Drag Along Rights: Everything You Need to Know

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.

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:

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.

Proceeds from a sale are distributed as described in the certificate of incorporation.

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.

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.

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.