Drag Along Rights: Everything You Need to Know
A drag along right or bring along right, gives majority investors the ability to sell a company to a third-party without consent from minority shareholders.6 min read
2. Why Is a Drag-Along Right Important?
3. Reasons to Consider Using a Drag Along Right
4. Reasons to Consider Not Using Drag Along Rights
5. Frequently Asked Questions
Updated November 5, 2020:
What Is a Drag Along Right?
A drag-along right, drag along provision, or bring along right, is a right that gives majority investors the ability to sell a company to a third-party without consent from minority shareholders. This helps protect the majority and eliminate the minority. However, minority shareholders still receive an equal sales price, terms, and conditions as the majority. In a sale, the drag along agrees to sell the entirety of the stock they own. In a structured merger, the minority shareholder agrees to vote in favor of the merger.
Drag along rights are often written in a term sheet, which outlines the terms by which a venture capitalist or investor invests in a company. In addition to investors, a drag-along right can also be included in an option agreement so that the option holder has to go along with the drag along. In most cases, stock option agreements should outline this provision, as well as a waiver of dissenter's rights.
Why Is a Drag-Along Right Important?
In mergers and acquisitions, companies look to control 100 percent of their competitor. Because of the desire for complete ownership, a drag-along right facilitates the sale between companies. For example, a CEO of a startup may negotiate a drag-along clause during investment negotiations. This protects the CEO if someone wants to buy the firm later, as well as giving them a majority stake. It should be noted that a drag-along right that allows investors to force a sale is in some cases a detriment.
In rare cases, minority shareholders have blocked the sale of a company by renegotiating terms. Minority shareholders can also hold up transactions approved by the super-majority, causing a freeze-out of a merger.
Although drag along rights protects majority shareholders, they also aid minority shareholders. Because the sale price, terms, and conditions are the same as the majority, minority shareholders can get a cut of the profits they may not usually get. However, minority investors may have to waive their appraisal rights.
Appraisal rights are the right of a minority shareholder to petition the court for a fair value of their shares. To keep their appraisal rights, the shareholder cannot vote in favor of the sale. Because this puts a snag in sales, term sheets usually note that these are lost in a drag-along situation.
Waiving appraisal rights hasn't been controversial until recently. In Halpin vs. Riverstone Inc., minority shareholders, with the consent of the majority, challenged this ruling. They contended that cannot waive his appraisal right for a price determined by the majority later. The court didn't side with either, but it did raise the question of appraisal rights. Also, the court sided with the minority because the majority failed to exercise the drag along properly, as it didn't tell the minority of the transaction beforehand.
Reasons to Consider Using a Drag Along Right
Before deciding on a drag-along right, it's important to understand all the provisions it may contain, and how each is a key issue for both majorities, and more importantly, minority investors. This includes questions such as:
- Who can trigger a drag along?
In most cases, the controlling majority, or a minimum of 51 percent are allowed to hold a vote to trigger a drag-along the sale. However, 66 percent may be the ideal rate depending on the company. Voters are usually preferred stockholders. Common stockholders might also be included, but this is rarer. Changing preferred stock to common stock or vice-versa happens often during this time as a way to influence decisions. Preferred stockholders can also convert some of their stock to common to create a majority vote for a drag-along. This actually isn't a terrible thing for common stockholders, as it lowers the liquidation preference of the stockholder.
In some cases regarding venture capital financing, drag-along rights are moved from the preferred stockholders to the common stockholders. Because more investors own common stock, the majority of overall owners make the drag-along decision rather than the majority of preferred stockholders, which actually constitute a minority of total shareholders.
- How are the profits from the sale are distributed?
Proceeds from a sale are distributed as described in the certificate of incorporation.
- Does the board of directors have to approve the sale?
The provisions of a drag-along right state whether it needs board approval. In the landmark In Re Trados case, the board approved a merger of the company. However, it was below liquidation preference, and shareholders made nothing on the transaction. Common stockholders filed suit against the board for breach of duties, but the court ruled the merger was fair. Most of the time, founders should require board approval, while venture capitalists should reject it.
- Are there any limitations of the drag along?
To avoid common stockholders receiving nothing for the transaction, many drag-along will put a minimum purchase price, or liquidation price, in the contract. This helps avoid unfavorable or unprofitable terms, as many venture capitalist firms will lose money if the liquidation price is met.
- Is there any shareholder liability?
In a drag-along sale or merger, there are either joint or several liabilities. Joint liability requires each stockholder to cover the entire liability. Several liabilities make shareholders handle a proportionate amount of liability in terms of how much stock they own.
What types of transactions allow for a drag-along?
- Transactions that transfer 50 percent of the voting power
- Consolidations and mergers
- A lease, transfer, license, or sale of a majority of a company's assets
Drag along rights provide benefits for investors, especially if they want to sell the company below the liquidation preference. However, minority investors can push back and require protection. In venture capital cases, minorities are often the founders of the company. This gives them strong negotiation skills over detrimental terms.
Reasons to Consider Not Using Drag Along Rights
One of the biggest concerns of shareholders using drag along rights is that they don't always benefit everyone involved. Many times, a sale using drag along rights undercuts the profits of the minority. If you're looking to buy a company that has drag-along rights, remember that there is no marketplace to sell private stocks. This forces you to shop it around on your own dime if you wish to sell in the future.
Frequently Asked Questions
- If the majority exercises a drag-along right, is there anything the minority can do?
Unless there's a provision written into the agreement, the minority has no recourse.
- What are tag-along rights?
Tag-along rights are similar to drag-along rights, but they give minority investors the ability to sell shares along with the majority. This allows minorities a chance to share in the profits that would otherwise only be given to the majority. Tag-alongs are different from drag-along in that the minority isn't held to the same terms and conditions as the majority.
- Is the drag-along sale taxable?
If the sale is taxable, it's outlined in the sale documents. However, many stockholders object to taxable sales. Instead, they want and argue to sell only if they receive cash or unrestricted securities.
What does a drag-along on a term sheet look like?
- The (holders or common/preferred stock or founders) enter into a drag-along agreement where if a majority of the holders agree to a liquidation of the company, the remaining stockholders shall consent and raise no objections to such a sale.
- Can a drag along be blocked?
Yes, in some instances. If preferred stockholders have the ability to approve a drag along, common stockholders can refuse to vote on the transaction until preferred stockholders waive their rights. However, this very situation is one of the reasons why drag-along became more widely used.
- Where is the tag-along/drag along threshold?
Minority owners can tag along if the sale involves 51 percent or more of the company is sold. If only 50 percent is sold, they may be subject to drag along.
Drag-along rights are a complex topic that isn't always easy for entrepreneurs to understand. Fortunately, UpCounsel's team of experienced lawyers are available to answer your questions or concerns. Make sure to post to the marketplace to get the answers you need for your small business.