Term Sheets: Drag Along Rights

Intro: VC/PE firms are financial investors and not strategic. They look for capital appreciation and not income (cash cows). They always do their best to establish a clear exit strategy even before deciding to invest in the company. That means they’re looking to make a return on their investment (either through entry of lower valuation and exit on higher or both). Including drag along and tag along clauses help them achieve this objective and are standard in stock (purchase) agreements / shareholders agreement / term sheet because they want to ensure exit at the right time and when the opportunity is ripe (and not necessarily wait for cash to come in).

Drag Along Rights (Nuclear Option/Squeeze Out/Bring Along) gives the shareholders (usually majority) the right to force (or what we call drag along) the other remaining shareholders (usually minority) to join in the sale of the company (or accept an offer) when the shareholders are exiting, under the same price and terms. This clause is fairly standard in a stock purchase agreement, and will normally terminate upon an IPO.

Purpose: This is used in deal making to protect the (majority) shareholders from other remaining (minority) shareholders being difficult when it comes to selling the company at a particular price to a buyer who wants to own the company (sometimes 100%). This also protects the buyer from having to deal with potentially uncooperative or hostile or disruptive minority shareholders.

VC/PE firms consider this essential to deal making, on the other hand, founders (or minority shareholders) may see this as a threat if the VC/PE firm decides to sell the company at a (lower) valuation that they are not in agreement with and have no control over.

Provisions: To make things complicated, we can include many provisions, here are some:

• A provision stating that to invoke the drag along provisions, the drag-along offer must originate from a genuine third party, unconnected to the majority shareholder and acting on arm's-length commercial terms.
• A provision that the offer may also need to match or exceed a minimum agreed price or minimum time period (e.g. four or five years from the date of investment) before the drag along right can be triggered.
• A limited time period for the minority shareholder to match the offer and buy the majority shareholder's shares itself.
• A provision that the price may only be in cash, payable in full at completion (precluding, for example, any non-cash consideration (such as shares or loan notes), deferred consideration or an earn-out).
• Irrevocable powers of attorney authorising the attorney to sign the share transfer on behalf of the "dragged" shareholder, dealing with the formalities of transfer and holding the purchase price on trust for the dragged shareholder, unless and until it is prepared to co-operate with the sale.
• An obligation for investors to seriously attempt one or more methods of selling their interest without dragging along another shareholder;
• A provision that may require advance notice to other shareholder(s) to exercise the drag along right. Such notice may also be structured to allow the remaining shareholders the right to purchase the shares of the shareholder giving notice according to a particular formula (eg. EBITDA multiple).
• It might be possible to structure a Drag Along in such a manner that it might be overridden by a right of first refusal (eg. where one investor negotiates an agreement to sell shares to an outside investor, the existing shareholders would have a defined period within which to step in and buy on the same terms). However, not every investor will accept a right of first refusal, as this may diminish the marketability of the investor's interest. Also, for a first right of refusal to be of real benefit to a shareholder, it will usually require a cash reserve in order to exercise it.

The negotiation between an owner and investor with respect to Drag Along rights is a function of the relative bargaining strength of the parties and their negotiating ability. It balances the legitimate desire of an investor to exit from an investment at a time that suits them (minority investments in particular may be extremely difficult to exit without a Drag Along) with the legitimate right of a business owner not to have his or her interest in a business sold against his or her will.