This article was published as part of the July 2009 Sub-Debt Report.
In our October issue of the Sub-Debt Report, we discussed certain issues related to warrants, including dilution protection, put rights and change of control rights. As foreshadowed then, this article considers the rights and obligations of a warrantholder once it has decided to convert its warrant to equity. While a holder’s warrant remains outstanding, a warrantholder has various built-in protections, many of which were discussed on our last article. Many of those protections help ensure liquidity in the investment and protection from potentially abusive tactics by the equityholders of the Company. However, once a warrantholder elects to convert its warrant into equity, most protections cease to exist, unless the warrantholder has negotiated additional rights in advance.
This article considers some of the rights held by, and obligations imposed upon, a warrantholder that has converted its warrant to equity. Although some of these rights also exist during the term of the warrant, this article is focused on the rights of a warrantholder once it has converted. For ease of reference and to distinguish the former warrantholder from other equityholders, this article will continue to use the term “warrantholder,” notwithstanding that the warrantholder will have converted its warrant to equity. While most warrantholders never exercise their warrant – either because of their put right or the company engages in a sale transaction – it is still important to focus on these such issues in the event that exercising the warrant is the best alternative.
Rights and Obligations with Regard to Sales of Equity
What if another equityholder receives an offer to sell its equity?
A warrantholder generally has two key rights if another equityholder in the company in which the warrantholder has invested has the opportunity to sell its equity interest – a right of first refusal and a “tag-along” right. If an equityholder receives a bona fide offer to sell all or a portion of its equity, a right of first refusal provides the warrantholder the opportunity to acquire the selling equityholder’s interest in the company on the same terms as set forth in the offer. This right is shared on a pro rata basis with other equityholders. Rather than exercising its right of first refusal, a warrantholder also has the option to elect to participate in the sale on a pro rata basis based on the percentage of the company’s equity held by the warrantholder. This right is typically known as a “co-sale” or “tag-along” right.
Thus, if the warrantholder believes that the terms of the third-party offer are cheap relative to the true value of the company, it may exercise its right of first refusal; but if it believes that the terms of the bona fide offer are expensive relative to the true value of the company, it may exercise its co-sale rights. Absent a sale of the company, a tag-along right is the most realistic, even if only partial, interim exit strategy of the warrantholder once it becomes a direct equityholder because, as discussed below, stockholder agreements or other governance documents often contain transfer restrictions that limit the warrantholders’ ability to transfer the equity interest it receives upon exercise of its warrant. Moreover, a tag-along right ensures that the warrantholder participates in any control premium that may be paid if one or more equityholders sell a controlling interest in the company.
These rights are not controversial or particularly complicated. However, consideration should be given to ensure that the warrantholder has adequate time to consider the offer and to determine whether to exercise its right of first refusal or tag-along right, or to simply do neither. Too little time to consider or too short of a time frame to closing could limit the ability of the warrantholder to effectively exercise its rights, but too much time unfairly burdens the majority equityholder.
What if other equityholders want to sell the entire company?
It is common for a warrantholder to be subject to another equityholder’s “drag-along” rights. A drag-along right permits either a particular equityholder, or a majority of the equityholders, to force all other equityholders to sell their equity to a bona fide purchaser. These provisions exist to insure that a minority equityholder cannot block a sale that is structured as a stock acquisition or use its power to block a sale to extract a premium for its equity. This is not a particularly burdensome obligation as, under most state corporate statutes, a majority of the equityholders can approve a merger that is binding on all equityholders; the warrantholder subject to the drag-along obligation, however, would lose its statutory right to have a judicial appraisal of the value of its shares.
What obligations are generally imposed on a warrantholder with respect to sales of equity?
Most private companies will place restrictions on transfers of equity. These limits are necessary for securities laws compliance and give other equityholders some control over who becomes a fellow equityholder. The restrictions can vary greatly from company to company. Most will – and all should – prohibit a sale in violation of federal or state securities laws. In some instances, an equityholder may only sell its shares after it has provided the other equityholders and the company an opportunity to exercise their rights of first refusal and tag-along rights. This type of limitation is obviously needed in any situation where such rights exist. In limited situations, a company will prohibit all transfers without consent of the board of directors of the company or some percentage of equityholders. Notwithstanding any agreed upon limits on transfers, a warrantholder should have the right to transfer its shares to its affiliates and possibly to its limited partners.
May the Warrantholder Elect its Own Board Member?
A warrantholder may be granted voting rights or appointment rights with respect to board membership. It is not uncommon for a stockholders’ agreement to provide for a certain number of board seats to be allocated to each investor class, the warrantholder possibly being one such class. The board seat allows the warrantholder access to all of the company information, allows it to participate in the strategic direction of the company, and provides an easy way to oversee its investment. A board seat does not, however, come without drawbacks. Being on the board of directors brings with it fiduciary duties to all equityholders. While a discussion of fiduciary duties is beyond the scope of this article, it is important to be aware of this potential drawback to board membership.
Oftentimes a warrantholder finds the proper balance between protecting their investment and the burdens of board membership with board observer rights. These observer rights allow the warrantholder to receive all notices and access to information that a director would receive, without the accompanying fiduciary duties. While a board observer cannot vote on matters before the board, they are in the room when decisions are made; often, this is comfort enough for most investors.
Does a Warrantholder get to separately approve a major transaction?
Warrantholders can also negotiate for consent rights with respect to certain major corporate transactions, such as a merger or sale of substantially all assets. However, as a minority equityholder, these rights are often only granted in limited situations, such as where the warrant is exercisable for a more substantial portion of the equity.
When and how often may the rights be exercised?
Registration rights are designed to ensure that, if a company registers some of its equity shares under the Securities Exchange Act of 1934, as amended, thereby making those shares publicly transferable, the equityholder can force the company to likewise register its shares so that its shares are also freely transferable. The registration rights agreement will provide that the equityholders can demand registration of their equity after a certain set time (often referred to as demand registration rights); however, as noted above, the warrantholder’s demand registration rights will only become effective after a public offering of the company’s securities has taken place. Often the company will require that a certain minimum threshold of registrable securities be registered with any single registration request, so as to minimize the burden on the company of complying with the registration process.
The number of times registration rights can be exercised are usually limited in two ways. The first type of limitation limits the number of registration requests that a certain class or type of investor may make during the life of the registration rights agreement. The second type limits the number of times a request may be made during any given period of time. For example, it is often the case that no more than one registration request may be given to the company in any six-month period.
May the company refuse to honor registration rights?
Registration rights agreements contain customary carve-outs that allow the company to refuse registration rights in the face of a pending transaction or other event, the disclosure of which would negatively impact the company. The company is usually limited in the number of times it may refuse registration rights in a given time frame. While a company often can not refuse to honor the registration rights altogether, it may be allowed to postpone the registration for a certain amount of time.
What are piggyback registration rights?
In addition to demand registration rights, equityholders and warrantholders often receive piggyback registration rights. Piggyback registration rights refer to an equityholders’ right to include its equity in a registration initiated by the company or another equityholder. Because there is no limit on the number of shares or number of equityholders that may be registered on a registration statement, companies will frequently give all equityholders and warrantholders these rights in an attempt to reduce the cost of the registration process.
Piggyback registration rights differ from, and are inferior to, demand registration rights in two ways. First, those participating in the registration through piggyback rights are not in control of the registration process or the timing of the registration. In addition, registration rights agreements will provide carve-outs allowing the company to limit the number of equity registered, upon receipt of advice from their underwriter that there is only a market for a certain, smaller number of shares.
What if there is not a market for the company’s equity?
The registration rights agreement generally provides a mechanism to reduce the amount of equity to be issued in the offering if the company’s underwriter advises the company that there is not a market for all of the equity proposed to be registered. The order in which the cutbacks occur vary with circumstance, but a few general rules apply. If the company is participating in the registration, demand registration rights will be either fully cut back or cut back in some pro rata fashion between the demand registration holders and the company (usually with the demand registration holders being cut back more severely). If the company is not participating in the registration – and assuming that each demand registration holder holds the same demand rights – the holders of demand registration rights will be cut back pro rata among themselves. Finally, as discussed above, holders of piggyback registration rights are fully cut back before either the company or holders of demand registration rights are cut back.
As a potential minority equityholder, warrantholders need to be certain that they consider what rights they would like to have as an equityholder and to make sure that such rights have been included in an appropriate agreement, typically the agreement among the other equityholders of the company. Care should also be given to make sure that rights of other equityholders are not inconsistent with such right. Finally, as a minority equityholder, a warrantholder must understand that, after its exercises its warrant for shares, its rights may be very limited.