Drag Along Rights
What are Drag Along Rights?
What Are Drag-Along Rights?
Mergers, acquisitions, takeovers, and fund infusions can often be complicated in more than one aspect. For example, while transacting a deal, certain rights and warranties are incorporated into the agreements to protect various share classes.
Cases of a deal tanking include minority shareholders not agreeing to the terms. This often leads to bad blood and loss of acquirers. These rights give the power to majority shareholders to compel the minority into agreeing to the proposed transaction.
When triggered in case of a business sale, the minority must sell off their entire stake. On the other hand, in the case of a structured merger, the minority needs to vote in favor of the merger proposal.
These rights are included in shareholder agreements to avoid situations that may hamper potential sales or takeovers. While the majority can “drag” the minority into selling their ownership, the price and terms offered to the minority must be the same.
Drag-along provisions are important in negotiations as potential buyers look to gain 100% control of the company. When obstructed by the minority, these rights assist in selling the complete stake to the buyer by eliminating the current minority owners.
Benefits Of Drag-Along Rights
Investors secure their exit routes by incorporating drag-along provisions within agreements. Due to this reason, majority shareholders, such as founders and early 1. investors, insist on these provisions. As a result, easier exits are enabled as follows:
1. In most cases, acquirers look to attain a complete stake in the target company. To execute a 100% stake sale, every company shareholder must be convinced and on board.
This is quite a time-consuming process and sometimes a waste of resources if only some investors agree. Only the onboard investors can sell their rights without these rights, rendering the acquisition moot.
2. Drag-along rights offer protection against potential freeze-out merger situations where the majority pressurizes the minority into selling off its stakes. These rights offer peaceful closure of transactions.
3. They also help negotiate a better premium for control valuation by rendering complete control in the hands of the prospective buyer.
4. In scenarios of poor and under-projected venture performance, drag-along provisions help push the sale of the business at a price less than the liquidation preference if desired by the investors.
Alongside securing the positions of majority investors, they also protect the interests of the minority pool in a few ways.
- Minority shareholders are provided with the guarantee of being offered the same price, terms, and conditions as the majority in case the clause is triggered. However, this may be subject to certain caveats.
- Generally, it also requires a systematic chain of communication with the minority, keeping them in the loop of company affairs.
Such rights may or may not be perpetual. There exists scope for future shareholder agreements to nullify any past provisions. They also get nullified when a company goes public.
Key Terms In Drag-Along Rights
Being in the deal room, knowing the key terms within drag-along clauses is necessary. Drafting agreements, negotiating clauses, and implementing the same is a work of craft. So let's understand these terms in brief.
1. Triggering Transactions
A triggering transaction is an event that activates the execution of the specific clause contained in the agreement. The triggering transaction usually is a transfer or deemed liquidation event for drag-along clauses.
2. Triggering Thresholds
As may be negotiated, sometimes a basic majority approval of the proposed transaction might be required to trigger a drag-along provision. At times, a blended majority inclusive of common shareholders is included.
This shareholder consent requirement is known to be the triggering threshold. Under specific agreements, board approval requirements are incorporated too.
3. Notice Requirements
Upon exercising their drag-along rights, majority shareholders are required to provide a notice to the minority laying out the sale terms, proceeds, details of the potential buyer, sale date, number of shares held, and other agreement details as may be agreed upon.
This notice needs to be served a specific number of days in advance. Failure to properly serve this notice might even render the transaction void, as is seen in previous case laws.
4. Liquidation Preferences
For certain transactions, these rights can be structured in a manner where the proceeds get distributed as per the liquidation preference waterfall.
In cases where the total sale proceeds are less than the liquidation preference, there might be no receipts distributed to the common stockholders.
5. Minimum Price
This refers to the minimum price level to trigger the drag-along clause, often devised using liquidation preference as a base.
6. Lock-In Period
The shareholder agreement might include a clause restricting the majority from activating drag-along rights before a specified period. This time frame is known as the lock-in or lock-up period.
7. Form of Sales Proceeds
These clauses include specifications concerning the form of consideration involved in the transfer case. Most of the time, minorities prefer cash or liquid securities in consideration. Therefore, they specify this stipulation explicitly in this clause.
Considerations For Drag-Along Right Provisions
While framing the provisions, it is important to deliberate on the key considerations affecting the exercise of such rights.
1. Price
The minority holders often insist on a minimum price level to be decided in the agreement to avoid potential undervaluation if the situation worsens.
When the consideration is non-cash, the minority may ask for a mechanism to ensure their shares are priced on a fair value basis.
2. Form of consideration
In cases of third-party purchase offers, consideration may be cash or non-cash. Drag-along provisions apply equally to both kinds of transfer, creating a resistance point for the minority.
Minorities negotiate hard for the applicability of drag-along rights on non-cash transfers. A non-cash share swap may leave the minority shareholder with an even trickier exit option.
3. Representation and Warranties
Over and above their capacity and title, minority shareholders subject to drag along clause might not be required to give representations and warranties. But, again, this is favorable for the minorities being dragged along.
As seen above, a sizable mix of possible combinations exists regarding drag-along clauses. But ultimately, it boils down to the leverage in the hands of founders and investors forming the majority.
Drag-Along Rights Examples
Often seen in a term sheet drawn by a venture capitalist or an investor outlining the terms of the proposed transaction, drag-along rights get triggered on the occurrence of specific events, as discussed above.
They may also be included in option agreements to drag an option holder apart from shareholder agreements, as we know.
ome examples of trigger points are:
- Deals and transactions where over 50 percent voting power is involved.
- The transition from preferred to common stock.
- Sale or transfer of business or majority company assets.
- Startup consolidations.
- Mergers, acquisitions, and takeovers.
There is no standard format for the drag-along rights clause. However, it usually is framed on similar lines as laid out by the terms and purposes discussed till now.
A sample clause may be -
Startup K decides to raise funds from a leading venture capital player in the market. As a result, the co-founders of this startup own a majority chunk of shares, coming to approximately 60% of the total stake.
The venture capitalist agrees to invest USD X million against a 49% stake, reducing the founders’ share to 51%. In this case, the founder negotiates a drag-along provision to be included in the shareholder agreement.
This clause states that if the owner decides to sell out the company to a 100% buyer in the future, the venture capitalist would not have the power to obstruct the deal, subject to other conditions.
Drag-Along Rights Vs. Tag-Along Rights
The minority-friendly version of drag-along rights is tag-along rights, which provide minority groups with potential exit routes. Tag-along rights give the minority owners a right but not an obligation to participate in a transaction at the same terms as offered to the majority owners.
Being a less forceful version, it allows the minority shareholders to “tag along” on the sale if they wish to. Tag-along rights are often said to offer minority owners better protection and help them secure a better valuation for their stake.
This article focuses on drag-along rights; however, many concepts apply to the latter.
Conclusion
The end motive of any founder, investor, or shareholder is the same, to get a successful and easy exit. Drag-along rights are one category of facilitators of this motive. They make exits easier for the majority in cases of complete control transfers.
Granting drag-along rights increases the level of control investors hold over the business. Hence, drafting an ideal clause is an art and considers several factors and terms, such as triggering events, thresholds, minimum prices, lock-up periods, and liquidation preferences, to state a few.
A founder or minority-friendly version is a tag-along right. Drag along favors the majority, and tag along favors the minority. However, both are principal forms of investment realization in any shareholder agreement.
Amidst negotiations around these clauses in an agreement, the salient pointers stated above serve as useful tools and reference points, directly impacting the return on the shareholder's investment.
Drag-Along Rights FAQs
When negotiating a potential sale to a prospective buyer, drag-along rights give the power to majority shareholders to compel the minority into agreeing to the proposed transaction. It is also known as a bring-along right.
Although they are a tool favoring the majority, they offer some protection to the minority by offering an equivalent price, terms, and conditions. They also mandate an orderly chain of notice to the minority to be maintained.
They open a path for the investors and founders to complete a sale of business transactions by dragging along the minority. This makes the target business more marketable, as the buyers are often looking to obtain complete control.
They also act favorably to increase the control valuation figures by presenting a united business unit and not a piece-by-piece view.
A well-balanced mix of terms needs to be negotiated as a complex provision. These include discussions on triggering clauses, triggering thresholds, minimum price requirements, lock-in periods, liquidation preferences, notice requirements, representations, and warranties.
While the terms to be included vary case-to-case basis, all the above terms are usually seen in a standard drag-along clause.
Drag-along rights give the power to the majority to drag the minority along. On the contrary, tag-along rights give the minority owners a right but not an obligation to participate in a transaction at the same terms as offered.
A minority-friendly version of drag-along rights is tag-along rights.
As is widely seen, transactions that transfer 50 percent of the voting power, consolidations, mergers, a lease, transfer, license, or sale of most of a company's assets usually drag along.
A drag-along may also be allowed in various other circumstances, described in the original agreement clause.
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