As alluded to in last week’s article, controlling governance is a major purpose of shareholder agreements. Curtailing the powers of the majority is a driving force in several governance decisions. Beyond just the board power, other rights are often used. Personally, I believe every deal is unique. Consequently, assertions that anything is standard, market, or normal is often hyperbole. This is not to say that investors have to negotiate for all rights upfront. Throughout all of these deals, the golden rule – he who has the gold, makes the rules – applies.
To provide some framework, companies cannot willy nilly cheat their minority shareholders. There are contractual and statutory obligations that constrain boards and managers to put the company’s interest, as a whole, above their own interest. You cannot pay a distribution to one common shareholder/unit holder and not pay another common shareholder/unit holder in the same class. You cannot steal from the company. For the most part, these obligations are automatic and do not require further action.
That said, there is a good deal of leeway given to management and employees of the company. For example, the company may need a car for its executives, perhaps a nice club membership and maybe offices that are a little too cushy for the business. Proving fraud and deceit can be difficult business. If your business is brokering automobiles for instance, having a nice automobile may be a necessary expense. Accordingly, some limitations are necessary.
Three main restrictions affect the stock ownership. As discussed in earlier articles, absent agreement a shareholder can sell to whomever they please, whenever they like. The right of first refusal – a staple of operating and shareholder agreements – limits this and works in most situations. However, if a controlling owner wants to sell, and finds a party willing to sell to, a minority owner may be unable to meet that offer. For example, Benevolent Control Owner A owns 75% of the stock; little minority owner B owns the other 25%. Benevolent Control Owner A finds Evil Investor C to buy him out for $1,000,000. B cannot match that offer. Now B is a minority owner in an enterprise run by Evil Investor C instead of Benevolent Control Owner A. Obviously, this is not ideal for B.
To protect against such a scenario, B will ask for Tag Along rights. Essentially, Tag Along rights, as a matter of contract, require A, if A is selling A’s interest, to allow B to sell B’s interest on the same terms and conditions. This protects B and forces A to sell everyone’s interest if A wants to sell out. Such a scenario is probably equitable, and if contemplated, would be the intent of the parties at the outset of the deal. Thus, “tag along rights” – the right to tag along on a deal – are often inserted in operating and shareholder agreements.
A however, being the shrewd controlling owner, will ask B for something in return. A will say to B, “If I have the opportunity to sell out, I do not want you holding up the transaction.” In this case, A and C are talking and everything seems fine, except for B. Maybe B is a real stickler for rules, or has a daughter working for the company, or maybe C stole B’s high school girlfriend, but for whatever reason, C does not want to deal with B. Because B is not forced to sell B’s shares, B can hold up the transaction with reasonable (or unreasonable) demands. As a consequence, A will ask that a shareholder agreement include drag along rights. These provisions require B to sell if A is selling; in other words, B is dragged along in an equity sale. Again, drag along provisions are normal and reasonable and probably the intent of the parties if considered at the outset of the deal.
Along these same lines, if a company has to offer additional equity, equity holders oftentimes1 do not have an automatic right to participate in such an offering. A majority owner can sell additional shares, and this sale will dilute the minority owner. Sometimes dilution is good – a smaller piece of a larger pie; sometime dilution is bad – a smaller piece of effectively the same pie. Regardless, investors will usually want the right (but not the obligation) to maintain their percentage ownership, and preemptive rights provide this protection. Preemptive rights give all owners who have them the right (but not the obligation) to purchase the shares. Usually this is the correct outcome. However, the caveat is that preemptive rights can create procedures that can delay additional funding, and in cases where there are many shareholders, preemptive rights may not be appropriate.
You may have noticed that we still have not solved the fancy car problem. That is more tricky, but fundamental to good businesses. Indeed, there is not a good solution for that at the shareholder level. For the most part, that is handled at the board level. This is probably appropriate. Budget discussions are the realm of the board, and that is where the decision on fancy cars lies. Ultimately, however, trust is paramount, and only working collaboratively and in good faith will make a business reach its full potential.
Goodrich Law Firm, LLC
1 In Alabama corporate law, shareholders do have preemptive rights unless stated in the articles of incorporation.