What are drag-along rights and how do they affect my investments?

“Drag-Along Rights” do not sound like much fun, but they are an important consideration in any investment. When negotiating the sale of a company, drag-along rights provide a mechanism to protect the interests of major investors.

What Are Drag-Along Rights?

Drag-along rights can give major shareholders the power to force the sale of all the shares in a company without the consent of minor shareholders. When forced to join in a sale, the minor shareholders are entitled to the same terms, conditions, and price as the major shareholders.

Why Are Drag-Along Rights Used?

Drag-along rights can be used to force the sale of an entire company. Say a company wants complete ownership and control over a competitor and decides to buy them out, but the target of the acquisition has multiple shareholders and some of those shareholders do not want to sell. If the major shareholders want to proceed with the sale, they can force all shareholders to participate in the sale by triggering their drag-along right.

When Are Drag-Along Rights Triggered?

If the major shareholders who collectively hold a controlling interest in the company (generally this is more than 50% but can depend on the specific terms of the drag-along right or the conditions of the sale) want to sell the entire company, they can hold a vote to trigger a drag-along right to compel all the other shareholders to also sell their shares.

It is important to recognize that in addition to a simple sale of shares, drag-along rights may also be triggered by a merger, or the sale of significant company assets, or by a change in control of the company.

Even though majority shareholders can trigger drag-along rights, it is crucial that the required process be followed, so that the rights cannot be nullified. Communication protocols are often written into agreements to ensure that minority shareholders are informed of a potential sale, the triggering of a drag-along right, and the price, terms, and conditions of the sale.

How Do They Impact Majority Shareholders?

Drag-along rights can impact majority shareholders in a positive way by giving them the power to take advantage of an opportunity to sell their shares and avoiding the potential for minority shareholders to block the sale. It gives the majority shareholders the ability to negotiate their terms with the buyer without having to consult other shareholders (although there is still a requirement to inform them).

How Do Drag Along Rights Impact Minority Shareholders?

On the positive side for minority shareholders, drag-along rights offer the potential for them to be involved in a sale in which they may not otherwise have the opportunity to participate. With the terms, conditions, and price negotiated by the major shareholders, the minority shareholders have the chance to profit from the sale of the company.

On the negative side, drag-along rights can be considered a disadvantage to minor shareholders due to the lack of control and the potential for being forced into a sale that they may not want, or at a price and terms that they may not see as favorable. For example, if a majority shareholder was in a difficult financial position and decided to sell their shares at below-market price, minority shareholders could be forced to accept less than the fair value of the shares. Or they may be forced to accept an early sale of the company that may have potential upside value if a sale were to occur later in the company lifecycle, thereby causing potential losses through opportunity cost.

Appraisal rights allow shareholders to demand an independent valuation of a company’s shares to determine a fair value of the stock. Under the terms of a drag-along right, minority investors are often required to waive their appraisal rights, in which case they would have no recourse to object to the share price in a sale scenario.

Important Considerations When Negotiating Drag-Along Rights

To reduce potential negative impacts, minority shareholders may try to negotiate some restrictions on the ability of majority shareholders to trigger their drag-along right. Such restrictions might include a minimum period within which the right cannot be invoked, a guaranteed minimum share price, or a minimum rate of return for a certain time.

It is important to make sure that drag-along rights, for the deal, can only be exercised by a sale to a legitimate third-party purchaser, to ensure that a majority shareholder cannot trigger a drag-along right by transferring its shares to a subsidiary or related party.

Negotiating board approval of a drag-along sale is another way that minority shareholders can protect themselves from a related party sale or below-market price. However, majority shareholders should understand that board approval of a drag-along right sale may impact their ability to reach a sale agreement on their preferred terms.

Another consideration when negotiating drag-along rights is that of sale proceeds. It is important to document the acceptable forms and manner of sale proceeds that shareholders will receive in a drag-along sale. While majority shareholders will want to maximize value in the sale by considering various forms of sale proceeds including stock in other companies, it may not benefit minority shareholders to be forced to accept illiquid securities as a form of sale proceeds. Minority owners may therefore try to negotiate the form of acceptable sale proceeds only as cash or liquid securities.

Drag-along rights should spell out how different types of stock are treated in the event the right is triggered. Preferred stock , common stock, and different classes of shares or units should all be considered in the context of how they would have been treated or benefitted in a liquidation event if they were distributed in line with the agreed distribution waterfall.

To enable a drag-along sale to proceed, it is important for all parties to agree in advance their obligations in the event the drag-along right is triggered. This reduces uncertainty by forcing the relevant parties to do what needs to be done to complete the sale. These obligations might include representations and warranties, covenants, and sale procedures.

On The Opposite Side — What Are Tag-Along Rights?

Tag-along rights share some similarities with drag-along rights, with the key difference being the matter of choice. With drag-along rights, majority shareholders can force minority shareholders to participate in a sale. With tag-along rights, minority shareholders have the right (but not the obligation) to participate in a sale and can compel the majority shareholders to include them on the same terms and price.

While drag-along rights benefit major shareholders, tag-along rights benefit minority shareholders.

When Are Tag-Along Rights Used?

Tag-along rights may be included in a Stock Purchase Agreement and may be triggered by a minority shareholder if a majority shareholder is negotiating a sale of their shares. This right gives minority shareholders the opportunity to participate in a deal put together by a major shareholder.

It is important to note that tag-along rights may create some challenges in a sale and can discourage majority shareholders from making an investment in a company because they force consideration of minority shareholders in a sale scenario.

Do These Legal Standards Change the Ability to Sell Company Shares?

The legal standards* associated with drag-along rights and tag-along rights can impact the ability to sell company shares, depending on the objectives of the parties involved. Legal standards dictate the terms of the drag-along and tag-along rights to be followed in a company share sale.

The existence of drag-along rights in a share sale agreement makes the legal requirements clear and supports the ability of a majority shareholder to facilitate a sale.

The existence of tag-along rights in a share sale agreement could potentially inhibit the ability of a majority shareholder to facilitate a sale, because it may force the purchaser to buy more shares than they want or can afford.

Example of Drag-Along Rights in Action

An example of drag-along rights in action is presented in the following hypothetical scenario:

A startup raises capital by selling a 51% majority stake in the company to a venture capital firm. The remaining 49% of the shares are retained by the founders, angel investors, and employee stock options. To ensure they have complete control and flexibility to facilitate a sale in the future, the incoming majority shareholder requires the inclusion of drag-along rights as part of the deal.

Sometime after the initial investment, the venture capital firm decides the time is right to sell their stake in the company and finds a buyer who is willing to pay a premium if they can purchase 100% of the company. The venture capital firm decides to go ahead with the sale and informs the minority shareholders they are triggering their drag-along right. The minority shareholders (including the company founders) are forced to participate in the sale and sell all their shares, at the same price and terms as the majority shareholder.

Conclusion

Drag-along rights are an important tool for majority shareholders because it gives them control when negotiating the sale of a company by empowering them to force all shareholders to sell their shares.

While drag-along rights can be beneficial for minority investors by enabling them to participate in a potentially favorable sale arranged by a majority investor, those rights do leave minority investors without a seat at the negotiating table.

*This is for informational purposes only. We do not provide legal advice and investors should consult their legal advisor prior to making any investment.

Originally published at https://www.propelx.com on March 4, 2022.