Private Equity Exits in Nigeria: A Primer on Preemption, Drag-Along and Tag-Along Rights
A fundamental fact of private equity is that it has a definite time horizon, usually 5 to 10 years, within which the investment is expected to reach its maturity and return profits to the investors. The key ambitions are exit and profit. So, PE investors aim to avoid locking themselves into investment decisions from which they cannot conveniently disencumber themselves if their personal or business circumstances change or their investment objectives have been realized. Conversely, founders and other shareholders are also wary of PE exits that could negatively affect the quality of their investment and shareholding in a company and so seek to protect their interests as far as practicable. This brings to the fore the need to pay attention to provisions relating to exit in the composite package of documents forming a private equity investment. In this context, therefore, this article explores preemption rights, drag-along rights and tag-along rights, being some of the key provisions in private equity investments that may impact the exit strategies of PE investors in Nigeria and the interests of their co-shareholders, bearing in mind the relevant provisions of the Companies and Allied Matters Act 2020.
Preemption rights are a contractual clause that gives existing shareholders of a company the right (but not the obligation) to buy additional shares in any future issue of the company’s shares before they are offered to the general public or buy the shares of an exiting shareholder that is being offered to third party investors. Also referred to as “anti-dilution clauses”, “right of first offer” (ROFO) or “right of first refusal” (ROFR) depending on the context of the exit strategy embarked upon, e.g. trade sale, secondary sale or an initial public offer (IPO), a preemptive right gives a shareholder the option to, in the case of an IPO, maintain a certain percentage of ownership of the company and guard against dilution by acquiring a proportional share of the shares issued via the IPO, or, in the case of a contemplated trade sale or secondary offering, seize a bigger share of the pie of the company and prevent themselves from being locked up in the company with an unfamiliar or incompatible new investor – provided, of course, that they possess the requisite financial arsenal to take advantage of the opportunity.
Interestingly, with the passage into law of the new Companies and Allied Matters Act 2020 (CAMA), the preemption rights of shareholders are now statutorily provided for. For example, where an allotment of shares is proposed, e.g. to new investors or in an IPO, Section 141 makes it mandatory for a company (whether private or public) to first offer the shares to existing shareholders in proportion to their existing shareholding. Also, and as a corollary to the above, although the Act no longer mandates private companies to restrict the transfer of their shares, it nevertheless permits them to do so by providing, subject to the provisions of the articles of association, that: (a) assets of the company valued at 50% of the total value of its assets shall not be sold or disposed of without the consent of all the shareholders and (b) a shareholder shall not sell his shares to non-shareholders without first offering them to existing shareholders. The combined effect of these provisions is to effectively grant existing shareholders of companies preemptive rights (in this case, right of first offer) in respect of shares in the company.
However, while the incorporation of these statutory preemption rights into CAMA 2020 may be taken to mean that there is no longer a need to incorporate them into the shareholders’ agreement or articles of association of a company or – in the case of the latter provision – to incorporate as is without more, it is recommended that it may be safer to do so – and elaborately, too. This is because while CAMA 2020 may truly be said to give existing shareholders statutory pre-emptive rights, the Act provides no elaboration as to the mechanics of exercise as is normally thoroughly provided for in shareholders’ agreements and articles e.g. specified timeframe for the exercise or relinquishment of rights, manner and mode of exercise, etc. Consequently, it remains crucial to negotiate clear rules applicable to these mechanisms in companies’ shareholder agreements or articles of association.
Preemption rights are important rights for shareholders to have due to their protectionist impact and can prove particularly worthwhile in a “club deal” – i.e., the presence of multiple private equity fund investors in a portfolio company – since each PE investor may have a differing investment realization timeline. However, it is important to note that the existence of a preemptive right does not mandate/obligate an existing shareholder to purchase additional shares in the IPO or buy the shares of an exiting shareholder. The shareholder can choose not to exercise the right, in which case the shares can then be sold as contemplated.
Overall, preemption provisions exist to protect existing shareholders from unnecessary dilution and forceful acquisition as a result of an exit by private equity and venture capital investors or a sale by the founder(s). Consequently, it will be prudent to, while contemplating an investment or preparing for an exit, pay attention to the statutory preemption rights under CAMA 2020 and also take cognizance of the existence or otherwise of even more elaborate preemption rights in the shareholders’ agreement or articles of association of portfolio companies.
For private equity investors, having a smooth exit is a crucial part of any investment. Naturally, therefore, many insist on having drag-along rights to protect the marketability of their investment. Also known as drag rights or bring-along rights, drag-along rights entitle the majority shareholder to force the minority shareholder to sell his shares upon the same terms and conditions at which the majority shareholder is selling his stake under certain predetermined circumstances. The majority shareholder who is ‘dragging’ the other shareholders usually must offer the minority shareholders the same price, terms, and conditions that the majority shareholder has been offered.
In its simplest form, a drag-along right ensures that a reluctant minority cannot prevent a sale by a willing majority to a buyer who wants to buy all the shares of the company. Essentially, including drag-along rights in the shareholder documentation enables a private equity fund to exit the company and deliver 100% of the shares in it to the buyer. It is included in a target company’s shareholders’ agreement and/or articles of association as a way of pushing through a sale more quickly and on terms more appealing to the buyer. The most effective way to do this is to, by the shareholders’ agreement, make the minority shareholders grant an irrevocable proxy and/or a power of attorney allowing the majority shareholders to act on behalf of the minority with respect to any vote, action by written consent, or other action required to carry out the drag sale – including executing the transfers in their name and on their behalf. In the case of Cunningham v. Resourceful Land Ltd & Ors  EWHC 1185 (Ch), the Chancery Division of the High Court of England and Wales upheld such a drag-along provision as valid.
Generally, there are two ways of looking at the desirability of a drag-along provision in a PE investment. Firstly, by promising the opportunity/possibility of delivering 100% of the company with no minority interests, it increases the marketability/attractiveness of the investee company since the third-party purchasers may be unwilling to enter into a company structure with several minority shareholders with differing interests and with whom they have no prior relationship – as they may potentially be uncooperative or even hostile. Secondly, where 100% of a company can be sold, there is also a higher chance of obtaining a better offer i.e. a “control premium” on share valuation, as opposed to what will be obtainable in the sale of a partial shareholding. This opportunity for complete control is what increases the attractiveness of a company with a drag-along provision and makes paying a cost premium worthwhile. Consequently, while drag-along rights are notorious for protecting majority shareholder exit interests, they can also prove economically beneficial for minority shareholders as they allow them to realize favourable sales terms that may be otherwise unattainable in a sale of their unattractive minority interest.
Tag-along rights are the corollary to drag-along rights. Also known as ‘co-sale rights’ or ‘piggyback rights’, tag-along rights give the minority shareholders the option (but not the obligation) to join in a sale by the majority shareholders. That is, if the majority shareholders are arranging a sale of their ownership interests but not of the entire company, the minority shareholders have the right to sell a pro-rata portion of their stake at the same price and on the same terms and conditions to the prospective purchasers. As the name implies, the minority shareholder gets to ‘tag along’ with the majority shareholder’s sale to take advantage of a favourable deal negotiated between the Seller and a Third Party. This serves to protect against the majority shareholders or founders cashing out their interests without the minority owners having the same opportunity at some liquidity.
Essentially, tag-along/co-sale rights afford the minority shareholder all of the benefits of drag-along rights (i.e. access to the same terms as the majority shareholders) with none of the drawbacks (i.e. obligation to sell). Therefore, unlike drag along which mandates a minority shareholder to participate in the sale of the company, tag-along rights allow the minority shareholder to decide on a case-by-case basis whether they would like to participate in a sale on the same terms as the majority shareholders.
As a side note, CAMA 2020 has an interesting provision that appears to be some sort of a statutory tag-along provision for private companies. As already stated above, although the Act no longer mandates companies to restrict the transfer of their shares (pre-emption rights), a private company is allowed to provide in its articles of association that a shareholder, or a group of shareholders acting in concert, cannot sell or agree to sell more than 50% of the shares in the company to a non-shareholder unless that non-shareholder has offered to buy the shares of the other existing shareholders on the same terms. However, it is ideal for companies to provide in their governing documents a more elaborate and functional tag-along provision than CAMA has done.
The Interplay Between Preemption, Drag-Along And Tag-Along Rights – Alleviating Concerns
To make exits by private equity investors more seamless and mutually beneficial to all parties, it is imperative to, in drawing up shareholders’ agreements or subscription agreements, consider the interplay between drag-along, tag-along and preemption rights and how they may help all stakeholders to realize their investment objectives.
Although naturally constituting fiercely negotiated provisions in many companies’ governing documents – especially given the enormity of what is at stake, these rights, when included and defined from the onset, will give the shareholders – both minority and majority – a greater level of assurance or certitude with regards to how an exit opportunity plays out i.e. whether they tag along, get dragged along, or, worse still, get diluted in the case of, for example, an IPO. They may also be able to, in the case of a trade sale or a secondary offering, prevent getting locked into their investment with a third party buyer with a fundamentally divergent or incompatible business orientation. The proper contemplation and structuring of these provisions will, therefore, make the position of the parties not only clearer but also legally enforceable.
For example, while the private equity investors, or even the founders themselves, may seek to include a drag-along right in the investment due to its many advantages, the (disadvantaged) minority shareholders may protect their position with the inclusion of a preemption right or right of first refusal so that they can acquire the exiting majority’s shares before they are offered to the public in an IPO or on the same terms offered by the third party in the case of a trade sale or secondary offering. However, an obvious downside of a preemption right is that it will not be of any benefit should the beneficiaries not have the required funds readily available to take advantage of it – although this minor blip can be offset by way of leveraged acquisition finance.
It may also be imperative that the parties take into account the fact that the minimum percentage prescribed to trigger the drag-along is generally the same percentage used to trigger the tag-along right. Consequently, a majority shareholder negotiating for a low percentage threshold to trigger and take advantage of the drag-along should also bear in mind that the same low percentage threshold is generally the same for the minority shareholder to trigger the tag right.
Private equity investors provide much-needed capital as well as significant operational and transactional expertise that fundamentally aid in investee companies’ growth and expansion. But they also intend to realize their investment and exit the portfolio company within a definite time. To balance this fact with the competing interests of founders and/or other shareholders e.g. other PE investors in the portfolio company, certain concessions are made along the line of the bargaining strengths and negotiating ability of the parties and may involve a delicate balance between preemption rights, drag-along rights, and tag-along rights as discussed in this article
In a nutshell, a very important task in the structuring of private equity investments involves balancing the legitimate desire of PE investors to exit from an investment at a convenient time and the legitimate right of other shareholders not to have their corporate interest transferred against their will or altered to their detriment. Therefore, entrepreneurs and investors alike should endeavour to consider the relevant factors during the negotiations for, or the drafting of, terms for a private equity investment, taking care to strike a delicate balance between private equity’s well-known investment strategies and time horizons and the protection of founders’ and/other shareholders’ minority rights.
Akorede Folarin is an associate with Kevin Martin Ogwemoh Legal, Lagos.