What is a drag-along provision?
Takeaway: Drag-along provisions are a mechanism by which companies and investors facilitate sales of a business. They provide that if a certain group of people approve an acquisition, everyone else is obligated to vote in favor of it. The typical triggers for the drag along are the consent of (i) the company’s board of directors, (ii) a majority of the common stock, and (iii) a majority of the preferred stock.
In the world of startups, drag-along provisions play a critical role in facilitating exit events and ensuring a smooth transition during the sale of a company. This post will explore the concept of drag-along provisions, their purpose in the context of startups, and the implications for both founders and investors.
What is a Drag-Along Provision?
A drag-along provision is a contractual clause commonly found in stockholders’ agreements or investment documents (typically the Voting Agreement). This provision grants majority stockholders (typically founders and lead investors) the right to "drag along" minority stockholders in the event of a sale or merger of the company. In other words, if the majority stockholders decide to sell their stake in the company, the drag-along provision requires the minority stockholders to sell their shares under the same terms and conditions.
Role in Startups
Drag-along provisions play an essential role in startups for several reasons:
Simplifying the Sale Process: Drag-along provisions streamline the process of selling a startup by ensuring that all stockholders participate in the sale. This can be particularly important when there are numerous minority stockholders, as negotiating individually with each of them can be time-consuming and costly.
Ensuring Fair Treatment: Drag-along provisions help ensure that all stockholders are treated fairly during a sale or merger by requiring that all parties sell their shares under the same terms and conditions.
Attracting Investors: Including a drag-along provision in a stockholders' agreement can make a startup more attractive to investors by demonstrating that the company is well-prepared for a future exit event and that minority stockholders will not be able to impede a potential sale.
Implications for Founders and Investors
For founders, the drag-along provision offers several benefits:
Control Over Exit Events: The drag-along provision allows majority stockholders, often founders and lead investors, to maintain control over exit events by ensuring that minority stockholders cannot block a sale or merger. However, founders must ensure that they have a say in triggering the drag-along and that the investors do control the drag-along.
Ease of Sale: The drag-along provision simplifies the sale process by requiring all stockholders to participate in the transaction, making it more attractive to potential acquirers.
For investors, the drag-along provision also has significant advantages:
Protection of Interests: The drag-along provision helps protect the interests of investors by ensuring that they can participate in a sale or merger and receive the same terms and conditions as other stockholders.
Greater Certainty: By streamlining the sale process and minimizing the potential for minority stockholders to obstruct a transaction, the drag-along provision provides greater certainty for investors that their investment will result in a successful exit event.
Conclusion
Drag-along provisions are a vital component of the startup landscape, helping to facilitate exit events and protect the interests of both founders and investors. By streamlining the sale process and ensuring fair treatment for all stockholders, drag-along provisions play an essential role in creating a stable and attractive investment environment for startups. As a founder or investor, it's crucial to understand the implications of drag-along provisions and ensure that they are included in the relevant agreements to safeguard your interests and ensure a smooth transition during a sale or merger.