What Are Co-Sale Agreements
Co-sale is generally a right of investors of a company that gives them the right to sell their shares in a company when other existing shareholders sell their shares. Essentially, it gives investors the ability to sell their shares along with other shareholders, which can help them avoid being stuck with shares of a company whose other investors have pulled out. The co-sale agreement gives investors the opportunity to sell their shares alongside other shareholders so they do not get left holding the bag, even if they do not have any say over the sale of the shares.
Co-sale agreements are defined as any agreement in which a shareholder has the right to participate in a sale of a company’s shares. The co-sale right essentially allows a shareholder to sell the same percentage of their shares as another shareholder who is selling their shares. Co-sale and right of first refusal are often linked — if a shareholder wants to sell their shares , they often must first make the offer to the other shareholder and, if rejected, extend the opportunity to the individual who has the co-sale right. In many cases, the co-sale right can be viewed as an agreement to be bound by the first right of refusal on the part of the first selling person.
Co-sale only applies to the sale of common equity. It does not apply to a company’s merger or liquidation. All the shareholders involved in a deal must be allowed to participate in the sale through a co-sale agreement.
Co-sale agreements, sometimes called tag-along rights, are called such because the shares that are sold tag along with any other shares that are sold. That way, the investors and founders are able to avoid being left behind in a bad or shaky investment.
Components of Co-Sale Agreements
Co-sale agreements usually have several common elements, typically set forth in the exhibit attached to the investors’ preferred stock purchase agreement for the company’s financing or recapitalization transaction. As discussed below, co-sale agreements will vary from one deal to the next based on the specific situation, including the existing ownership structure of the company, the relative bargaining power of the stakeholders, the terms of the concurrent financing or recapitalization, and other factors. The following is a brief overview of what you can usually expect to see in a co-sale agreement:
Co-Sale Rights
The co-sale agreement generally allows participating shareholders to sell their shares of Common Stock in a future sale of the company and thereby make some or all of their investment liquid. The right of co-sale usually exists concurrently with a "right of first refusal" (discussed below). If the holders of shares of participating common stock (PSCs) choose not to exercise their co-sale rights, the shares are generally subject to the corporate right of first refusal as discussed below.
Notice
The notice clause generally requires a proposed seller to provide notice to all of the participating shareholders stating its intent to sell, and indicates that the participating shareholders will have an opportunity to exercise their co-sale right within a relatively short period of time (usually say 10 days). The clause should also provide that the proposed seller will have an obligation to use its reasonable efforts to close the proposed sale or (if applicable) take payment for its shares within a specified period of time (usually say 30-45 days) from the date it provides the aforementioned notice or the date of the proposed sale. It is common for the company (or representative(s) of the non-selling shareholders) to have additional time to acquire shares in a parallel offering (the company or representative(s) shall have an additional 30-days to close its share purchase). If the proposed buyer is a third party, the clause often allows the seller an additional extension to negotiate and finalize the terms of the proposed sale with the company and/or third-party buyer (usually a further 30-days). The purpose here is to allow the proposed seller to maximize the value of its shares by completing the transaction as negotiated with the company/third-party buyer. This also enables the company to avoid being left with an inordinate number of shares held by minority shareholders post-closing of the proposed sale because the minority shareholders failed to exercise their co-sale rights.
Right of First Refusal
The right of first refusal essentially allows the company to buy back the common shares from a selling shareholder before such shares are available for sale to a third-party. This is an important term for existing shareholders, as it allows the company to maintain control over the composition of its shareholder base by preventing third-parties from becoming shareholders through transfer of existing shareholder shares. If the company does not exercise this right prior to the end of the co-sale notice period, then the proposed shares will usually be the subject of the co-sale rights as discussed above (to the extent such right has not been waived by the participating shareholders). The right of first refusal clause also protects current shareholders by increasing shareholder liquidity through allowing shares to be sold to the company before selling in a co-sale right.
Benefits of Co-Sale Agreements
One significant advantage of a co-sale agreement is to ensure liquidity for minority shareholders and investors. In the event of a liquidity event, minority investors’ positions may be difficult to unwind. In addition to providing for adequate liquidity for minority shareholders and investors, a co-sale agreement can provide leverage points relating to the timing of a potential liquidity event. For instance, if market conditions or other circumstances indicate declining valuations for a potential liquidity event, having a co-sale right enables minority investors to stay in the company longer should they so desire.
Downsides to Co-Sale Agreements
There can be potential drawbacks associated with co-sale agreements. If a co-sale transaction is triggered, the selling stockholder may be required to sell his or her shares at a sub-optimal price or may lose out on other value from a competing offer in order to allow the other holders of co-sale rights to continue to hold their shares. Despite the non-binding term sheet statement that "Any sale of Shares by any such Selling Stockholder shall trigger the Co-sale Right," a co-sale agreement can be triggered even if the terms of the sale that trigger the co-sale right are not acceptable to the stockholder seeking to sell the shares. For example, if a large stockholder sells his or her shares at a preferred return, other stockholders who have co-sale rights might not be entitled to any money until the large stockholder has received its preferred return.
A co-sale transaction can also trigger share transfer restrictions and lockups on stockholder sales, which can prevent the selling stockholders from obtaining a fair market price for their shares. For example, many co-sale rights require the co-sale consideration to be paid in cash and equivalents and do not allow other forms of consideration, such as preferred stock or securities convertible into preferred stock or other equity. If the proposed consideration for a proposed acquisition includes an equity kicker or earnout in the form of shares in the acquiring company, the selling stockholder may be precluded from selling his or her shares.
Another risk associated with this provision is that the representational rights can lead to possible conflicts between shareholders or corporate governance issues. If our lot is large — which would be a good thing — then we could hold up the deal and negotiations until our clients were made whole.
How Co-Sale Agreements Vary From Tag-Along and Drag-Along Rights
Co-sale agreements permit certain investors to sell some or all of their shares in a company alongside the selling shareholder, while tag-along and drag-along rights generally permit the purchase of the remaining shares in connection with a third-party sale of the company. A co-sale right provides that if a certain investor (sometimes referred to as a "co-sell") receives an offer to purchase shares of the company from a third party, such co-sell has the right to sell its shares to such third-party buyer on the same terms such that the third-party transaction can close without regard to the co-sell’s decision on whether or not to sell. Co-sale rights are sometimes referred to as "tag-along" or "piggyback" rights, but they are not the same analysis as tag-along rights because a tag-along right provides an investor the right to purchase shares along with a third-party purchaser but does not require a participation in such transaction.
Co-sale rights are usually granted to co-sells, who are sometimes more junior investors in the capitalization structure of a company who have no other means of selling their shares in a third-party sale of a company . Take for example, Series A and Series B investors who receive their pro-rata share of stock upon a sale from the Series A investor who may be the only shareholder invited to sell shares as part of a full-blown sale process. In such case, allowing the Series B to participate in the sale requires the Series A to share or "tag-along" along side of the Series B.
Co-sale rights are also different from drag-along rights which are contractual provisions between larger groups of shareholders (which are generally also referred to as a "investor drag-along" from Series A and Series B shareholders and sometimes a founder drag-authority from common shareholders) in which those shareholders agree to sell their stock to the acquiring buyer or to require all shareholders to sell to the third-party purchaser pursuant to the same terms and conditions (thereby removing obstacles to closing). Unlike co-sale rights with respect to a third-party transaction, drag-along rights require all shareholders to sell their shares to a third-party purchaser pursuant to the same terms.
When Do You Need a Co-Sale Agreement
A co-sale agreement can be created on its own or as part of the overall investment documents. However, from a practical, real world perspective, they are used most often when two major factors exist: 1) high valuations and subsequent high dollar investments; and 2) at least two of the founders/major principals want to have the ability to sell their ownership interests to a buyer.
When a company is valued high, and a major investment occurs, it becomes more affordable for a buyer to acquire the entire company. That can happen when there are more than one interested buyer who can make such a purchase. In other cases, a company founder or other person in control of the company knows that the time is right to sell.
A potential problem with an M&A scenario involving co-founders or other owners is that one, or more, of the owners want to stay with the company and one or more wishes to exit at the time of acquisition. When "internal" personalities are such that a departure will work smoothly, and it makes sense from a business standpoint to have all or most of the shareholders stay with the company, then co-sale rights are not needed. However, when some of the holders of stock want to stay and other(s) want include themselves in the sale, a co-sale agreement is often used to protect those who wish to stay.
Best Practices for Crafting Co-Sale Agreements
Drafting a co-sale agreement involves a careful balance of competing interests and potential future events. The drafting must be flexible and fluid, yet specific enough to ensure enforceability and clarity.
A well-drafted co-sale agreement will include the following main provisions: These provisions are usually incorporated into a single agreement. The above provisions and other negotiated provisions meant to address particular issues should be listed in a designated section of the agreement, or in a schedule specifically referred to in the agreement, so that any additional agreements, schedules or documents that affect or modify the provisions of the co-sale agreement are identified and specifically linked . The entire agreement should be set out in clauses or sections that can be numbered for ease of cross reference. All provisions (whether or not specific to the overall co-sale arrangement) should be numbered consecutively.
Agreements may be executed in counterparts which may constitute a single agreement with the parties. Only the signed copy of the entire agreement should be appended to a certificate or an order of the Board of Directors or other formal authority approving the total agreement (including the provisions establishing the co-sale rights and obligations). Any other signed counterpart of the agreement should be physically stored with the attachments and the original agreement.