This article sets out a very brief summary of some of the provisions most commonly found in investment agreements, service agreements and company articles of association in private equity deals. This article also considers some common issues that may arise in relation to these key share transfer provisions. These simple summaries may serve as a useful intro to investors or company owners considering stepping into a private equity transaction.

Private equity transactions include the provision of funding for a start-up business, the provision of funding to an existing business to help it grow and the funding of a buyout of an existing business. A buyout often involves a management team acquiring a target business with the help of private equity finance and, possibly, additional debt finance from financial institutions. The shareholders in a private equity-backed company can usually be divided into the private equity investor (the investor), and the key members of the company’s management team (the managers).

A private equity transaction is commonly structured using a holding or ‘top’ company that acts as the vehicle for the investment, and a number of wholly-owned subsidiaries of the top company that act as the purchasing and bank debt vehicles. When considering share transfer provisions, the key documents are the subscription and shareholders’ agreement for the top company (also known as the investment agreement) and the top company’s articles of association. Certain parts of the managers’ service agreements may also be relevant to certain share transfer provisions. In private equity transactions, the investment agreement, the articles of association and the service agreements are known together as the ‘equity documents’.

The various types of share transfer provisions that are typical for private equity-backed companies include:

Lock-up. These restrict the transfer of shares for a specified period of time. The purpose of including a restriction on managers transferring shares is to align their interests with the investor’s interests, that is, to drive the performance of the business in order to increase the value of the shares.

From a manager’s point of view, they may want to be able to realise some of the value in their shares within a reasonable time frame. An investor may want to insert a longer minimum period of lock-in. The time frame is a matter of negotiation between the parties but a compromise position might include staged time limits to spread out disposals and dilute their impact.

Pre-emption. These are standard provisions which provide that, on a proposed transfer of shares by a shareholder, the relevant shares must first be offered to all of the other shareholders in proportion to the number of shares that they hold.

Possibilities here might include how the price for transferred share might be calculated – such as fair market value or a figure set by the selling shareholder. These provisions will not usually apply to drag-along or tag-along rights or to any transfers that are specifically permitted in the equity documents (see ‘permitted transfers’ below).

Permitted transfers. These specify the transfers to affiliates that will fall outside of the lock-up and pre-emption provisions, , e.g., transfers to a manager shareholder’s family members or beneficiaries of trusts created by a manager shareholder for that manager or its family members.

Drag-along. These give shareholders that hold a specified majority of the shares the ability to procure an exit by way of share sale to a third-party buyer by forcing the minority shareholders to accept the offer for their respective shares. Where a company is majority owned by a private equity investor, the investor will almost always have drag-along rights. From the perspective of the dragging shareholder, the drag-along right should not be subject to pre-emption rights. Minority shareholders will want to ensure that they can only be dragged into a sale on arm’s length terms and to a bona fide third-party buyer that is not in any way affiliated to the dragging shareholder.

Tag-along. These set out the ability of minority shareholders to participate in a sale of their respective shares to a third-party buyer at the same price and terms as the majority shareholders. Tag-along provisions are an important protection for minority investors, as they may represent the only right to achieve an exit. However, it is increasingly common for minority private equity investors in growth capital investments to insist on having a right to procure that the investee company appoints advisers to instigate an exit process where an exit event has not occurred within a specified time period.

Compulsory transfer. Also known as ‘leaver provisions’, these require the managers and other shareholders who are officers or employees of the relevant group to transfer or otherwise forfeit some or all of their respective shares when their office or employment ends. Compulsory transfer provisions are often the most complicated and contentious type of share transfer provision in private equity transactions as they can cover a multitude of scenarios, each of which may merit separate consideration and they will often take the longest to negotiate.

Two of the main issues are relevant when considering the scope of compulsory transfers by departing managers, namely, the proportion of a manager’s shares that are to be subject to buy-back or forfeiture; and how the buy-back price is calculated. A different approach may be appropriate for certain shares but not other types of share. For example, shares already owned by a manager pre-investment or share acquired for or in lieu of cash on a disposal of that manager’s interest in the target company. This type of shareholding is sometimes called ‘strip equity’.

Shares that a manager has acquired for a low subscription price as a consequence of a manager’s employment (often known as ‘sweet equity’) are commonly made subject to compulsory transfer to allow buy back by the company. The price to be paid to a shareholder is such situations may depend on the circumstances of their departure. These are generally known as good leaver/bad leaver provisions where good leavers may be paid more for their shares than bad leavers.

Good leaver/bad leaver provisions will be discussed in more detail in a separate article.