Drag-along rights, on the other hand, are control provisions that can protect against minority shareholders holding up a deal for the sale of the company. Specifically, it requires a stockholder to vote in favor of sale if the transaction is approved by a certain percentage of stockholders and/or board members. The provisions generally expire upon a qualified initial public offering of company shares. The specific characteristics of the drag-alone provision generally include:
- Subject to Drag-Along – Investors will negotiate for certain common shareholders to be subject to the drag-along provision (to ensure liquidity of their investment). Dissent by a large group of shareholders or sufficient minority shareholders could thwart the transaction or cause the transaction to lose it’s tax-exempt status in a 1031 exchange.
- Minimum Threshold – Parties will identify the percentage of shareholders (total shareholders and percentage in each class) which could trigger the drag-along provision.
- Minimum Price – Investors may set a minimum price per share in the sale for the drag-along provision to take effect. This is the case for shareholders with lower priority who may not receive a distribution after the liquidation preferences of higher-priority shareholders is paid.
- Liquidity Qualifiers – Shareholders may require that any sale be in exchange for liquid assets for the drag-along provision to apply. This allows the shareholder to avoid being trapped holding an illiquid asset.
- Exemptions from Warranties and Representations – The sale of the shares will inevitably include representation and warranties as negotiated between the parties to the sale. The dragged-along shareholder may wish to exclude herself from those representations and warranties (which could entail liability if false or misleading).
These provisions have a risk shifting effect and may protect or detriment either the investor or entrepreneur, depending upon the equity structure. While a majority-shareholder entrepreneur is protected against investor hold up, a minor entrepreneur risks losing control of her company to facilitate an investor exit. The status of the entrepreneur as majority shareholder is subject to change, as the ownership interest of the entrepreneur is diluted with every subsequent round of investment. Most shareholders will reserve dissenters rights, which allows the shareholder to receive the cash-value (or a cash value) for their shares.
Example of Drag Along Rights
For example, a startup X decides to collect investment from a venture capital for raising capital. The founder of the startup holds 51% of the shares and sells the 49% shares to the venture capitalist. The owner of the company negotiates a drag-along with the venture capitalist, so in future, if the owner decides to sell out the company, the venture capitalist won’t have the power to stand in the way
The drag-along rights are beneficial for the minority shareholders as well, as it ensures the minority shareholders sell their shares on the same terms and conditions as the majority shareholders.