Part I of this series gave a brief overview about the right of first refusal, one of the more common tools used by closely held companies to ensure that ownership stays within the existing group. This Part II will discuss another tool – the co-sale right. On first blush, a co-sale right is a mechanism to assist equity holders to sell, rather than restrict them from selling. But a deeper review of the mechanics demonstrate that a greater function of the co-sale right is to present barriers to any equity holders trying to sell because of what they would have to do to comply with the co-sale rights of co-owners. In the context of a family business, co-sale rights make it substantially harder to sell any interest to a third party. In this way, the co-sale right is a very effective tool for keeping ownership within the family.
A co-sale right (also called a “tag-along” right) is the right of an equity holder to participate on a pro rata basis in a sale by another equity holder. In its most typical formulation, Stockholder John, who owns 100 shares in the family business, wishes to sell 10 of his shares to an outsider to get some liquidity. Because of thoughtful preparation, the family business implemented a stockholders’ agreement years before that grants co-sale rights to all stockholders. Therefore, Stockholder Jane, who owns 50 shares in the family business, has a co-sale right on Stockholder John’s impending sale. This means that Stockholder John, even if he can find a willing buyer to acquire the 10 shares, can sell those 10 shares only if that buyer is also willing to purchase 5 shares from Stockholder Jane. Stockholder Jane’s co-sale right is a right to a proportionate amount of liquidity in any third party sale. (Note: this ratio can vary depending on the stockholders’ agreement. It might be the ratio of the total stockholdings of the two stockholders. It might be the ratios of their respective percentages of the total business. Agreements can vary.)
As can be easily imagined, co-sale rights can wreak havoc on a prospective buyer. If the buyer negotiated to buy 10 shares, he or she probably wants to buy 10 shares, not 15. Furthermore, the buyer probably only wanted to deal with Stockholder John, with whom he or she had negotiated the transaction. Now the buyer also has to deal with Stockholder Jane (along with any other stockholders of the family business who want to participate). This alone can be enough to scare off a prospective buyer, particularly in a closely held business. Additionally, this involvement by Stockholder Jane substantially reduces the value of the transaction to Stockholder John. Most co-sale rights provide that, if a buyer does not want to buy everyone’s “co-sale shares” along with the initial seller’s shares (i.e., the buyer only wants to buy 10 shares, not 15), then the seller has the option of buying those “co-sale shares” directly from all the other participating stockholders in order to get the deal done. In other words, Stockholder John could sell his 10 shares to the buyer, but would have to turn around and buy 5 shares from Stockholder Jane. Obviously, this cuts in half any proceeds Stockholder John was hoping to receive in the sale.
As indicated above, these ratios are subject to some variation. In addition, the terms and conditions can be crafted in various ways to make the process more or less difficult for either John or Jane. But the concept is consistent. While good for Stockholder Jane who might want some liquidity but could not find a buyer, a co-sale right is certainly not good for Stockholder John. In general application, a co-sale right is a serious impediment to a third party sale by any stockholder. Along with a right of first refusal (many stockholders’ agreements include both!), a co-sale right can make it so difficult to sell as to effectively block any stockholder sales without unanimous approval of all the other owners. This is just one more way a thoroughly considered and well drafted stockholders’ agreement can help keep ownership of a family-owned business within the family.
Drew Steen is an attorney in Davis Wright Tremaine’s Seattle office. He represents both buy-side and sell-side clients in mergers and acquisitions, venture capital investments, joint ventures, equity co-investments and restructurings. He also serves as regular corporate counsel for several closely-held companies. Drew can be reached via email at [email protected] or directly at 206.757.8081.