Imagine you have spent a decade building your company. You finally find a buyer willing to acquire the business for a price that changes everyone’s life.
Most of your investors are thrilled. The founders are ready to sign.
But there is a problem. One early angel investor, who holds a very small percentage of the company, refuses to sell their shares. They think the price will be higher next year. Suddenly, the buyer gets cold feet because they want to own 100% of the company, not 99%.
This is the specific scenario drag-along rights are designed to prevent.
Defining the Mechanism
#Drag-along rights are provisions usually found in a company’s shareholder agreement or articles of association.
These rights enable a majority shareholder or a collective majority of shareholders to force a minority shareholder to join in the sale of a company.
When the majority triggers this right, the minority shareholders are “dragged along” into the deal. They are compelled to sell their shares to the third-party buyer.
This does not mean the minority gets a bad deal.
The provision almost always stipulates that the minority shareholders must receive the same price, terms, and conditions as the majority shareholders. If the founders are selling for $10 a share, the dragged shareholder gets $10 a share.
Why Buyers and Founders Need This
#In the context of a startup exit, simplicity is valuable.
Acquirers generally look to purchase 100% of a company. They want total control and do not want to deal with the administrative burden or strategic friction of having leftover minority owners on the cap table.
If a minority shareholder blocks a sale, the deal can collapse.
For the founders and major investors, drag-along rights provide the authority to deliver a clean company to the buyer. It eliminates the leverage of a holdout who might otherwise try to hold the deal hostage for better individual terms.
Comparing Drag-Along and Tag-Along Rights
#You will often hear these two terms used in the same conversation, but they serve different groups.
- Drag-Along Rights: These protect the majority. They force the minority to sell so the majority can close a deal.
- Tag-Along Rights: These protect the minority. They give the minority the right to “tag along” and sell their shares if the majority sells.
While the drag-along forces you to sell, the tag-along ensures you are not left behind holding illiquid stock in a company where the founders have already cashed out and left.
Questions for Your Agreement
#Simply knowing the definition is not enough. You need to understand how it applies to your specific governance structure.
These provisions are not one size fits all.
When reviewing your term sheets or shareholder agreements, you should look closely at the threshold required to trigger the right. Is it simple majority of 51%? Or is it a supermajority of 75%?
Does the trigger require approval from the Board of Directors in addition to the shareholder vote?
You should also ask if different classes of stock have different voting power regarding this provision.
Understanding these nuances helps you predict how much control you actually retain when an exit opportunity arises.