What are drag-along rights?
Drag-along-rights allow majority shareholders to force minority shareholders to sell their stakes in a company. These rights are a provision, usually stipulated as part of a share issue or equity for capital deal. They allow the majority shareholders to control the direction of the company.
Because drag-along-rights are used to force through a sale, they can create conflict both within the boardroom and within the ownership of the company. With this in mind, let’s look at simplifying how drag-along-rights work and how they affect startup founders.
Drag-Along-Rights and their Terms
These contractual provisions get their name from majority shareholders “dragging” minority shareholders, against their will, towards selling their shares. At first glance, this seems quite unfair. After all, a minority shareholder may want to hold onto their share of a business.
However, there are counter stipulations that make being dragged into a sale a little easier to swallow. These stipulations are included to ensure that minority shareholders are treated as fairly as possible, even when being forced into selling.
Minority drag-along-rights protections include:
- Majority owners only being able to force minority shareholders into a sale by offering them the same price and conditions offered to all other sellers. This stops minority shareholders from being short-changed with a lower offer.
- Minority shareholders may be able to secure more favorable sales terms than they would otherwise have been able to, though this is not guaranteed.
Drag-Along-Rights: The Majority Shareholder Perspective
It’s clear to see that when any drag-along-rights provisions are activated, the experiences of the majority and minority shareholders will differ drastically from each other. Despite the protections put in place for minority shareholders to at least soften the blow of a forced sale, drag-along-rights are designed to benefit majority shareholders the most.
If all shareholders were given an equal say on whether a business is sold, then all it would take is for one minority shareholder to block the sale. Needless to say, for those who have invested much larger amounts, this obstruction would be extremely uncomfortable, especially if it blocked any meaningful exit strategy.
The beauty of drag-along-rights provisions then, is that they protect the majority shareholder’s interests. They effectively ensure that the majority shareholder decides when a business is sold and at what value.
If the majority shareholder likes an offer being made for the company, they do not need the permission of minority shareholders in this situation to accept the offer. This also means that a majority shareholder can actively pursue buyers to make an offer, effectively controlling when they can make an exit.
Drag-Along-Rights: The Minority Shareholder Perspective
If drag-along-rights are there to benefit the majority shareholder, then it’s clear that they put the minority shareholder at a disadvantage. For the minority shareholder, this is a stipulation that takes control out of their hands.
However, a minority shareholder should be aware of “tag-along rights” which allow some minority shareholders to benefit from a forced sale.
In some instances, you will have a situation where some minority shareholders want the sale to go through while others do not. This may also include a minority shareholder choosing to capitalize on the sale.
For example, if a majority shareholder wants to sell their share of a company, the minority shareholder with tag-along-status can join the transaction and sell their shares as well, for the same rate.
This provides minority shareholders with protection should a talented major shareholder up and sell their stake. They cannot be forced to remain a minority shareholder under these terms, allowing them to exit if that is desirable.
Drag-Along-Rights Vs. Non-Controlling Interest Provision
In some instances, a minority shareholder can secure a provision limiting any liquidation or sale decision without their express agreement.
A company cannot offer both a minority shareholder this provision while a drag-along provision is given to a majority shareholder unless there is a specific agreement in the fine print as to when each can be invoked.
When there is a majority shareholder with a drag-along provision and a minority shareholder with a non-liquidation or sale provision, it’s usually the case that the company’s governing agreements stipulate that the drag-along-rights provision should be given priority.
Usually, a company will only include one provision over the other, and invariably, it’s the majority shareholder’s drag-along-rights provision which is far more common.
It’s important that entrepreneurs ensure that such provisions do not clash by seeking appropriate legal advice when bringing in new investors. Otherwise, there could be a legal battle to see which provision should be activated.
Founders and Drag-Along-Rights
When raising startup capital, a founder can be on either end of a drag-along-rights provision, it’s entirely up to them. They can have that provision as part of their own shareholding or they can find themselves a minority shareholder and forced to sell their stake (in the worst-case scenario).
This is why it is usually preferential for founders to either have a majority stake (51% at least) in their business or a non-controlling interest provision meaning that, even though they have a stake of 49% or less in the business, they can’t be forced to sell their interest in the company.
If a founder does have drag-along-rights, then this means they have control over who they sell their company to. That’s a powerful motivator, especially when it’s the founders of a company who normally have put their blood, sweat, and tears into making it a success.
However, some investors will insist that a founder takes a minority stake in order to secure investment, which is, unfortunately, sometimes necessary. I would highly recommend not accepting any deal too onerous on the part of the investor if your business does not desperately need it.
These are terms you want to keep in mind when fundraising as once you sign the offering documents with the investor there is no turning back. Remember that storytelling plays a key role in fundraising and you will need capital to scale things up. This is being able to capture the essence of the business in 15 to 20 slides. For a winning deck, take a look at the template created by Silicon Valley legend, Peter Thiel (see it here) that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.
Remember to unlock the pitch deck template that is being used by founders around the world to raise millions below.
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