Tag along rights are a clause included in many M&A or mergers and acquisition agreements and give the minority shareholders the right to sell their shares at the same price that majority shareholders can. Each board of directors and transaction has a different definition of majority and minority owners. Generally, the majority of shareholders own at least 50% of the company with minority shareholders holding less than 50% of the company’s stock.

Drag along rights give more power to majority shareholders as they can force minority shareholders to participate in the sale of the company. These rights protect majority shareholders, but require that minority shareholders have the same price, terms, and conditions that other sellers would have. Drag along rights might sound similar to tag along rights, but they have many fundamental differences, definitions, and applications.

Check out our Comprehensive Guide to Tag Along Rights

So what are drag along rights?

Drag along rights force minority shareholders to sell their stock during the sale of a company. These terms are commonly used by venture capital and private equity firms. Also, they can be quite disadvantageous to these shareholders as some may not want to sell these shares, but instead, hold them long term. Some might believe that the company will appreciate over the long run and could miss out on potential gains.

This concept can also be described as an opportunity cost, which represents foregone benefits due to choosing one alternative or another. Opportunity cost happens among regular investors that choose to invest in bonds for safety but miss the higher returns because they choose not to invest in stocks or equities.

Drag along rights primarily serve majority investors and eliminate 100% of minority investors. This also prevents minority shareholders from blocking the sale of a company. However, these rights do have some advantages for minority shareholders. For example, minority shareholders are entitled to the same selling terms and conditions that everyone else has access to. This could give them the opportunity to sell at an advantageous price that they wouldn’t be able to obtain on their own. Tag along rights give minority shareholders the same benefit, but the main difference is that these clauses give minority shareholders the right, but not obligation to sell their shares.

It can be tricky to imagine the benefits of this clause, and the following example will provide some practical uses:

A tech startup has seen massive growth and has begun the series A investment round. This process means that the company is trying to sell ownership or equity to venture capital firms in exchange for funding. The CEO has 52% ownership in the firm and wants to protect himself in case a buyer wants to take control of the company.

Therefore, he negotiates drag along rights with the venture capital firm, which will force it to sell its equity ownership in the company at a minimum price. Drag along rights can supersede minority shareholders that want to prevent the sale of a firm, even if the minority shareholders have the backing of the majority shareholders.

A recent real-world example of drag along rights occurred when Bristol Myers- Squibb acquired a pharmaceutical company, Celgene in 2019. Bristol Myers used both cash and stock to make this acquisition, which was valued at roughly $74 billion. As a result of this, Bristol-Myers Squibb majority shareholders own 69% of the combined entity;  with Celgene shareholders owning the remaining 31%.  Also, Celgene stockholders will receive one Bristol Myers share and $50 per Celgene share.

Terms to know

Series A Funding

The first round of funding once seed capital has been provided. Seed capital is the first type of funding a startup could receive and Series A funding is generally the first occasion where external investors can purchase sales. This is different from an initial public offering (IPO), which occurs when a company lists its stock for sale to the public on a stock exchange like NASDAQ or S&P 500.

Opportunity Cost

This represents the missed gain from choosing one alternative over another. Opportunity costs occur in all facets of life, including investments. Choosing investments in public stock might result in a lower return around 7%, than another sector like rental real estate which could have returned around 10%. The 3% difference represents the opportunity cost missed from not investing in real estate.

Non-Controlling Interest

Non-controlling interest is a fancier way to define minority interest. Most shareholders are minority shareholders, even those that own 5-10% of a company. Each company has a different definition of a minority shareholder, but usually, they own less than 50% of a firm.

Mergers & Acquisitions (M&A)

This broad term refers to two companies taking part in a transaction that could involve buying or selling shares. Some companies can take over smaller firms, while others choose to combine forces to become a bigger entity. A famous and large merger occurred when oil giants Exxon and Mobil joined forces. This occurred during the 1990s when energy prices were low and oil companies were struggling. Therefore, these two firms decided to combine forces to drive down costs, increase revenue and it’s been considered one of the most successful mergers in history.

Mediation

It’s prudent to consult a competent attorney when drafting these documents and clauses. Mediation is another way attorneys can provide value and occurs when a third neutral party helps the opposing first and second parties negotiate compromises. An attorney usually conducts this process, which ends when both parties have reached an agreement.

Arbitration

This process is usually conducted by attorneys and it differs from mediation as the arbitrator makes the final decision. Arbitration usually occurs in a courtroom-like setting and is less formal than standard trials. This procedure has two parties compete against one another and show evidence proving their own arguments. Then, the arbitrator makes the decision in favor of one party. Keep in mind that both mediation and arbitration are much quicker and cheaper than traditional trials.

Drag along rights best practices

Drag along rights can be triggered in numerous scenarios including but not limited to: transfer, control, along with mergers & acquisitions of not just entire companies, but their assets. For example, companies conduct acquisitions to obtain certain assets like real estate from another company. It’s important to consider which events will trigger drag along rights.

Sometimes, selling a certain, predetermined stock threshold will trigger this, while selling entire asset classes will accomplish this. Drag along rights also have to receive board approval as well. These types of transactions must be written in clear language and have ethical provisions. Failing to do this could result in more legal troubles, negative returns, and being voided by a federal judge.

Transfers refer to when shares are exchanged in a non-sale transaction or a pledge of ownership interests. This occurs when people want to sell shares, but not sell an entire company.  

Another important question to ask is “what percentage is needed to trigger a drag along?” This percentage can vary based on the company and different factors like ownership strength, bargaining power, among others. It’s important to note that this same percentage will trigger tag along with rights as well. This means that a minority shareholder would have the right to participate in the transaction and have more flexibility.

Minority shareholder protection

Minority shareholders would be wise to bargain for additional protections from drag along rights. For instance, blackout periods, price floors and minimum returns are some ways that minority shareholders have protected themselves in the past. In addition, minority shareholders could argue that drag along rights only be triggered when a company is sold to a legitimate bona fide third party.

Conversely, drag along rights that are triggered when sold to a company affiliate don’t provide the fiduciary protection as a bona fide third party would. Having a fiduciary or someone who is legally required to put the buyers and sellers best interests first, would ensure that everybody would have access to reasonable fair market values (FMV).

Give fair notice to shareholders

It might sound simple, but it’s important to clearly label giving prior notice to shareholders prior to drag along rights. It would be wise to ensure that it gives all parties adequate time to prepare and include these in the shareholders’ agreement. In fact, failing to comply with this rule can make a drag along rights null and void.

A real-world example of this occurred during the 2015 case of Halpin v. Riverstone National, Inc., C.A. No. 9796-VCG (Delaware. Ch. Feb. 26, 2015). Some majority shareholders from Riverstone National invoked a drag along to merge with Halpin. However, the court determined that this drag along wasn’t valid as Riverstone National failed to provide notice until after the drag along occurred. This demonstrates the importance of following fundamental procedures as outlined by the shareholders’ agreement. Notice rules can vary, but generally, 1-2 months is a good rule of thumb.

When not to use these rights

Drag along rights can protect majority shareholders but can deter investors. Investors have to remember that they’re investing in private companies. Thus, those shares aren’t nearly as liquid as a stock listed on the public exchange. Therefore, it would be harder to sell these shares, which could result in unfavorable returns.

(FAQ) frequently asked questions

Are drag along sales taxable?

This can depend based on the agreement which will clearly define if it’s taxable. Unsurprisingly, most stockholders object to taxable sales and only want to sell if they can receive cash or even unrestricted securities. Unrestricted securities are more volatile than restricted ones and aren’t regulated by the SEC. These securities are usually sold for short term gains and have large price swings.

What power does a minority shareholder have when a drag along right is exercised?

Unfortunately, minority shareholders have no power, unless there are specific terms written in the shareholders’ agreement. This is why it’s crucial for them to negotiate certain provisions like percentage thresholds and proper notice to give themselves more leverage. As seen in the Halpin Case, drag alongs can be made void by a federal court if they’ve been found to violate the written terms.

What does this look like on a term sheet?

Drag along rights can be tough to spot in a term sheet or shareholders’ agreement. These are usually written by lawyers and use legal jargon. Yet, a common way to identify this clause includes looking for language similar to the following: “The (holders of common, preferred, or hybrid equity or founders) enter into a drag along agreement where if a majority of the holders agree to a liquidation of the company, the remaining stockholders shall consent and raise no objections to such a sale.”

Can a drag along be stopped?

It can be stopped in some cases. Sometimes, preferred stockholders can approve drag along, but common shareholders can refuse to vote until preferred stockholders waive their rights.

It can also be stopped if minority shareholders have included clauses for conditions like price guarantees, blackout dates and more. These situations have prompted drag along with rights and many majority shareholders work to make the contracts as favorable for them as they can.

What are the main differences between preferred and common stockholders?

This difference is not only relevant to M&A but also to general investing. Preferred stockholders will get paid first should a company liquidate, compared to common stockholders who will get paid last. In fact, creditors and bondholders are the first investors who get priority over a liquidated company’s funds.

Preferred stock is a hybrid between bonds and common stock as it offers investors a higher, fixed dividend payment. This dividend is higher than the dividends paid to common stockholders. Common stockholders have voting rights and can benefit from high price appreciation. Conversely, preferred stock investors don’t usually have voting rights and primarily rely on dividend payments for income.

Bottom line

• Drag along rights and tag along rights are key clauses used in the M&A process.
• These are becoming more relevant as the M&A industry is booming due to the success of many tech startups.
• Drag along rights protect the majority shareholder by forcing minority shareholders to participate in company sales.
• Drag along rights have many applications and have been used in many industries, but it’s important to avoid common mistakes like not giving prior notice when implementing drag along rights.