After a holiday break last week, we’re back to our regularly scheduled Friday term sheet provision discussions. Today we’re taking a look at drag along agreements.
What is a drag along agreement?
Drag along agreements are term sheet provisions which allow a subset of investors to force all other stockholders, including the founders of a company, to consent to a sale of the company. Usually these provisions allow for a majority of preferred stockholders to force the sale, even if a majority of common stockholders oppose the transaction. These provisions generally come into play when the company is being sold at a low price, and the preferred stockholders’ liquidation preference will result in the common stockholders receiving few, if any, proceeds from the sale. However, these provisions can come into play whenever parties have different business and economic goals.
These provisions became commonplace shortly after the Internet bubble burst and holders of common stock began refusing to consent to the sales of companies unless the preferred stockholders waived their liquidation preference rights. On the one hand, you can see how founders might feel cheated if they don’t receive any proceeds from the sales of their company. But, on the other hand, you can also see how investors would feel cheated if they don’t receive the liquidation preference right that they negotiated for, and the founders agreed to.
While acquirers generally want 85-90% of shareholders to approve the transaction, unanimity is not usually a technical requirement. The percentage of shareholders required to consent to a transaction is often two-thirds, but varies by jurisdiction. If you are one of only a few minority investors, these provisions may not be of much significance. For instance, if you are one of three 2% holders and there are only a few other investors who each own a large percentage, they could drag you along with or without a drag-along provision.
Options to make drag along agreements less draconian
If traditional drag along agreements seem overly harsh, there are a number of changes to the standard terms that founders can seek in negotiations.
First, the drag along agreement could provide that a majority of common, not preferred, stockholders have the authority to drag along the remaining stockholders–including preferred stockholders. Preferred stock is convertible to common stock, so preferred stockholders would still be able to convert and possibly affect a drag along, but in converting their stock they would lose their liquidation preferences.
Second, rather than allowing for a simple majority of preferred stockholders to drag along all other investors, the provision could require a super majority, such as two-thirds.
Third, the provision could require approval of the board of directors in order to be effective. The preferred shareholders will generally have considerable influence on the board, but this additional protection would require that the directors have grounds to conclude that the sale is in the best interest of the company.
