Drag-Along Rights

Full Definition

Drag-along rights (also called drag-along provisions or forced sale rights) allow the holder of a majority interest in a company—typically the controlling shareholders or a specified percentage of investors—to require all other shareholders to consent to and participate in a sale transaction on the same terms. The purpose is to prevent minority shareholders from blocking an acquisition that the majority has agreed to accept, which would otherwise allow minority shareholders to hold out for better terms or simply impede a transaction that is in the best interests of the majority. Drag-along rights are a fundamental protective provision for private equity investors who need certainty that a majority-approved exit transaction can be completed without minority veto rights. Drag-along provisions in venture-backed companies typically specify a threshold ownership percentage required to trigger the drag (often a majority of preferred stock plus a majority of common stock, or a specified percentage of the fully diluted capitalization), the transaction types that trigger the drag (sale of the company, asset sale, merger), the protections afforded to dragged shareholders (dragged shareholders must receive the same price per share and same consideration type as the majority, may not be required to make representations extending beyond their own ownership, and their liability for indemnification is typically limited to their proceeds), and the mechanics of requiring dragged shareholders to execute transaction documents. Drag-along provisions protect majority investors but can be problematic from a governance perspective when the majority dragger and dragged parties have significant economic conflicts. A PE sponsor that controls the board and holds a majority of shares can drag management and employee shareholders into a transaction that the management team believes undervalues the company—particularly where the PE sponsor has received its full preferred return and any incremental value goes primarily to common holders (management and employees). Management-friendly drag provisions include minimum price thresholds below which drag rights cannot be exercised, board consent requirements alongside shareholder majority requirements, or specific protections for management equity that ensure adequate return before drag is exercised.

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