Drag along rights enable a majority shareholder to force a minority shareholder to join in the sale of a company. They are designed to protect the majority shareholder and are often seen on private equity deals to enable the investor to sell a portfolio company and realise its investment.
A buyer will rarely be content purchasing anything less than the entire share capital of a target company and will want complete control. Drag along rights help to eliminate minority shareholders and allow a buyer to purchase 100% of the shares.
The rights are often put in place during investment negotiations between a company’s majority and minority shareholders and may be included in a target company’s articles of association as a way of pushing through a sale more quickly and on terms more appealing to the buyer. So majority shareholders can benefit from drag along rights, but what about minority shareholders who are effectively ‘dragged in’ to a deal? Well they can also benefit. For drag along rights to be triggered and applied effectively, they require the price and the terms and conditions relevant to the deal to be consistent. So interested parties who may only hold a small percentage of the shares can realise better terms than might be expected for a shareholding with little or no influence over corporate matters.
Drag along in private equity
A private equity investor will want to realise its investment in a portfolio company within a few years so that it can return the sale proceeds (hopefully with a healthy profit) to its own investors. An exit might be achieved via an IPO, a trade sale or a secondary buy-out (a sale to another, bigger investor). In each case, drag along rights can help secure that important exit for the investor.
An exit would be easy if all the shareholders were willing to sell their shares in the target company. But if one or more of the other shareholders is reluctant to sell (perhaps because they believe the company’s performance and value will increase in the future, or they are emotionally invested in the company and don’t want to leave any potential success behind), this can cause a problem. Including drag along rights in the shareholder documentation from the start ensures that a reluctant minority cannot prevent a sale by a willing majority.
Typical drag along provisions will empower the shareholder who wants to sell (and has found a buyer) to ‘drag’ and force the other shareholders to sell to the buyer on the same conditions and terms. So a private equity fund holding the drag along rights is able to exit the company and deliver 100% of the shares to the buyer.
Drag along rights are generally described as favouring majority shareholders, but in private equity investments the investor will still expect to have the benefit of drag along rights even if it holds less than 50% of the shares. This enables the fund to benefit from the added value that a buyer would otherwise pay only on the controlling shares. The sale of all the shares by all the shareholders must be done on the same terms and so the added value, or the control premium, is divided between all the sellers increasing liquidity and value.
Although a private equity investor will expect to have drag along rights in its favour, it will want to avoid being dragged out of its investment for a value below its expectations. So, even where the investor is a minority shareholder, the majority should not expect to have drag along rights in their favour enabling them to force the investor to sell.
Minority shareholders will not necessarily be content with receiving payment for their shares and they may want to remain part of the company going forward. Their initial investment may have been a long term venture and selling out now may mean they lose out on any future profits the company achieves.
If shareholders are concerned about being dragged there are a number of provisions which could protect their position. For example, they could have a right of first refusal so they can acquire the majority or investor’s shares on the same terms offered by the third party. But if they don’t have the required funds readily available to purchase the shares, the provision will be of little use or benefit.
Drag along rights could contain a general lock-up period, preventing the rights from being exercised until a certain time period has elapsed. Underselling concerns can be eased by attaching a minimum price to the drag along rights meaning they cannot be triggered until that minimum price is satisfied by the proposed buyer.
Striking a balance between the need for the majority or investor to be able to deliver a 100% sale, and the concerns that other shareholders may have about being forced out of the company against their wishes, will require some tricky negotiations.
This blog post was written by Elliot Gibson. For further information, please contact:
Sophie Brookes, partner, Corporate team
T: 0161 836 7823