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Drag Along Rights – Definition

Drag-Along Rights Definition

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.

Academic Research on Drag-Along Rights

An analysis of shareholder agreements, Chemla, G., Habib, M. A., & Ljungqvist, A. (2007). Journal of the European Economic Association5(1), 93-121. This paper provides an economic explanation for many of the key clauses and agreements that govern the relations among shareholders in privately held firms. Clauses like put-and-call options, tag-along and drag-along rights, piggy-back rights, and catch-up clauses are analyzed. Various settings are described to illustrate the purpose and effectiveness of these clauses and agreements.

Venture capital exit rights, Bienz, C., & Walz, U. (2010). Journal of Economics & Management Strategy19(4), 1071-1116. This article examines the reasoning for exit rights such as drag-along and tag-along rights. Using a set of data derived from real-world venture capital contracts in Germany, the authors find that almost all contracts are used to allocate exit rights to the venture capitalists, and that these rights are included to mitigate the potential hold-ups in the event that the venture capitalists choose to exercise those rights.

Private contracting and corporate governance: Evidence from the provision of tag-along rights in Brazil, Bennedsen, M., Nielsen, K. M., & Nielsen, T. V. (2012. Journal of Corporate Finance18(4), 904-918. This paper analyzes the effects of tag-along rights against the backdrop of Brazil’s stock market. The authors examine the effects that come from the announcement of tag-along rights and their relation to the average rates of return.

Specific investments, opportunism and corporate contracts: A theory of tag-along and dragalong clauses, Lacave, I. S., & Gutiérrez, N. B. (2010). European Business Organization Law Review (EBOR)11(3), 423-458. This paper is intended to analyze the effectiveness of tag-along and drag-along arrangements. The authors take a look at these contract features in the light of the assumptions that they are designed to address. These motivations are analyzed and addressed for their validity.

How do legal differences and learning affect financial contracts?, Kaplan, S. N., Martel, F., & Stromberg, P. (2003).  (No. w10097). National Bureau of Economic Research. This paper compares the venture capital (VC) investments of 23 non-U.S. countries with VC investments in the U.S. Methods of allocating cash flow, board, liquidation, and control rights are discussed. The difference in legal regimes and international contract styles are also analyzed.

Preplanned exit strategies in venture capital, Cumming, D., & binti Johan, S. A. (2008). European Economic Review52(7), 1209-1241. This paper employs a sample of 223 entrepreneurial firms financed by 35 venture capital funds in 11 European countries to analyze the role of pre-planned exit strategies in venture capital (VC) situations. The data shows how exit strategies affect financing options and initial public offerings (IPOs), as well helping to define shareholder rights and corporate structure. The different levels of these effects are also compared in the different countries.

Private contracting and corporate governance: Evidence from the provision of tag-along rights in an emerging market, Bennedsen, M., Nielsen, K. M., & Nielsen, T. V. (2008). This article analyzes the owners’ incentive to use tag-along rights and private contracting to protect non-controlling owners against self-dealing. The benefits of these rights are examined, as are the costs associated by implementing them. Empirical results are obtained using data from Brazilian equity offerings. The results find that private contracting offers a strong governance mechanism to protect the investors.

Contracts and returns in private equity investments, Caselli, S., Garcia-Appendini, E., & Ippolito, F. (2013). Journal of Financial Intermediation22(2), 201-217. This article examines the relationship between contracts and returns in private equity (PE) investments. The authors look at the reasoning for contractual covenants, and the correlation between the perceived quality of the company and the way that PE investors choose their covenants and board structure.

Contracts and exits in venture capital finance, Cumming, D. (2008). The Review of Financial Studies21(5), 1947-1982. The author uses a sample of venture capital (VC) investments to study the relation between VC contracts and exits. The findings, which are robust to controls for a variety of factors, show that stronger VC control rights increase the likelihood that an entrepreneurial firm will exit via an acquisition rather than through a write-off or IPO.

Evolution of decision and control rights in venture capital contracts: an empirical analysis, Bienz, C., & Walz, U. (2006). This study analyzes a sample of 464 contracts between German portfolio firms and venture capitalists (VC) to examine the formation and shape of decision and control rights. The study works along three time dimensions: the point at which the contract was signed, the expected duration of the contract, and the actual duration of the contract. The findings illustrate the nature of the relationships between the VC and portfolio firm and the nature of the distribution of rights between the two.

Deal structuring in philanthropic venture capital investments: Financing instrument, valuation and covenants, Scarlata, M., & Alemany, L. (2010). Journal of Business Ethics95(2), 121-145. This study examines the unique structure and investor behavior surrounding philanthropic venture capital (PhVC) for social enterprises. The unique drivers and return expectations of PhVC are examined and compared to their for-profit counterparts.

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