted to the shareholders. This will typically apply where shareholders holding a certain percentage of the company’s voting power decide to sell their shares to a third party. The absence of a tag-along right is a red flag for any investor. Its presence is one of several provisions that tend to provide assurance to shareholders (especially minority) that if other larger shareholders intend to sell their shares, these smaller shareholders will be able to oblige the buyers to also buy the smaller shareholder’s shares and provide them with the same opportunity to cash out together with the larger shareholders.  

Segment Two: Efficacy of exit clauses

There are several key points that alter the effectiveness of exit clauses:

1. Operational integrity: If the persons controlling the operations of the company are permitted to devalue the company, the value of exit clauses will be diminished. Key matters to watch:

  • Creation and vesting of IP
  • Interested persons transactions
  • Divestment of assets
  • Reserved matters

2. Share emission pre-emption: The ability to dilute shareholding by issuance of shares affects the value of your shares and hence how effective your exit clause is.

3. MFN clauses: The CARE standard terms have an MFN clause (i.e. “Most Favoured Nation” clause) that allows investors to ensure their rights against other investors are just as favourable. However, this is a key loophole as it only applies to prior investors and allows the company to offer more favourable terms to future investors and hence sideline and devalue existing shareholders’ investments.

Closing

Do not hesitate to reach out to the Flint & Battery transactions team. Our team is bolstered by CICERO colleagues and their extensive international experience and capability in the US, Europe, and Asia.


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