What are drag along rights?
Drag along rights are a type of contractual provision that enable majority shareholders to force minority shareholders to sell their shares in a company. This can happen in a liquidation event, such as the sale of the company or the company filing to go “public”.
While triggering these rights can force minority shareholders out of a company, the minority shareholders will get the same price, conditions, and terms as the majority shareholders.
How do drag along rights work and what triggers them?
With drag along rights, the majority shareholders have the power to “drag” the minority shareholders along with them in the event of a liquidation.
Any liquidation event, such as a merger, acquisition, public listing or sale of assets that would result in a change in control of the company would trigger the provision.
In order for the drag along rights to be activated, a minimum ownership percentage must be met. Hence, defining said level of “majority ownership” is crucial prior to agreeing to drag along rights.
This percentage is typically set between 51-75%.
Why is understanding drag along rights important?
Drag along rights are important to understand as they can have a big impact on your ownership stake in a company. If you are a minority shareholder, it's important to be aware of these rights so that you can make an informed decision about whether or not to invest in a company.
Additionally, if you are considering selling your shares in a company, it's important to be aware of drag along rights and how they may impact the sale of your shares.
Why do investors sometimes require drag along rights?
Investors who purchase a majority stake in a company often require drag along rights to be included in the contractual provisions. This is because they want to have control over if/when a liquidation event occurs (assuming they secure the terms).
What is the difference between drag along and tag along rights?
The difference between drag along and tag along rights lies in the ability of the minority shareholders to opt-in. With drag along rights, the majority shareholders can force the minority shareholders to sell their shares at the same price, conditions, and terms as the majority shareholders.
Tag-along rights give minority shareholders the option to sell during a liquidation event but are more benevolent in nature since they don’t outright force minority shareholders to sell.
How do drag along rights benefit minority shareholders?
Drag along rights are often put in place to protect minority shareholders from being left behind by the majority.
By requiring the minority to sell their shares when the majority does, drag along rights ensure that everyone is on the same page and moving in the same direction. This can be beneficial when a company is looking to be acquired or merged with another business.
Drag along rights also ensure that the minority shareholders get the same price, conditions, and terms as the majority shareholders, which can be beneficial if the majority is getting a good deal.
What are the key terms related to drag along rights?
The key terms related to drag along rights are:
- Triggering Transactions: This is the event that will activate drag along rights. This typically includes a sale of the company, a merger, or an acquisition. A "deemed liquidation event" can also trigger drag along rights (such as a public listing).
- Drag Along Notice: When drag along rights are triggered, the majority shareholders must give notice to the minority shareholders. This notice will include the terms and conditions of the sale or transaction.
- Liquidation Preferences: Shareholders who have drag along rights will often have a "liquidation preference." This means that they will get paid first if the company is sold or liquidated.
- “Lock-Up” Period: A "lock-up period" is a time period during which shareholders are not allowed to sell their shares. This is often put in place to prevent shareholders from mass selling their shares, flooding the market and potentially driving down the market value of each unit.
What are some of the common pitfalls to avoid when agreeing to drag along rights?
Some of the common pitfalls to avoid when agreeing to drag along rights include:
- Putting drag along provisions in place that are too broad
- Giving drag along rights to shareholders who don't need them
- Not understanding the tax implications of drag along rights
- Failing to negotiate drag along provisions that are fair to all parties
- Agreeing to drag along provisions that are not legally enforceable
If the majority exercises a drag-along right, is there anything the minority can do?
The minority shareholders may be able to negotiate for a better price or terms, but they will not be able to stop the sale from happening.
It is important to consult with legal counsel before agreeing to drag along rights. Drag along rights can have a significant impact on the value of your shares, and it is important to make sure that you understand the implications before agreeing to them.
Can a ‘drag along’ be blocked?
Yes, a ‘drag along’ can be blocked if the triggering threshold is not met. The drag along provision will typically state the minimum percentage of ownership that must be held by the shareholders who are trying to trigger the ‘drag along’ in order for the rights to be enforced.
For example, if a drag along provision states that at least 75% of the shares must be held by the shareholders initiating a drag along, and those parties only have a 74% ownership stake,
then the drag along rights cannot be enforced.