Key Takeaways

  • Drag-along rights allow majority shareholders to compel minority shareholders to sell in a company sale.
  • These rights ensure full ownership transfer and protect deal completion.
  • They typically require identical sale terms for all shareholders, including minority ones.
  • Term sheets often include drag-along clauses and waive appraisal rights to streamline exits.
  • Important considerations include who can trigger the drag-along, required approvals, and liability distribution.

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. 

Common Provisions Found in Drag-Along Rights

Drag-along rights are governed by specific provisions that clarify when and how the right can be exercised. Common provisions include:

  • Trigger Threshold: Usually a majority or supermajority (often 51%–66⅔%) of preferred shareholders, or sometimes a combined majority of common and preferred shareholders, must approve the sale to trigger drag-along rights.
  • Notice Requirements: The company must notify all shareholders about the transaction, ensuring that minority shareholders are informed and can prepare accordingly.
  • Board Approval Clause: Some agreements require that the board approve the transaction before the drag-along right becomes enforceable, though this can be waived in investor-friendly agreements.
  • Appraisal and Dissent Waiver: To avoid delays and complications, shareholders typically agree to waive dissenters’ or appraisal rights upfront as a condition of investment.

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.

Drag-Along Rights in Venture Capital and Startup Exits

Drag-along rights are especially prevalent in venture capital deals. VCs negotiate for these rights to ensure that when an exit opportunity arises—such as an acquisition—they can force a sale even if founders or other minority stakeholders resist. Key benefits in this context include:

  • Expedited Liquidity Events: Ensures that investors can capitalize on favorable exit opportunities without obstruction.
  • Mitigating Founder Resistance: Founders may resist sales that dilute their control or vision. Drag-along rights prevent a small minority from blocking a value-maximizing deal.
  • Simplified Exit Structuring: Helps streamline mergers or acquisitions where the buyer requires full ownership of the company.

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.

Minority Shareholder Protections and Pushback

While drag-along rights aim to simplify corporate sales, they can present risks to minority shareholders, particularly if their rights aren’t clearly outlined. To address this, companies sometimes include:

  • Minimum Price Protections: These provisions prevent triggering a drag-along unless the sale price exceeds a defined threshold, helping protect minority shareholders from low-value exits.
  • Carve-Outs and Exceptions: Certain drag-along provisions limit the scope to specific transaction types (e.g., asset sales vs. equity sales) or require additional consents for related-party transactions.
  • Fairness Opinions: Some agreements require an independent fairness opinion to support the deal value and protect shareholders from coercive sales tactics.

Frequently Asked Questions

  1. What is the purpose of drag-along rights in a startup?
    To ensure majority investors can sell the company without being blocked by minority shareholders, streamlining exit strategies.
  2. Do drag-along rights apply to both preferred and common stockholders?
    Usually, they apply to preferred stockholders, but some agreements include common stockholders depending on voting structures.
  3. Can a drag-along clause be enforced if appraisal rights are not waived?
    Enforcement can be challenged if appraisal rights are not explicitly waived. Courts have scrutinized such cases, like Halpin v. Riverstone.
  4. What happens if shareholders refuse to comply with a drag-along?
    They may face legal action or be compelled through contract enforcement. Agreements typically obligate compliance with no objections.
  5. How can minority shareholders protect themselves?
    By negotiating fair terms, minimum exit valuations, or exclusions from specific transaction types during initial investment agreements.

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.