What are Drag Along Rights?

What happens when a startup gets an attractive acquisition offer—but the minority shareholders don’t want to sell? This situation can lead to contentious negotiations, bad blood, and perhaps the potential acquirer walking away.

Majority shareholders often ask to include drag along rights in the shareholder’s agreement to avoid this situation. These rights allow the majority shareholder to forcibly “drag” the minority shareholders along in the acquisition, with the same price, terms, and conditions.

However, not all drag along rights are created equal. There are crucial details that both investors and founders should be aware of. In this guide, we’ll go over how drag along rights work, how they benefit investors, key terms to look out for, and how drag along and tag along rights differ.

What are Drag Along Rights?

Drag along rights are provisions that allow the majority shareholders to compel the minority shareholders to participate in the sale of the company. Sometimes known as “bring along rights” or “drag rights,” these provisions are usually found in the term sheet and subsequent shareholder's rights agreement, if included in a deal.

In venture capital, the majority shareholders can either be the investors or the founders—it typically depends on the company's stage. The earlier the stage, the more likely it is that the founders are the majority shareholders.

Here’s a sample draft of a drag along rights clause:

The holders of the Common Stock shall be required to enter into an agreement with the holders of the Series A Preferred that provides that all such holders of Common Stock and the remaining holders of the Series A Preferred will vote their shares in favor of a transaction in which 50% or more of the voting power of the Company is transferred or any other Deemed Liquidation and which is approved by the holders of 50% of the outstanding shares of Series A Preferred, on an as-converted basis.

In the above example, only the majority of preferred shareholders from Series A can trigger the drag along provision. If at least 50% of the Series A shareholders agree, the drag along rights clause can be exercised.

Drag Along Rights vs. Tag Along Rights

A less forceful version of drag along rights are called tag along rights. Tag along rights (also called co-sale rights) give minority shareholders the right—but not the obligation—to participate in the sale. The minority shareholders can “tag along” if they so choose. Tag along rights can be paired up with a right of first refusal clause, giving the minority shareholder the right to buy out the majority stake.

While this guide is focused on drag along rights, it’s important to understand that—other than the differences in obligation—a lot of the information can also apply to tag along rights.

How do Drag Along Rights Benefit Investors?

Investors often insist on including drag along rights—especially those that only allow preferred shareholders to exercise the right—to give themselves an easier exit path. Drag along rights enable easier exits because:

• In most cases, acquiring companies want to receive 100% of the target company. Without drag along rights, investors would only be able to sell their own stake (which might not even be a true majority stake if the common shareholders are included). Each investor in the target company—no matter how small their ownership stake—would need to be individually convinced to sell. The time and resources required to do so would likely render many acquisition attempts moot.
• Even if the investors hold a majority, drag along rights can help avoid contentious and time-consuming “freeze out” merger situations. This, of course, presumes the acquirer is still interested despite minority shareholders holding out.
• If the startup is not performing as expected, the investors may want to sell a price that is less than their liquidation preference. In such a scenario, the common shareholders could be wiped out. Having drag along rights would allow the preferred shareholders to force the sale through.

Drag along rights can disproportionately benefit preferred and majority shareholders at the expense of the common shareholders or minority shareholders. However, drag along rights provide the following protections:

• Minority shareholders are guaranteed the same price, terms, and conditions of the sale. A caveat to this is that any sale may be subject to preferred shareholders’ liquidation preferences. If the sale price is below the total liquidation preference payout, there’s a possibility that the common shareholders could receive nothing from the sale.
• Drag along rights may not be perpetual. Future shareholder’s agreements can nullify previous drag along provisions. Further, drag along rights will no longer apply if the company goes public.

Understanding the Key Terms Within Drag Along Rights Clauses

Here are the key terms within drag along rights clauses to be aware of:

Triggering Transactions

Drag along rights clauses are triggered by a transfer or “deemed liquidation event.” The definition of what constitutes a “deemed liquidation event” can be subject to negotiation. For example, if the startup is selling most, but not all, of its assets, is that a deemed liquidation event?

Triggering Threshold

Investors may request that a simple majority of preferred shareholders be enough to exercise the drag along rights. However, the parties can also include common shareholders (whereby the threshold would be determined by treating preferred shares as if they were converted to common).The percentage of shareholder consent itself can also be negotiated. For instance, it may be raised to take two-thirds of preferred shareholders to exercise the drag along rights. Combinations are also possible—for example, requiring majority approval of common shareholders and a two-thirds majority of preferred shareholders. Finally, board approval requirements can also be required to trigger the drag along.

Notice to Minority Shareholders

When the majority shareholders exercise their drag along rights, they must also provide advance notice to the minority shareholders—sometimes called a Drag Along Notice. A few items such a notice can contain are:

• Details of the third-party purchasers
• Proposed amount and form of sales proceeds
• Sale date
• Confirmation that the third-party purchaser has agreed to the sale terms
• Number of shares held by the majority shareholders exercising their drag along rights

The notice should also be provided a certain number of days before the proposed sale date. This is not merely administrative, but can have significant implications. In a famous court case, Halpin vs. Riverstone Inc., the court deemed the majority shareholder’s exercise of the drag along rights as essentially unenforceable because it only provided notice of the merger after it had already happened.

Form of Sales Proceeds

What form of sales proceeds will allow the drag along rights to be exercised? The drag along rights clause may thus specify that it can only be triggered if the sales proceeds are in the form of cash or liquid securities. This stipulation is also known as a “liquidity qualifier.” The reason being if the transaction is a stock-for-stock merger, minority shareholders might be uninterested in receiving another company’s stock—especially if the acquiring company is private.

Liquidation Preferences

If the preferred shareholders have a liquidation preference, the drag along rights can be structured such that the sales proceeds are distributed according to the liquidation preference waterfall. If the total proceeds are less than the liquidation preferences, the common shareholders might receive nothing. The founders may thus request to distribute sales proceeds as if the preferred shares convert into common stock—which would help negate the effects of liquidation preferences.

Minimum Price

The minimum sales price to trigger drag along rights may be set with the preferred shareholders’ liquidation preference as a basis—for instance, two times the liquidation preference.

“Lock-Up” Period

It’s possible to insert terms where the majority shareholder would only exercise their drag along rights after a certain period. This is known as the “lock-up” period.

As you can see, there’s substantial diversity possible within drag along rights. It ultimately comes down to the negotiation leverage between the founders and investors.

Drag Along Rights: Final Thoughts

Drag along rights can make the end goal of both investors and founders—a successful exit—easier. But founders should be aware that they increase the level of control investors have over their startup by granting drag along rights. Thanks to liquidation preferences, it’s possible that exercising drag along rights could eliminate the value of the common stock.

This makes understanding the key terms like triggering thresholds, minimum prices, and lock-up periods crucial to successfully navigating the balance between investors and founders. One more founder-friendly alternative, for instance, may be replacing them with tag along rights.

To learn more about key terms related to a venture deal, read our guide to venture capital equity financing documents.