Drag Along Rights — Demystified

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Almost all founders who have been involved in a financing or are negotiating a financing have come across the term “Drag Along Rights”. For founders who have not, this Drag Along Right, is usually requested by investors in most financings and it grant the majority shareholder of the company, usually the investors, the right to force minority shareholders to sell their shares in the event of a sale of the company. As the term connotes, these minority shareholders are being dragged along for the ride.

However, while the Drag Along Right is common in almost all, if not all, financings, how exactly is it applied in practice is not? To answer this, a look at the relevant provisions of a sample Drag Along Right clause is imperative. You should know that drag along clauses come in different shapes and forms. There is significant standardization through the NVCA nonetheless, there is some significant flexibility on the parameters of the drag along. Some venture deal term sheets refer only to customary drag along rights, while other term sheets spell out significant details. Most early stage VCs and founders don’t pay enough attention to this provision from our experience, because they want the deal done. Many are surprised at “exit” that certain financial decisions are blocked by the drag along clause, which was meant to make fast decision making possible.

What is a sale?

The Drag Along clause usually starts with the definition of what a sale is. Usually a sale is defined as a transaction where “more than fifty percent (50%) of the out­standing voting power of the Company” is acquired “Stock Sale” or where a liquidation event as defined in the certificate of incorporation occurs (i.e., a merger consolidation, etc.). While the threshold for a Stock Sale is usually 50% or a majority, the parties have the power to negotiate any amount as a threshold. Any type of sale of shares that does not conform to this definition will not trigger the Drag Along Rights, e.g., a sale of 49% of the outstanding voting power where the threshold is 50% will not trigger the rights.

The out­standing voting power

Additional, in the event of a proposed sale of company stock, it is important to note that “the out­standing voting power” of a Company excludes all stock options that have not been exercised, i.e., this threshold cannot be calculated using the fully diluted capitalization of the company. Why? Because stock option holders cannot vote.

Who is involved?

The next provision in a standard Drag Along clause is the determining factor as to whether or not a Drag Along Right may actually be exercised. This is usually stated as:

“Actions to be Taken. In the event that (i) the holders of at least [specify percentage] of the shares of Common Stock then issued or issuable upon conversion of the shares of Series A Preferred Stock (the “Selling Investors”); [(ii)the Board of Directors;] and [(iii) the holders of a majority of the then outstanding shares of Common Stock [then providing services to the Company as an officer] (other than those issued or issuable upon conversion of the shares of Series A Preferred Stock)] (collectively, the “Electing Holders”) approve a Sale of the Company in writing, shall apply to such transaction, then each Stockholder and the Company hereby agree:”

This provision ensures that a vote is taken by certain parties before the Drag Along Rights may be exercised. These parties are usually (1) majority of the preferred shareholder and (2) the majority of the common shareholders. In some cases the Drag Along trigger requires in addition the approval of the Board of Directors of the Company. The involvement of the Board of Directors raises additional considerations which we highlight below.

The Board of Directors

The role of investor director is extremely tricky in the Drag Along scenario, where the drag along itself requires investor or Board of Directors approval. The investor director has to balance a conflict of interest between their duty to the investor they represent on the Board of Directors and their duty to the minority shareholders in the company. Under Delaware law in such a scenario the directors have to consider the interest of the common shareholders. Many non-US VC are surprised about their legal duty to the common holders, which in most cases are the founders and employees. As a result of this possible conflict, most investors elect not to make the board of directors a necessary party to trigger the Drag Along Rights in Silicon Valley style venture deals. This is counter intuitive to most non-US VC who want to add board level approvals for the Drag Along.

If you want more information on this please check out the case of Re Trados Shareholders Litigation, where the drag-along was triggered by a sale of the company to the detriment of the common shareholders, the Delaware Chancery Court held that where the interests of the common stockholders may diverge from those of the preferred, a director can breach his or her duty by approving a sale which could be viewed as improperly favoring the interests of the preferred over those of the common stockholders. As such, to prevent this from happening, all interested directors (i.e., directors who would benefit from the sale) may need to sit out of the vote or the company may need to engage an investment bank and law firm to assist in the process.

Founders providing service

Most Founders may want to consider including a provision that states the common stockholders should be limited to the founders providing service to the Company. This clause agreement grants the founders and some form of veto rights in the event the investors plan to exercise their Drag Along Rights. This balances out the power of the investors to drag along the minority shareholders in the event of a sale, and allows them control on whether or not the Drag Along Rights to be exercised.

After Drag Along is Triggered

By having a Drag Along Clause in an agreement, all parties to the agreement, the Company, Investors and existing (and future shareholders) agree, upon the triggering of the Drag Along Rights, to take all actions in support of the sale of the Company. This may include voting to approve the transaction, (i.e., where the shareholder has veto rights pursuant to another agreement with the company), selling the same proportion of shares as the selling shareholders are selling, submitting and executing all necessary documents, refrain from dissenting or taking any actions that might stop the sale. Note however, that where a minority shareholder believes that the triggers were exercised inappropriately, such as where a director failed to disclose a conflict or where the value of the sale of the company was outrageously low and with no basis in reality, that shareholder may proceed to court to challenge the exercise of the Drag Along Rights

Distribution of proceeds of Sale

Finally, most Drag Along Clause provide that no Stockholder shall participate in a sale unless the consideration received is allocated in the manner specified in the Company’s certificate of incorporation. This basically ensures that the proceeds of the sale triggering a Drag Along are made subject to the liquidation preference agreed to between the Company and the investors. This could be non-participating, participating, capped liquidation. Where sale of the company is being triggered by majority shareholders which do not include the investors, the investors will not lose the benefit of the liquidating preference negotiated with the Company.

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Law firm specializing in startups, series A and US expansion. No legal advice I No attorney client relationship I Attorney advertising

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