Hogan Lovells

Joint Ventures: Issues and Analysis: Looking forward to a smooth exit

Selecting the pathway to a smooth exit in an equity joint venture 

Whether one drafts a joint venture agreement from the perspective of a minority stakeholder or from that of the majority, it is often extremely difficult to second guess the exact point or circumstance where a co-venturer will want to invoke a right to exit the relationship or to force a counterparty to do so. This means that provisions addressing exit need to be considered carefully in the context of the composite package of documents that ultimately form the basis of the joint venture arrangement. Complex provisions encapsulating pre-emption rights; drag along/tag along rights, options and permitted transfers are often included, but the contractual construction of the interrelationship between those provisions can give rise to significant issues in the event of a contested exit. This note focusses on contractual issues relating to those provisions. The parties to the venture need to think carefully about the interrelationship of these clauses; not least because, if their interpretation were to be challenged in court, a judge would be further removed from the commercial circumstances of the transaction, necessarily introducing a degree of uncertainty as to their application. 

This note does not attempt to address issues surrounding pricing, tax and valuation. Nor does it focus on the possibility of the company purchasing/redeeming its shares or the Russian roulette/Texas shoot out mechanisms commonly associated with 50/50 joint ventures, each of which may well be valid additional exit mechanisms. 

Key drivers for a majority stakeholder

A majority shareholder will be keen to agree, to the extent commercially possible, an unfettered set of exit rights which sit within its discretion and control. It may ultimately have plans to realise the company's value (through a third party sale or listing) and will therefore wish to reduce the opportunities for a minority stakeholder to interfere in the realisation process. They would therefore be likely to consider a set of rights which give it the option to buy in the minority stake itself (or through its group), the right to force the minority to sell to a preferred third party acquirer (avoiding the need for it to take any ownership prior to an onwards sale) and in some circumstances (although this may not always be commercially viable) the right to force a sale of its own stake to the minority. 

In this context the core mechanisms at its disposal would be the right to exercise a put/call option and the right to invoke a sale of the minority interest into a sale to a third party purchaser (a drag along right). It would also need to establish a secure basket of protection in the form of pre-emption rights (on transfer and on issue) and clearly stated permitted transfer provision to ensure that the minority's stake could not be transferred to a third party without its consent.

Key drivers for a minority stakeholder

The minority, in turn, would be likely to be concerned to seek their own level of protection through contractual pre-emption rights on transfer and issue, a clear statement of permitted transfers, the right to exercise a put option and the ability to initiate a tag along right in the event of a predefined exit scenario. 

The minority will also be concerned to influence, to the extent it is able to do so, the level of contractual commitment it is required to offer on exit to a third party purchaser or the shareholder acquiring its stake and will be concerned to minimise the level of warranty or other commitments given.

In certain situations the minority may well view a tag along right as a source of greater protection than the pre-emption rights, as they may not have the resource to acquire a majority stake; nonetheless the package of rights should be considered in the round.

Key points to consider when building an exit matrix

It is quite common for joint venture agreements to address the position of put/call options in terms of whether they take precedence over pre-emption rights, but for there to be silence as to the total interplay between other exit provisions. Sometimes alternative exit mechanisms are spread across the articles and shareholder agreement and even where contained in the same agreement there may be a situation where two processes could theoretically run simultaneously with very different end results. It is this inconsistency which a party might seek to exploit in the event that there is a disagreement over exit.

If there is the potential for overlap, it is critical to agree the order of precedence between the provisions and the most appropriate mechanisms for waiver, revocation or suspension of competing provisions. Different exit mechanisms typically have and need separate and independent mechanisms for exercise, therefore the potential for a party to invoke one process to thwart another has to be carefully assessed. This extends to an assessment of what triggers the right, the contents of any notice and disclosure provisions, the timing of the service of any transfer notice and exercise period and what rights/warranties will be required to be given. 

Key points when drafting options: put and call options will often be a top priority for a party contemplating exit. Where they rank in the exit process will be a point for commercial debate, but a party who has the benefit of an option right will be keen to consider the following:

  • Which option takes priority and should it take precedence over other exit rights? If there is to be any precedence between various option rights then this must be clearly set out. For example, the agreement might comprise a mutual put and call option framework or have multiple options catering for different classes of shares or different trigger events/exercise consequences. It is often the case that the timeframes for processing an option to completion mean that the first option exercised would always effectively get to completion first, but if the agreement will address multiple options and those options could potentially be triggered within a competing timeframe by different parties, consider whether to impose, after the service of the initial/priority option notice, a waiver of or moratorium on the exercise of any subsequent options or other exit processes pending completion of the priority option process. 

    Also consider what should happen to any transfer process (another option, a pre-emption right or permitted transfer) exercised (but not completed) prior to exercise of the priority option. Is it acceptable to agree a mechanism to revoke/suspend the prior process on service of the applicable option notice? This is aggressive and will be resisted, but if agreed, the applicability of the standard statement in a transfer notice (that such transfer notice forms an irrevocable and binding offer) should be assessed. 

    If any option is to take ultimate precedence over other exit mechanisms then action must be taken to enshrine this is in the shareholder agreement and, if appropriate, across the suite of key transaction documents and to consider any consequential commercial ramifications (if, for example, the exercise of the option would in itself generate a termination event under an ancillary agreement in the suite of joint venture documentation).

    A majority may prefer that any options (be they put or call), if exercised, take priority over the exercise of any subsequent drag along, tag along, permitted transfer and pre-emption rights. The commercial rationale for where the option sits in the hierarchy of exit rights will be driven by the commercial intentions of the parties and to some extent the nature of the various trigger events for the exit scenarios may influence this (e.g. if a process is triggered by the default of a party it would be harder for that defaulting party to argue that  an option exercise or a drag along process (and therefore a third party sale) should be delayed or stymied by a requirement to effect a pre-emption process that favours the defaulter where there is no certainty that the defaulting party would accept the pre-emption offer). 

    Any shareholder who is asked to consider agreeing to the waiver/suspension of a competing transfer process should consider preserving its position in the event that the priority transfer process is not ultimately completed. A shareholder may have to wait for a considerable period under the terms of, for example a drag along process, only for the third party sale to fail to go ahead. In this situation they could argue that any time that has elapsed under the failed process should count towards any applicable notice/exercise period if they elect to restart any process (for example a pre-emption process) suspended as a consequence of the priority exit process.

  • Definition of option shares? In some circumstances it might be commercially appropriate to limit the scope of an option to just those shares that are in issue at the date of the agreement. If this is the case it is worth considering clarifying that the option captures both the company's capital at the time of grant and also any form of capital equivalent in the company at that date (preference shares, bonds, warrants, loans, convertibles, options or similar instruments which are convertible or exchangeable for, or which carry a right to subscribe for or purchase shares, or any instrument or certificate which represents a beneficial ownership right). Capturing the entirety of the potential share capital at that time.

    A more standard approach is to provide that shares subsequently issued by the joint venture company are to also fall under the umbrella of the option. It may then be necessary to assess associated subscription rights and, if necessary, ensure that there is an obligation to assign a right to subscribe. Obviously the scope of the shares covered by the option (and any necessary adjustments to allow for capital reorganisations) will have a significant effect on the valuation and pricing mechanisms and the mechanism must be broad enough to address all issues and transfers of the relevant shares.

  • Capture transfers of beneficial and legal title. Transfers of beneficial, as well as legal title must be addressed. This point impacts not just on any option drafting, but in fact on all exit mechanisms. In this context the core definitions of what constitutes a transferring share and what constitutes an "exit" are important. Any transfer of a joint venture entity's shares which trigger an exit mechanism (for example a change of controlling interest) must be broad enough to capture transfers of both the full legal title to, as well as the beneficial ownership of, the relevant classes of shares.  

    The joint venture agreement must also ensure that in this context, as against the company and other shareholders, no one is entitled to establish title to any in the shares without adhering to the agreed exit mechanism. Whilst beneficial interests may be established in breach of a clear agreement it would be hard to see how an encumbrancer or holder of a beneficial interest could assert their rights against a purchaser or make successful claim to title if there has been a breach of the joint venture agreement. The position of the board should be made clear in this context - as it would present issues for the board in terms of whether to register a transfer or not. 

  • Breach events as a trigger for exercise of the option. If the exercise of an option is triggered by, or dependent on, a breach of the main agreement or another agreement in the suite of documents (for example a share purchase agreement or a key service agreement) be careful to ensure that there is not a potential risk of double recovery. It is also necessary to look at the pricing of such an option carefully in this situation – a fair market value allocation is preferable to ensure that the option is not constructed as a deterrent rather than a mechanism for the proper compensation of loss/ fulfilling any other legitimate commercial or economic function. Current case law suggests that there is a risk in these circumstances that a pricing clause that is not linked to a fair market value may be found to be penal and therefore potentially unenforceable.

  • Process is very important. Consideration should be given to whether the trigger events for the option have been clearly and objectively stated and, if there is the potential for the events to be satisfied on more than one occasion, whether it would be appropriate to limit the trigger to the first occasion or extend it across all subsequent occasions. 

    The timing and methodology of the option notice requirements and the mechanics of exercise need to be carefully considered. The option holder must consider whether there are any trigger events (such as a listing) where the timing of the exercise of the option will be critical to ensure that the exercising party may take the full benefit of the trigger event. 

    The timing and interplay between other potential transfer notices (pre-emption/drag along /tag along notices) needs to be thought through. If another stakeholder could potentially start a rival process within the time required to complete the option then this could seriously undermine the process as the pricing or nature of the exit may well vary significantly. It is critical to map out the potentially competing exit routes.

    Where the option is exercisable against multiple shareholders, the exercising party needs to consider whether to appoint a lead recipient for who will manage the process on the counterparties behalf and bind them – the question of joint or several liability (for example to pay a call option price) arises in this context, as does the argument that effective exercise may not to occur unless all the minority shares are sold simultaneously. 

    If there are multiple buyers or sellers of the transfer shares then the allocation of shares between purchasers may need to be established (for example, it may be made on a pro rata basis and the potential for fractional entitlements will need to be addressed). 

    Finally the question of whether there could be more than one or a partial exercise of an option should be considered. 

  • The role of the company as agent. The company is usually appointed as the transferor's agent to complete the sale, although it should be noted that this is a provision of last resort. Whilst an agent will clearly be imbued with the necessary power to transfer the shares and can be assumed to be capable of giving a warranty in that context as to title to those shares, it is worth noting that it will not be able to give any broader set of warranties, representations or other assurances that may have been envisaged by the option mechanism.

  • Deed of adherence/termination. In situations where the shareholder agreement will survive the exercise of the option, complications can occur if an effective process is not established to ensure that a new shareholder can adhere to the agreement. Signing mechanics need to be considered (especially where the ownership profile of the company is complex). Additionally an exiting shareholder needs to ensure that its board nominees may effectively resign from the board and any separation mechanics addressed with minimal disruption.

Key points when drafting drag along/tag along rights:  A drag along right is a useful vehicle for a majority shareholder and usually presents a mandatory exit requirement on the minority in the event of the sale of a controlling interest. Drag along rights are included in joint venture arrangements to give comfort to a majority that the minority may not block a sale to a third party where the prospective purchaser is unlikely to obtain complete agreement amongst the shareholders to the sale and is unwilling to participate in a joint venture structure with a rump of shareholders who refuse to sell their stake. This formulation is designed to bind the minority to accept an offer accepted by the majority.   The advantage of a drag along process over a squeeze out under s 979 of the Companies Act 2006 is that it provides the parties the opportunity to set a lower required-majority to approve the third party sale. It is also worth noting that it would not give rise a non-consenting shareholder the power to apply to the court and the additional perceived complexities of applying 979 to a private company are excluded.

A tag along right is often seen as a more useful tool for the minority than a pre-emption right and, whilst it is not used as a substitute for pre-emption, it will often be seen as a complimentary pathway. This is particularly the case where there is an economic or skills base disparity between the shareholders and the prospect of increasing/enhancing a stake when a key shareholder has departed or where the shareholder does not have sufficient financial resource to do so is unattractive. The tag along does not present a mandatory exit requirement and therefore the parties should not automatically expect the tag along and drag along provisions to mirror one another.   

Key considerations are as follows:

  • The status of the drag along right in the context of pre-emption rights. It is generally thought that where a joint venture agreement is silent in relation to the interplay between a drag along right and a pre-emption right, it would be likely that a court would assert that the pre-emption right took priority. A failure to address this could require the majority shareholders to give a potential third party purchaser express comfort that that a waiver of pre-emption rights will be forthcoming on sale and a need to seek an express waiver might impact on its freedom to negotiate in confidence with the third party. A joint venture agreement should therefore specifically address the interrelationship of these clauses and if applicable address the waiver of pre-emption rights on service of a drag along notice. The issues mentioned above in relation to the interplay of option provisions and the technical implementation of any hierarchy of clauses, particularly if a competing process has been initiated also apply here.

    In assessing the position of a drag along right in the context of any options and pre-emption provisions then the financial/commercial viability of a pre-emption offer from the minority should be assessed. If this is not commercially likely then the arguments that a drag along notice should take precedence over pre-emption are enhanced. The level of precedence afforded to a tag along right is often a less sensitive issue as the other shareholder(s) may expect such a right to arise once they have had an opportunity to evaluate the right to drag or purchase shares via pre-emption. 

  • The minority's opportunity to approve the terms of the offer and the disclosure of key terms. From the majority's perspective it is important that the minority solely obtain the benefit of an extended offer to buy their shares from the third party purchaser and that they do not have a chance to negotiate terms. In terms of the question of disclosing the price of the offer there is no definitive answer. The argument against a disclosure of price at the drag/tag notice stage is that as there is no choice for shareholder in accepting the deal, therefore the price does not need to be disclosed.

  • From the minority's perspective, it will need to ensure that it gets as much information about the key terms of the deal through the drag along notice process as possible so that it has a clear understanding of, inter alia, whether there is any element of cash alternative, deferred pricing in the offer, whether it is conditional and whether any warranties/indemnities will need to be given. The minority will want to ensure that it can fully ascertain the highest price per share at which the third party purchaser can purchase the shares and may wish to reference this to offers in a prior period to ensure a fair value minimum applies. If non-cash consideration is included it will want to understand the mechanics for assessing this element of the price.

    It may well not be applicable for each shareholder to be treated in the same way (the expectation in relation to on-going support and service agreements may differ, intra group loan arrangements may need to be unravelled, and the scope of restrictive covenants and warranties/indemnities negotiated) and this should be factored into any process/notice provision. There is often an expectation that "standard warranties/indemnities" are to given by the transferring shareholder and therefore a party needs to be very careful in evaluating how this should be clarified. Obviously the party which is negotiating with the third party will want to give that third party as much assurance as possible, but a shareholder with a low equity, but high technical contribution for example, will want to make very sure that the assurances it is contractually required to give in respect of its stake are as narrow as possible, especially given that it will not control the sale process.

  • Process and timing. As mentioned above, it is important to ensure that any notice or disclosure requirements tie in with other exit provisions.

    Any difference between the extent of information provided under drag along and tag along provisions should be thought through. A minority being dragged may be less open to giving warranty/indemnity protection than a minority opting to tag. If a disparity in the notice periods or disclosure requirements is negotiated then the parties need to ensure that this disparity cannot be manipulated. 

    Another point to bear in mind concerning the notice of a third party offer is that in a conditional sale or one where there are market sensitivities the dragging party's ability to give a significant amount of prior notification may be limited. Consider the need to convene a general meeting to approve any third party offer and the methodology of approval in that context.

  • The relationship with the articles. Any provision that is not replicated in the articles must be backed up with further undertakings to effect registrations of share transfers. It is often typical to repeat the drag along and tag along provisions in the articles, but great care must be taken as the articles will bind all future shareholders and the terms of the drag and tag should not be transposed without being tailored to reflect this. 

  • Exit trigger. Triggers for termination, exit and rights of first offer may differ, but those applicable to tag along and drag along rights will be likely to be centred on a change of a controlling interest. The parties should also consider whether this should not just capture a sale of shares but also a merger, scheme of arrangement or consolidation.

Key points when drafting permitted transfers: It is common practise to include a provision that enables transfers within a group, as long as a deed of adherence is signed and there is a commitment to transfer back if the transferee ceases to be part of the group. This concept is often extended, where the parties to the agreement are individuals, to permitted transfers to relatives or family trusts and where the parties are investment funds to other funds under same management. One needs to consider the potential for creating a moratorium on the exercise of a permitted transfer notice once a competing transfer notice that is higher up the hierarchy has been served. This may be necessary if the time periods for such a transfer are shorter. Often the permitted transfer will have a neutral effect on the other exit provisions so it may only be necessary to ensure that the mechanics for registering such a transfer and deed of adherence are as effective as possible.

Key points when drafting pre-emption provisions: Sitting at the heart of the exit mechanics will be a set of pre-emption rights. Joint venture agreements tend to contractually extend the concept of pre-emption to the transfer of shares, as well as the issue of additional capital and as such the concepts in the Companies Act are usually specifically modified and as such the parties must determine the amount of precedence to be afforded to these rights. 

Key considerations are as follows: 

  • Where do they fit into the hierarchy of exit mechanics? As for the processes mentioned above the commercial bargaining position of the parties and the potential for pre-emption to be a useful method of increasing a stake need to be assessed. They are often viewed as less favourable to a tag along right to a party that is not financially strong, but even for a party considering a third party sale – they may be a useful tool to enable stake building. 

  • Process and timing. The drafting considerations mentioned above in relation to the definition of the shares and legal and beneficial title apply equally to the pre-emption rights. With multiple shareholders or multiple classes of shares it is also necessary to consider what happens if the offer contained in the transfer notice is not taken up by every shareholder. A total transfer condition is sometimes included or an allocation process provided for, which would extend to fractional entitlements if need be.

  • Right to withdraw. As for all mechanisms the valuation and pricing mechanism needs careful consideration. Should a recipient of a transfer notice have a right to withdraw from the process at any stage if it can demonstrate that the pricing mechanism will not deliver a fair value consideration for the shares? Obviously this sort of option would run against the parties desire to achieve contractual certainty. Likewise a transferee is likely to want to ensure that a transfer notice, once served, is served on the basis that it is an irrevocable transfer notice. The terms of the transfer notice require consideration if there is to be any suspension or revocation of process.

  • Triggers: As for all mechanisms the triggers need to be carefully thought through. It is often common to include compulsory transfer events such as change of a controlling interest, transfer of a beneficial transfer, death etc. Any events linked to an insolvency event in relation to a party need careful attention to ensure that they would not be set aside. 

Any company whose shares are listed in the UK will additionally need to factor in the rules under Chapter 10 of the Listing Rules to ensure that any requirement for an announcement or shareholder consent under Rule 10 can be accommodated. If the relevant thresholds are met the rules can apply to the establishment of the joint venture, the transfer of an existing business to the joint venture, the purchase by a listed co-venturer of the shares of another party or the transfer of assets to a listed co-venturer on termination. Additionally if a listed company retains sole discretion over the exercise of an option the exercise could be classified, so it may be necessary to ensure that any exercise period is long enough to cater for the necessary shareholders' consent to be obtained. If the listed entity does not retain sole discretion the option could be classified at the time of grant, this concept can also extend to a scenario where the listed company is required to acquire shares of another party in circumstances beyond its control. Further consideration should also be made of Chapter 11 of the Listing Rules where a transaction takes place between related parties and also any relevant provisions of the Takeover Code.