The Drag-Along is a right for a group of shareholders to force all shareholders to sell the entire company. Typically this right is awarded to the majority shareholders so that minority shareholders can’t take exit negotiations hostage.
Most funded startups will have several Investors with likely very different shareholdings. Founders might retain the majority of shares for a very long time and hence determine most decisions of the company. However, when it comes to selling the company, every shareholder generally sells their shares individually. But most buyers either want to buy a majority stake (around 51%) or ALL of it. And it makes sense, either they just want control or acquire all financial benefits.
But here comes the problem: How do you actually sell ALL shares? Again they are owned by individuals and you can’t just “force” someone to sell their property. Well, not unless you have a Drag Along clause setup in your agreements that is!
Mechanics of a Drag Along
The Drag Along, as the name suggests, “drags” the minority Investors, or even the Founders “along” into a an exit deal. Usually there will be some threshold setup and a definition made how many votes you would need for a Drag Along to kick in. Thresholds usually circle around deal valuation and percentages of shareholdings. So for example a deal needs to be for a high enough valuation to protect Investors from undervalued exits. Also the voting structure can ensure that Founders have to consult Investors in some form, e.g. by setting the voting percentage just above the Founders’ shareholding percentage. Additionally a Drag-Along could be either for the benefit of only the Founders or Investors or both.
Example of a Startup Drag Along
A sample Termsheet Drag-Along could read as below. Please note the full Drag-Along in a Shareholders Agreement or in the Memorandum and Articles of Association (M&A) would be more detailed, specifying also the full mechanics and deadlines to be upheld.
If an offer is received for the Company at a value in excess of US$20m then either shareholders representing 75% of the Investor Group or 100% of the Founders shall be able to sell their shares and force all other shareholders to accept the offer.
This Drag Along sets a minimum deal value to protect all shareholders from a fire sale. It has to be at least US$20m. Of course this can be increased with every future fund raise. It also determines that both the founders and the investors have a right to force either side to a sale of the company.
When drafting such a clause it is vital to think through the dynamics among the shareholders. This is especially true if there are a large number of founders and/or investors and what the relationships are among each group. The Drag Along needs to be realistic, but also not too easy to achieve. Especially early stage Angels and Founders can have much larger incentives to force a sale. In contrast last round’s investors likely haven’t seen much equity value growth yet.
Normally, Drag-Alongs are established for majority shareholders as a protection against minority shareholders blocking a deal. This right can however be turned around as a safe guard for Investors to avoid Founders never selling their “baby” and potentially waiting too long. If Founders agree to Investor Drag-Alongs they should make sure they are not too easy to execute. Specifically simple majority votes among Investors are probably too easy. Instead consider of 2/3 or 75% votes of Investors having to agree to the Investor Drag-Along. Otherwise 1 or 2 Investors might suddenly be in a position to force an exit single handedly.
Downsides to Drag-Alongs
There is hardly a scenario where Drag-Alongs don’t make sense. It is just too risky that one single shareholder blocks a deal to wait for more growth or even worse, requires the rest of the shareholders to provide her with some kind of financial incentive. That said one should still be careful in not providing too sweeping rights to Founders or Investors. Always think through at what voting percentages does which Shareholder suddenly have decision making power in a deal.
Alternatives to Drag-Alongs
Frankly there are not many alternatives to Drag-Alongs. You can add strategic review clauses that force the management into whatever action you write into them. But that is a bit cumbersome in practice and likely hard to enforce in a meaningful way.
One alternative that at least deals with the question of liquidity are Put-Options to the company or to Investors. That means whoever owns these puts can get some price-predetermined liquidity. This can however be very dangerous cash flow wise for the company or plain financially unattractive for the Investors. Hence we would recommend these kinds of options and encourage you to focus your company’s cash on growth and a mutually beneficial exit for all shareholders.
The Drag-Along is a standard and necessary clause that allows the majority shareholders to sell the entire company. It prevents minority shareholders from blocking a deal and is an important safe guard. As always analyze the power dynamics of all shareholders carefully before setting voting percentages and determining which share classes can vote on this and for what deal valuation.
This guide is not intended to and does not constitute legal or tax advice, recommendations, mediation or counseling under any circumstance. This guide and your use thereof does not create an attorney-client relationship with Startupvaluationschool.com or Ed.Pres Limited. The guide solely represents the thoughts of the author and is neither endorsed by nor does it necessarily reflect Ed.Pres Limited’s belief. Ed.Pres Limited does not warrant or guarantee the accurateness, completeness, adequacy or currency of the information in the guide. You should seek the advice of a competent attorney or accountant licensed to practice in your jurisdiction for advice on your particular problem.
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