Drag-Along Clause In Term Sheets: What Does It Mean?
As we briefly mentioned this blog post a few weeks ago, drag-along rights are a quite common clause of most term sheets. When equity is divided among different shareholders – like the Founders, investors or employees – drag-along rights are useful to ensure that majority shareholders can negotiate an exit. These are usually accompanied by tag-along rights, which protect the interest of minority shareholders in an exit.
Drag-Along Rights Explained
Drag-along rights are design to protect the majority shareholders of a company in an exit event, particularly a merger or acquisition (M&A). They enable majority shareholders to force minority shareholders into a sale, provided that minority shareholders are offered the same exact terms as the majority ones.
This is particularly important for acquisitions, as it allows the buyer to negotiate the sale with the majority shareholders while eliminating the minority and eventually taking control of 100% of the company.
Benefits of Drag-Along Rights for Majority Shareholders
Depending on who is the majority shareholder in a negotiation, the benefits of drag-along rights vary.
In the event of a start-up seeking investment from a VC, a drag-along clause could be required by the company’s Founder or CEO, if they are retaining the majority of shares in their company, in order to protect themselves in the case of an eventual sale.
This means that, if the opportunity for an acquisition arises the Founder or CEO is free to negotiate the terms of the sale with the buyer and the investors are forced to adhere to such terms and sell their shares.
Conversely, if investors own the majority of the company shares, drag-along rights may be negotiated in order to boost the valuation of the portion of equity that investors are purchasing, as the possibility of forcing a sale makes the majority shares more valuable.
Drag-along and tag-along rights are normally outlined in a company’s governing agreements, such as the Articles of Association and Shareholders Agreement. They typically end when an IPO takes place.
Benefits of Drag-Along Rights for Minority Shareholders
While, as mentioned, drag-along rights were designed to protect majority shareholders, minority shareholders can also benefit from them, as this type of provision requires that the price, terms, and conditions be homogeneous across the board. This means that small equity holders can realise favourable sales terms that may be otherwise unattainable.
Tag-along rights typically complement drag-along rights, they are designed to protect minority shareholders by giving them the right, but not the obligation, to join in a company action with the majority shareholder. This provision protects the minority shareholder from having to pay separately for an offering, being forced to accept a deal on lesser terms, or being forced to stay a minority holder in a company after the majority sale.