Drag-Along Rights – A Closer Look
Drag-along rights might be implemented when raising capital or during merger and acquisition discussions. For example, consider a technology startup launching a Series A investment round. In exchange for an injection of capital, the startup must give up some percentage of ownership to the venture capital firm. In this illustration, the chief executive officer (CEO) of the startup controls 51 percent of the firm’s shares, indicating majority ownership. The CEO wants to retain majority ownership while also protecting himself in the event of an eventual sale. To do this, he negotiates the provision of drag-along rights with the venture capital firm’s share offering. This gives the CEO the right to compel the venture capital firm to sell its position in the business if a buyer ever presents itself.
This provision avoids any future circumstance where a minority shareholder might undermine a company’s sale. Particularly a sale agreed upon by the majority shareholder or a collective majority of current shareholders. It also ensures that no former shareholders retain any shares in the purchased firm. Drag-along rights may be more common in private-sector agreements in particular instances. When a firm goes public with a fresh share offering agreement, drag-along rights from privately held shares may also expire. An initial public sale of share classes will often annul earlier ownership arrangements. Also, if relevant, an IPO may create new drag-along rights for future shareholders.
Why are Drag-Along Rights Important?
Often, mergers and acquisitions are motivated by the desire to eliminate a competitor. As a result, companies are looking to control 100 percent of their competitor via the merger. Drag-along rights help when selling a company to another due to the desire for entire ownership. A startup founder, for example, may negotiate a drag-along provision during fundraising discussions. This protects the founder in the event that someone subsequently wishes to acquire the company. It also grants the founder a majority interest. However, it should be emphasized that drag-along rights permitting investors to compel a sale might be detrimental in certain situations.
On rare occasions, minority shareholders disrupt a company’s sale by renegotiating conditions. Minority shareholders may potentially stall deals already approved by the supermajority. While drag-along rights benefit majority owners, they also benefit minority shareholders. This is because the selling price, terms, and circumstances are the same as for the majority. As a result, minority shareholders get a portion of profits that they might not otherwise receive.
Benefits of Drag-Along Rights for Majority Shareholders
From the perspective of the majority shareholder, a drag-along right has two key advantages.
- Marketability – It improves the marketability of the firm by providing a target company with no minority stakes. Otherwise, purchasers may be unwilling to participate in a joint venture structure with a mottled collection of minority shareholders with differing interests.
- Control – By transferring the whole stake in the target firm to the prospective purchaser, it may gain a greater premium for control share value. This is as opposed to only a partial shareholding or purchase.
Benefits of Drag-Along Rights for Minority Shareholders
Drag-along rights are intended to reduce the consequences of minority shareholders. Nevertheless, they also have benefits that minority shareholders might not otherwise realize. This sort of provision demands that the price, terms, and circumstances of a share sale be uniform across the board. This means that tiny equity investors might benefit from advantageous sales terms that would otherwise be impossible. Drag-along right clauses often stipulate an organized chain of communication with minority shareholders. This gives the minority shareholder prior notice of the corporate action that has been ordered. It also communicates the price, terms, and circumstances that will apply to the minority shareholders’ shares. As a check and balance, drag-along privileges may be revoked if the required processes for exercising them are not followed.
Drag-Along Rights vs. Tag-Along Rights
Though they have the same basic aim, tag-along rights vary from drag-along rights. Share offers, as well as merger and acquisition agreements, may include both sorts of rights. Tag-along rights provide minority shareholders the option to sell but do not obligate them to do so. When they exist, they introduce different ramifications for the conditions of a merger or acquisition than drag-along rights.
Tag-along rights are commonly referred to as co-sale rights. In practice, they are the antithesis of drag-along rights. When a majority shareholder sells their shares, a tag-along right allows the minority shareholder to participate in the sale at the same time and for the same price. If the rights are exercised, the minority shareholder then participates in the sale of the dominant shareholder. However, tag-along rights can allow a small minority the ability to completely stifle a deal. Clauses are often phrased such that if the tag-along procedures are not followed, any effort to purchase shares in the firm is illegitimate and will not be registered.
Why are tag-along rights used?
Tag-along provisions are intended to safeguard minority shareholders. It protects them from being left behind when a dominant shareholder sells their shares. If a minority shareholder owned 10% of a firm, it would be difficult to sell since most purchasers demand 100% of the company. This puts minority shareholders in a risky position. They could be compelled to sell their shares at a price that is much lower or has no reference to the company’s true worth. Minority shareholders who do not have tag-along rights may find themselves with unsalable or undervalued shares.
Bristol-Myers Squibb Company and Celgene Corporation entered into a merger agreement in 2019. Under the agreement, Bristol-Myers Squibb purchased Celgene for roughly $74 billion in cash and equity. Following the purchase, Bristol-Myers Squibb accounted for 69 percent of the merged entity’s shares, with converted Celgene stockholders accounting for the remaining 31 percent. Minority shareholders at Celgene were not granted any special rights and were compelled to accept one Bristol-Myers share and $50 for each Celgene share held.
Celgene shares were delisted as part of this transaction. Minority owners were expected to follow the terms of the agreement and were not entitled to preferential treatment. Tag-along rights may have featured more significantly if Celgene’s shares had not been delisted. In certain cases, such as this one, majority shareholders may negotiate unique share rights under an alternative class structure. Minority owners may not be able to get the same benefit owing to the consequences of drag-along rights.