How do Drag Along Rights Work?
Drag-along rights are contractual provisions – usually within a shareholder agreement – that provide majority shareholders with the right to force minority shareholders’ participation in the future sale of a company.
- For majority shareholders: Drag-along provisions help ensure majority owners can sell the company when and how they want, and “drag” minority owners into the deal even if the minority owner does not want to sell.
- For minority owners: Drag-along rights force minority owners to sell their shares, but usually at a price and on terms equal to the majority. Minority shareholders may also negotiate what are known as “tag along” rights to ensure they won’t be left out of any future sale.
A drag-along provision may be included as a clause in a stand-alone shareholder agreement or incorporated into a company’s bylaws or Articles of Association. Investors and majority shareholders should pay close attention to this provision and its elements when crafting or negotiating these governing documents as it may impact the terms of any future sale of the company.
Why Are Drag-Along Rights Important?
Drag-along provisions make a company more attractive to potential buyers. Buyers often want full control of a company, and a drag-along provision ensures that 100% of the company is for sale, not just the majority shareholder’s interest.
Without such a clause, an obstinate minority owner or investor could hold out and refuse to sell, making it difficult for new owners to assume full control of a company or tanking the deal entirely.
Who Benefits from a Drag-Along Provision?
Majority shareholders benefit from a drag-along provision by making it easier to find a potential buyer and by having more control over the sales process. Without a drag-along provision, a minority shareholder’s opposition could greatly complicate the deal or force the new owner to share their new company with potentially reluctant minority owners.
Minority shareholders realize some benefits from a drag-along provision as well. If properly drafted, minority owners receive the same terms and conditions and price as the majority shareholder. Drag-along rights are not automatic, however. That’s why you need a tag-along provision in case the majority shareholder does not exercise the drag-along provision and the minority shareholder wants in on the deal.
What Triggers a Drag-Along Provision?
Triggering events are among the elements of a drag-along provision that should be negotiated and determined prior to signing or investing. Some questions to consider include:
- What types of transactions will trigger the drag-along provision? For example, will a merger trigger the provision, the sale of major business assets, or will it apply strictly to a sale of ownership interests in the company?
- What percentage of ownership will trigger the provision? Can a majority owner sell 30% of her shares without triggering the provision? What is the threshold?
- Is the majority owner required to give advance notice of a sale to minority owners? How much advance notice? What is the content of the advance notice?
- Are there any restrictions to invoking drag-along rights, such as a minimum sale price or only after a specific length of time?
Drag-Along Sale Proceeds and Sale Procedures:
Another element for shareholders to consider is the payment of sale proceeds. Majority owners may negotiate for illiquid securities to secure the most favorable deal, while minority shareholders may want the flexibility of receiving cash proceeds.
Drag-along sale procedures should also be determined in advance if possible. For example, which party will foot the bill for transaction expenses, such as attorney’s fees, valuation services, consulting fees or other transaction costs? Will expenses be pro-rated accorded to ownership interest or charged solely to the shareholder who invoked drag-along rights? What is the dispute resolution process?
An attorney experienced with drafting and enforcing shareholder agreements and other corporate governance documents can help shareholders anticipate and address these and other contingencies and negotiate a favorable agreement.
Are Drag-Along Rights Enforceable?
Drag-along rights are enforceable if the drag-along provision is drafted properly and contained within a valid and enforceable contract, and if the transaction is executed according to the terms of the provision.
For example, if the drag-along provision includes a notice requirement – i.e., the majority shareholder must give advance notice of a sale – and minority shareholders did not receive notice until after the transaction was completed, the courts may rule the provision unenforceable.
What are Tag-Along Rights?
Tag-along rights protect minority shareholders from being left behind in the event a key shareholder exits the company. It also prevents shareholders from being forced to remain in business with a new, unknown – and possibly incompatible – majority owner.
What Is the Difference Between Tag-Along Rights and Drag-Along Rights?
A tag-along provision is essentially the opposite of a drag-along provision: Instead of being dragged into a sale, minority shareholders can “tag along” with any deal a majority shareholder makes to sell shares to a third party. A tag-along provision gives the other shareholders a right to join with the deal and sell their shares on the same terms and conditions negotiated by the majority owner.
Consult an Experienced Contract Law Attorney to Review Drag-Along Provisions
Whether you’re a majority or minority owner, drag-along provisions can be structured to provide benefits for both parties and blend holistically with a company’s governing documents and overall goals.
At Hendershot Cowart P.C., we have decades of experience counseling shareholders in matters of business formation, mergers and acquisitions, and business transactions, and with drafting, reviewing, and negotiating essential documents and contracts, including shareholder agreements, preemptive rights, and drag-along provisions. Our firm also offers general counsel services.