Why do preferred stock investors in start-up companies (such as venture capital firms) want these rights? To ensure that if the preferred stockholders want to sell the company, they can.
Drag-along rights are a bit complex, and this post will try to demystify them.
If a private company receives an offer to purchase the company, then a majority of the holders of the drag-along rights (usually the preferred stockholders) can notify the company that they approve the deal and that they are exercising their drag along rights. The drag-along rights require all other stockholders to also approve the deal and to sign all documents and take all steps necessary to make the deal happen.
Why is this Important?
When a buyer buys the stock of a company, they want to buy 100% of the stock of the company. Legal complications can arise if a buyer acquires less than 100% of the stock of the target company. Big legal complications occur when a buyer acquires less than 90% of the stock of the target company. Drag-along rights ensure that 100% of the stock (or almost 100%) can be delivered in the sale of a company.
The key terms that are negotiated in preferred stock financings (such as venture capital financings) are:
- Whether there should be drag-along rights;
- The timing of when they should be available;
- A minimum return required for the drag-along to be available;
- The majority threshold for the holders of the drag-along rights to be able to exercise the rights;
- Whether any other group should also have to approve the sale of the company for the drag-along rights to be effective.
Let’s discuss each of these.
Should There be Drag-Along Rights? Company founders don’t want drag-along rights, as these rights can be used to sell the company and the founder could then be out of a job. Investors want these rights so they can exit their investment within a reasonable amount of time.
Time When Drag-Along Rights are Available. Investors in early-stage companies know that it can take 7 to 10 years for a company to achieve sufficient size to either hold its initial public offering or be sold for a substantial amount of money. But many companies grow very slowly, and investors may want to sell the company and move on to other investments. Companies will often push for drag-along rights to only start after several years, such as 7 years, to provide the company with enough time to grow before being forced to sell. Investors don’t want any time frame, in order to have maximum flexibility to exercise this right.
Minimum Return Requirement. When a company is sold, the proceeds of the sale are paid to the stockholders based on their liquidation preferences (see the post “Preferred Stock Financings: Understanding the Liquidation Preference” for more on this). In some cases, a company can be sold and because of the liquidation preferences held by the preferred stockholders, the preferred stockholders will receive all of the proceeds from the sale and the common stockholders will receive nothing. To avoid this situation from happening, founders want the drag-along right to only be effective if some minimum return to the common stockholders is obtained. Preferred investors will not want to have any minimum return requirement, as it is precisely these situations where the drag-along will typically be exercised.
Majority Threshold for Exercise. The majority threshold for exercising drag along rights is usually a simple majority, or 50.1%, of the preferred stockholders, or it can be a super-majority, such as 66.6%. Company founders want this threshold to be as high as possible, to make it harder to exercise the right, while investors want this threshold to be a simple majority.
Other Groups Required to Vote to Exercise the Drag-Along Rights. Generally, it is only the preferred stockholders that vote to exercise the drag-along right. But in some cases, another group must also approve the sale of the company for the drag-along rights to be effective. For example, in some cases the board of directors must also approve the sale of the company for the drag-along rights to be effective. In rare cases, a majority of the common stockholders must also approve the sale of the company for the drag-along to be effective. Company founders want to have these additional groups vote to approve the sale before the drag-along becomes effective. Investors want to be the only group that must approve the sale of the company before the drag-along rights become effective.
When preferred stockholders negotiate a drag-along provision, the company and the common stockholders have to sign an agreement accepting this drag-along provision. This is done through the preferred stock financing transaction documents. The drag-along right is usually found in an investor rights agreement, a voting agreement or a stockholder agreement. In effect, the common stockholders are agreeing now that they will in the future go along with the preferred stockholders in a sale of the company. This is why these rights are often resisted by founders of companies and heavily negotiated.
Drag-along rights can be very complicated, and this provision needs careful consideration by companies and investors so a reasonable drag-along provision can be negotiated.
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