Drag along rights can be an important protection for a company's founding or controlling shareholders. Here's what you need to know.
What is a drag along right?
If a shareholder finds a buyer for the company, a drag along right in a shareholders agreement will allow it to 'drag' the other shareholders into the sale.
A shareholder with a drag along right can initiate a sale of the entire company, regardless of whether the other shareholders agree.
A drag along clause implicitly recognises that minority shareholdings in private companies are not readily liquid. It will often be easier for a shareholder to find a buyer for the entire company, rather than just for its stake.
Although tag along rights and drag along rights are sometimes confused, they are two completely different concepts. (Learn more about that here.)
How do drag along rights work?
Drag along rights can be structured in different ways.
There are two threshold questions you will need to decide:
- What is the minimum proportion of shareholders that should be required to agree to the sale, before the drag along right can be exercised?
- Should there be a pre-emptive round before the drag along clause applies?
These are discussed below.
Who should be able to exercise the drag along?
This will depend on your circumstances.
Sometimes a key shareholder, such as a founder of the company or (more commonly) an investor, may require a drag along right even if they don't hold a majority of shares.
Other times, particularly where the share register is more evenly balanced, it may require an agreement between a majority (50%) or special majority (75% or maybe even higher) before the drag along clause can be triggered.
The competing considerations are:
- ensuring that a small number of shareholders cannot thwart a sale that has been approved by a critical mass of shareholders, however that critical mass is defined; and
- ensuring that a shareholder cannot drag the other shareholders into a sale where a critical mass (again, however defined) is against it.
Should there be a pre-emptive round before the drag along?
The answer to this question ties into the issues discussed above, and is sometimes used as a way to balance the competing considerations.
A pre-emptive round would help any shareholder(s) who may wish to exit to offer their shares for sale to the other shareholders, before being allowed to sell their shares to a third party.
If the pre-emptive round does not result in the shares being sold, usually the person wishing to sell would have a limited time (eg 6-12 months) to sell their shares to a third party. But they would not be able to do so on terms that were more favourable to the terms offered to the other shareholders in the pre-emptive round.
Whether a pre-emptive round is an appropriate pre-condition to the exercise of a drag along right will depend on:
- who holds the drag along right; and
- the likelihood of the other shareholders being willing and able to buy their shares under a pre-emptive round.
For example, if a drag along clause can only be exercised by shareholders holding 90% of the company's shares, a pre-emptive round may be inappropriate if the remaining 10% of the shareholders will not have the capacity or desire to buy 90% of the company.
Conversely, if a minor investor holds a drag along right (say 10%), it may be entirely appropriate for the other shareholders to be given the opportunity to buy that person's shares before being compelled to participate in a sale.
If you have any further questions about drag along rights or shareholders agreements generally, please download our comprehensive guide below.
