are clauses usually contained in financing agreements that require management members to share any future sale of their stock with the present investors. Sometimes referred to as tag-along provisions, they are usually entered into at the insistence of the outside investors as a condition to their providing funding.
The purpose of a co-sale agreement is to prevent important management members from selling out (perhaps at a large profit) and leaving the investors "holding the bag." While co-sale agreements do not prevent management shareholders from selling their shares at a profit, they do force them to share the benefit of their sale with the investors by allowing the investors to include their shares in the sale.
In practice, co-sale agreements work like this: Whenever a management shareholder is approached and has the opportunity to sell his shares of company stock, he must notify the investors and tell them the terms that have been proposed. Then the outside investors have an opportunity to sell some of their shares to the purchaser. If the outside investors elect to include some of their shares in the sale, the management shareholder will reduce the number of his shares being sold so that the purchaser acquires the number of shares he originally offered to buy. The number of shares the outside investors are entitled to include is usually a predetermined percentage of the total number of shares being sold. Often, that percentage reflects the relative number of shares held by the investors and the selling management shareholder.
The operation of co-sale agreements raises some interesting securities law questions. For instance, does the participation by the outside investors in the management shareholder's sale of shares create an obligation on the management shareholder to provide more formal disclosure to the buyer of the shares than he would otherwise have had to make? Certainly, it creates an obligation on the part of the participating outside shareholders to be as candid with the buyer as the management shareholder is required to be. Just as certainly, the management shareholder has a separate responsibility to the participating outside shareholders to make full and accurate disclosure to them about the offer and the condition of the company. How to fulfill this obligation can be a troublesome question in a real world where companies have extensive activities and even investors who sit on a company's board of directors may not have a full or accurate understanding of the company's operations.
What happens if the buyer of the shares obtains rights against both the management shareholder and the outside selling shareholders because of an inadvertent misrepresentation or omission made by the management shareholder? Has the management shareholder created additional liabilities for himself to the participating investors by permitting them to participate in the sale? (Probably yes.) Does the management shareholder risk incurring liability as a selling shareholder if the participating shareholders make a misrepresentation that entitles the purchaser to rescind the purchase or obtain damages? (Again, the answer is probably yes.)
Because the use of co-sale agreements raise so many securities questions, which in turn can create liability for management shareholders, they are often resisted by management. Because they are so frequently used by venture capitalists, however, managements are infrequently successful in avoiding co-sale agreements. When they cannot be avoided, cross-indemnification agreements can be used with them to make each party responsible for any liabilities created by their misrepresentations or failure to comply with applicable securities laws.
Co-sale agreements should be for as short a term as possible and should terminate automatically when the company goes public. Management shareholders can also try to limit co-sale rights by making them nontransferable and requiring participating sellers to bear a share of the cost of consummating a sale. These costs could be significant if the sale requires the preparation of an offering circular or other significant disclosure document.
Whenever possible, management should negotiate a minimum number of shares that it can sell in any twelve-month period without triggering the co-sale rights. After all, the rationale for the co-sale provision is to prevent management from selling out wholesale and leaving the investor with an unmanaged company. Sales of small numbers of shares should not diminish management's interest in the company. Sometimes gifts of shares and use of the shares to secure a legitimate debt can be excluded from a co-sale obligation.
In all events, any sales made under a co-sale agreement, whether the outside investor chooses to include his shares or not, should be made only on the advice and with the assistance of counsel. Otherwise, management and the outside investors these rights are designed to protect may find themselves being exposed to unexpected and unwanted liabilities. See: Blue Sky Laws, Exits, First Refusal Rights (Company), First Refusal Rights (Shareholder), Reg D, SEC (Securities and Exchange Commission), 10b5, 33 Act.