The Trados decision rendered last year by the Delaware Court of Chancery has thrown a wrench into the traditional notion that preferred stockholders will receive payment on their liquidation preference before common stockholders receive anything.
The case focused on the Trados Inc. board of directors' approval of a sale of the company in which the common stockholders received no consideration, but the preferred stockholders received nearly their entire liquidation preference. The court, in rejecting the defendants' motion to dismiss, noted that under certain circumstances directors can be held liable for favoring the interests of the preferred stockholders over those of the common stockholders.
In light of Trados, commentators have highlighted investors' concerns that liquidation preferences will not be fully respected in transactions where common stockholders do not share in the sale proceeds. Commentators and practitioners have suggested several approaches by which preferred holders may sidestep the Trados result, most prominently in the form of drag-along rights or redemption rights.
Drag-along rights, typically found in shareholders' agreements, provide a group of shareholders (often preferred shareholders) who wish to effectuate a sale of the company with the right to require the other shareholders to sell all ownership interests as part of the transaction. It has been suggested that a drag-along right solves the Trados problem by forcing directors to adhere to the express terms of the shareholders' agreement as a basis for approving a sale. But proper attention should be given to the practical implications of the enforcement of a traditional drag-along right.
If a company is sold for the amount of the preferred stockholders' liquidation preference and the common stockholders receive nothing for their shares, the drag-along right may have to be enforced over the objection of the "squeezed out" common stockholders. Many acquirers, however, may be hesitant to agree to a deal made possible only by the exercise of drag-along rights that force common stockholders to consent to a fruitless transaction. Although Delaware courts have enforced drag-along provisions, the prospect of litigation to enforce such provisions may be enough to scare off many acquirers of smaller private companies, which generally do not covet companies mired in such litigation.
Mandatory redemption rights provide their holders with the option to demand that a company repurchase their shares, typically after a period of five years or more. But suggestions that such redemption rights provide a workaround to the fiduciary duty obstacles outlined in Trados again fail to take full account of certain accompanying practical problems.
Frequently, the very companies that are most likely to receive shareholder redemption demands are the companies that can least afford to fulfill such demands. Delaware statutory law provides that a company in such a situation may redeem shares only out of its capital surplus or else risk possible liability for both directors and shareholders. Moreover, Delaware courts have classified mandatorily redeemable preferred stock as equity, not debt, substantially limiting the leverage of a preferred investor asserting a redemption right against a cash-starved company. In such a case, the investor may have no practical recourse beyond launching a costly litigation in hopes of forcing a sale.
Private equity investors should be aware that drag-along rights and redemption rights may not be silver bullets for stockholders searching for ways to insulate themselves from the realities of Trados. However, tightly drafted contractual rights that provide for clear remedies can give investors greater leverage in forcing a sale of the company without having to forgo part of the applicable liquidation preference to do so.
The most effectively drafted provisions would include such additional protections for preferred stockholders as the right to control the company's board, an express right to sell the company or irrevocable proxies over the shares of common stockholders. With careful drafting and attention to stronger drag-along and redemption rights, preferred shareholders may be better placed to ensure the benefit of their liquidation preference bargain in those unfortunate circumstances where a company's value is equal to or less than the liquidation preferences originally funded by such preferred shareholders.
Gordon R. Caplan is a partner in the corporate and financial services department and co-chair of the private equity practice of Willkie Farr & Gallagher LLP in New York. Jared B. Nicholson is a corporate associate with the firm.