Drag Along Rights: 5 Examples of Drag Along Provisions in Venture Capital
In basic terms, a drag along rights clause in a venture capital agreement allows an investor to force the company founders and shareholders to agree by vote to an ownership change that liquidates a part of the company. This most typically occurs in the form of a sale, a trade liquidation, or a merger with another business entity. This is a critical term for venture capital firms, especially when the investor has decided it’s time to get out of the agreement and wants to settle on a price that the other company players may not particularly like or prefer.
Now in many cases investors are able to just make a drag-along provision happen. It’s a trade-off for the company having access to the investor’s cash. This leveraging is effective, if not outright blunt, but it definitely doesn’t do much for relationships, and the company founders often start looking for a way out of the agreement as soon as it starts. That can also lead to brain drain where the most important people in the company start to bleed away as well.
What does a drag along rights provision look like? (examples herein)
Here’s a drag along rights sample one could tweak as boilerplate:
Common stock holders of Company X shall be bound to an agreement with the holders of Series A preferred stock. This agreement shall require that all such common stock holders and any remaining holders of the Series A preferred stock will vote supporting a transaction where 50 percent or more of the voting power of the Company is transferred or otherwise liquidated, and it is approved by 50 percent of the holders of outstanding Series A preferred stock, on an as-converted basis.
Now, company founders know they are not going to have much of a leg to stand on refusing a drag-along provision altogether. They need the investment cash to grow, expand and operate. So they will agree to the provision but will often want the trigger point to be higher, something like two-thirds versus a simple majority of 51 percent. And they even try to add a Board approval on top of a vote, just to add another layer of resistance to an arbitrary trigger or sale.
Another twist company founder may attempt to compromise with is a switch of the investor’s interest to a majority of common stock instead. It can seem appealing, especially when couched with a conversion to a pure equity majority holding from a preferred stock holding.
A third twist would be agreement to the trigger, and agreement to the forced sale with a simple majority, however, the founders may insist on a minimum sales floor to protect their own holdings and value when the sale does occur. The thinking of this position is that if the company is going to indeed be sold off, the founders will get their good share as well too at a minimum value floor. Or it can be a forced protection, by making the floor so high, the company won’t be sold any time soon. Either way, it makes liquidation harder, something an investor needs to watch out for with compromise language drafted too easily.
A last tactic a founder team could use in negotiation would be to make a sale extremely hard by excluding the founders from any required representation about the company to a would-be buyer. That includes any kind of documents that have to be signed, financial statements, legal representations, historical records, or other potential liability-creating records normally necessary in the course of a sale, acquisition, merger or liquidation. One of the most common versions of this would be a demand for several liability of company risk versus joint liability. This allows the founders to separate themselves from the interests of the investor as soon as ownership changes in a sale or merger.
A drag along rights provision can be useful as an exit strategy tool, but they can also backfire easily too. Founders will often take a Ju-jitsu approach to their presence, letting the force pass them by and then adding on a twist that works in the company leadership’s favor versus the investor. Nobody likes to be told what to do, but if an investor is going to insert a drag-along term, then he or she needs to write it clean and resist add-on changes.
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