Understanding Drag-Along Rights

Shareholder agreements (“SHA”) are agreements among shareholders of companies that govern a wide array of aspects related to the inter-se rights of such shareholders.  It is common practice to safeguard the interests of specific categories of shareholders, such as financial investors, who understandably aim to protect the value of their investment through various mechanisms outlined in these agreements. One such mechanism is the granting of a drag-along right to these investors. This note shall focus on the concept, purpose and implementation of the right.

The drag-along right provides shareholders, typically financial investors (“dragging shareholder/s”), the right to require the remaining shareholders (“dragged shareholder/s) to participate in a sale of the company they hold shares in (“company”). Investors frequently seek a drag-along right during negotiations as it enables them to compel the sale of additional shares beyond their own, potentially resulting in a higher sale price or favourable terms in negotiating with a third party acquirer (“acquirer”), due to a greater number of shares being offered for purchase.

Typically, a drag-along right is triggered when the founders of a company fail to provide an exit opportunity to the dragging shareholders within a pre-defined exit timeframe, or there is otherwise an occurrence of an event of default in the company. Under such circumstances, it is critical that the dragging shareholders are provided an unfettered right to liquidate their investment in the company. One such way to facilitate an exit is for the dragging shareholders to directly negotiate with a potential acquirer for the sale of shares or assets of the company. The dragging shareholders, in particular, are able to achieve favourable terms with the acquirer by exercising their drag-along right and being able to offer not only the dragging shareholder’s shareholding in the company, but a percentage of the shareholding above and beyond their own shareholding.

Given that a prospective acquirer would likely seek to acquire at least fifty percent (50%) or more of the company, to allow the acquirer to exercise control over the company, the drag along right in effect facilitates this and incentivises the acquirer to contract with the dragging shareholder. Therefore, in such a situation, the drag-along right vests the dragging shareholder with the ability to compel the remaining shareholders of the company to sell all or part of their shareholding to the acquirer. This allows the financial investor to obtain a complete exit from the company, while also achieving the dual purpose of reposing control of the company in the hands of the acquirer.

As previously mentioned, the drag-along right typically comes into effect as a last resort measure for the dragging shareholders to exit and salvage its investment in the company. It is important to note that the sale of shares pursuant to the exercise of a drag-along right is required to take place at the price the dragging shareholder negotiates with the acquirer. In effect, this means that the dragged shareholders have little to no effective control over the price at which they are required to sell their shares to the acquirer. Consequently, the drag-along right is considered by some schools of thought to be draconian in nature.

Considering that this right is a powerful tool in the hands of the dragging shareholders, it is often the case that dragged shareholders try to include provisions to safeguard their interests against an untrammeled usage of the drag-along right. Such protections may include delineating specific periods before which the right cannot be exercised, or prescribing a minimum company valuation for determining the sale price, restrictions on sale to competing businesses or even a minimum rate of return guaranteed for the dragged shareholders.

When signing off on a drag-along right, dragged shareholders should negotiate to receive the same pro rata consideration as the dragging shareholder and that the terms of the sale are objectively fair. While drag-along provisions typically stipulate that the dragged shareholders receive the same per-share price as the dragging shareholder in a sale, the specifics of what constitutes total consideration are crucial. For instance, if the dragging shareholder receives any non-cash consideration (e.g. securities of the acquirer) for the sale, the dragged shareholders should also be entitled to the same non-cash consideration in addition to any cash consideration. Similarly, if the dragging shareholder is paid any non-compete fees by the acquirer, the dragged shareholders should also negotiate for similar non-compete fees if they are being bound by non-compete obligations as part of the drag-along sale.

More often than not, dragged shareholders do rely on financial alignment with the dragging shareholders to ensure that they receive fair value for their shares. As long as both the dragging shareholders and dragged shareholders remain on the same page financially, dragged shareholders can typically trust experienced financial investors  not to hurt their own interests by selling their shareholding for less than what is perceived as fair value.

Situations may still arise which could severely harm the interests of the dragged shareholders. Instances have arisen where the acquirer is an entity in which the dragging shareholder or its affiliates have an existing interest, i.e. the sale becomes an indirect method of the dragging shareholders accumulating further control over the company rather than an exit. In another instance of inherent bias in favour of the dragging shareholder, there have been instances of dragged shareholders receiving securities as a consideration, in a drag-along transaction, that did not grant them the same rights as the dragging shareholders. Such terms allow the dragging shareholder to disproportionately benefit at the expense of the dragged shareholders.

Dragged shareholders may also wish to negotiate the extent to which they can be compelled to undertake continuing obligations as part of drag-along transactions. For instance, they may not agree to be bound by non-compete covenants that the dragging shareholder may be required to enter into with the acquirer as a condition of the transaction. In juxtaposition, dragging shareholders may not want to be liable for breaches of representations and warranties relating to a business in which they were only passive financial investors or, at a minimum, seek to have joint (and not sole) liability with the dragged shareholders for any post-sale indemnification payments required to be made to the acquirer.  Similarly, dragged shareholders may seek to limit their indemnification exposure to the amount of the purchase price they actually receive.

Another consideration regarding drag-along provisions is the expenses associated with negotiating and documenting the transaction in which dragged shareholders are compelled to participate. The dragging shareholder may require dragged shareholders to proportionately contribute to these expenses, even if they are being involuntarily involved in the transaction. Dragged shareholders, if they consent to sharing these costs, typically request that their own legal fees and expenses incurred in the sale be added to the transaction costs and shared by the dragging shareholder as well.

In conclusion, the drag-along right is a double-edged sword of sorts, having multiple facets and considerations attached to it. Overall, it grants dragging shareholders significant control over sales transactions but could potentially leave the dragged shareholders vulnerable. While it can expedite deals and maximize returns, it necessitates careful negotiation and consideration to protect interests of participating shareholders. In negotiating and documenting a drag along right, provisions ensuring fair treatment, equitable consideration and limited liability are essential for fostering trust and fairness among shareholders.

About the authors: Arindam Basu is a Partner and Varun Rao is an Associate at Poovayya & Co.