You’ve just received a term sheet for your Series A financing, and it mentions a “drag-along.” What does this mean, and should you be concerned about it?
In its simplest terms, a “drag-along” is a contract term requiring stockholders to vote in favor of the sale of the company under certain conditions and otherwise cooperate with the sale process – in other words, it allows certain parties to “drag” other stockholders to support such a transaction. Drag-along provisions have become common, though not universal, in venture financings of Delaware-incorporated companies, especially after the Series Seed stage, and are nearly universal in other non-US jurisdictions where 100% of a company’s stockholder base must be party to a sale transaction.
Purpose of a drag-along
When a US-incorporated company is bought, the buyer will often require that a supermajority of the selling company’s stockholders approve the deal – that threshold is often 95% of the shares or higher. Buyers insist on this high threshold to reduce their exposure to target stockholder claims after closing the acquisition, as stockholder consent minimizes the number of potential dissenting stockholders under Delaware (or other state) law. As part of the sale process, the buyer often has the target stockholders sign a release of claims, which also helps the buyer reduce its exposure after the acquisition. In many non-US jurisdictions, the sale of a company inherently requires the sale of 100% of the company’s shares by 100% of the stockholders, so a drag-along is necessary to keep very small stockholders from holding up a sale process.
Since most companies have many stockholders by the time they are sold – and coordinating their votes can be time-consuming and distracting to the sale process – a drag-along provision assists the sale efforts by providing a mechanism to efficiently collect the necessary votes once the board of directors and a smaller group of stockholders have approved the sale. Importantly, the drag-along also can be used to get approval from stockholders who might otherwise not be inclined to support the sale.
While it’s not always necessary for a company to formally enforce a drag-along provision against its stockholders, the presence of the drag-along provision makes selling stockholders more likely to approve the deal, as well as sign releases and cooperate with other buyer requirements. In practice, the provision is more often used for its moral value rather than as a contractual mechanic.
The key question: Who can trigger the drag-along?
The most negotiated aspect of a drag-along is the “trigger” – i.e., which parties have the right to drag other stockholders to vote in favor of the sale of the company. Often the trigger is structured to have separate “prongs” that require the consent of each of the following to activate the drag-along:
- The founders (usually expressed as the holders of common stock, or the holders of common stock who are then employed by the company).
- Some portion of the investors (usually expressed as the holders of preferred stock).
- In some cases, the board of directors.
In this scenario, if the consent of any one of these groups is not obtained, then the drag-along cannot be activated.
If the investors and founders must both consent for the drag-along to be triggered, then the drag-along would primarily be used to ensure that the rest of the stockholder base, including smaller stockholders, consents to the sale of the company. If, as is sometimes the case, the investors can trigger the drag-along without founder approval, then the investors can potentially use the drag-along to secure sufficient stockholder consent for a sale that the founders and other common stockholders may not otherwise approve. These circumstances may include a situation where the investors and founders do not agree on the exit strategy for the company or the optimal sale valuation – for example, a sale where most of the proceeds must be used to pay out the liquidation preferences of the preferred stock. The question of who can trigger the drag-along provision involves complex legal and fiduciary issues (especially if board approval is one of the triggers for the drag-along) that are beyond the scope of this article – and that your lawyer can advise you on.
Special thanks to partner Daniel Paramés for his contributions to this article.