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What are Drag Along Rights?
What’s important to know about this concept?
In this article, I will break down the meaning of Drag Along Rights so you know all there is to know about it!
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What Are Drag Along Rights
In business, drag along rights refers to the rights majority shareholders may have in a company to force minority shareholders to sell their shares along with them.
In other words, the majority shareholders “drag along” minority shareholders in a sale.
When minority shareholders are forced to sell, they have the right to receive compensation based on the same terms and conditions as the majority shareholders in the transaction.
For example, if a company is made up of two shareholders where one owns 75% and the other 25%, the majority shareholder may want to sell to a third party for $20 per share and can force the minority shareholder to do so the same.
Drag along rights are commonly used in merger and acquisition transactions as acquirers can potentially acquire full control of a company without having to deal with minority shareholders.
It’s important to note that companies may have complex share structures having different types of shares issued, different voting structures, and rights associated with the shares.
As a result, it’s important that the drag along rights be used to target the right class of shares.
Keep reading as I will further break down the meaning of drag along rights and tell you how it works.
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Why Drag Along Rights Are Important
Drag along rights are important as they are used to manage minority shareholders in an organization.
Although the drag along rights gives majority shareholders the right to force minority shareholders to sell, both majority shareholders and minority shareholders can benefit from these rights.
The majority shareholders benefit from drag along rights as they can legally force minority shareholders to sell when a good offer is presented to the company.
The minority shareholders can also benefit as a third party may offer a generous price to purchase the company knowing that it can acquire the company without minority shareholders remaining in place.
Minority shareholders will have the ability to cash out without having to deal with another majority shareholder or group of shareholders who may have different visions and aspirations for the company.
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When To Consider Drag Along Rights
Companies can consider establishing drag along rights in a variety of situations.
The most common scenario where drag along rights are established is in the context of capital fundraising or in M&A transactions.
When a company sells shares to third parties who may acquire a minority stake in the business, the majority shareholders may want to include drag along rights to ensure that the minority shareholders cannot prevent a potential sale.
For example, if a company sells 40% of its shares to investors, the majority shareholders controlling 60% of the shares may want to be able to sell their shares at some point without having the minority shareholders block the transaction.
Drag along rights may also be important in M&A transactions as a buyer may be interested in offering to purchase a company to the extent it can acquire full control of the organization.
Without drag along rights, the majority shareholders approving a potential transaction may not have the legal ability to deliver full control of the organization to the buyer who may eventually back out of the deal.
To avoid losing a potential M&A deal, companies will exercise drag along rights so they can provide buyers full control of the entity without having any minority shareholders sticking around.
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Drag Along Right Process
Drag along rights are generally outlined in shareholder agreements, investor agreements, or purchase and sale agreements, or other related agreements.
Generally, drag along provisions include a clear process that must be observed by the majority shareholders to force minority shareholders to sell.
The majority shareholders will generally trigger the drag along provision by sending a notice to minority shareholders.
In the notice, the terms and conditions of a potential sale are generally outlined and the minority shareholders are informed about the specifics of the transaction.
Shareholders are requested to tender their shares at a certain place and certain time in order to receive the sale proceeds.
To the extent the process is not adequately followed, minority shareholders may have the ability to contest the exercise of the drag along rights.
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Drag Along Rights Example
Let’s look at an example of drag along rights that may be exercised by a company.
Let’s assume that Company A is owned by John (25%) and Mary (75%).
John and Mary have signed a shareholder agreement where Mary has drag along rights in case she receives a bona fide offer from a third party to sell.
Mary is approached by an investor who is interested in buying 100% of the shares of the company (without any minority shareholders).
Since Mary has the majority control of the company and drag along rights, she can approve the sale to the third party and force John to sell.
This way, she can deliver 100% of the company shares to the buyer.
However, if Mary did not have drag along rights, she could approve the sale of the company but she could only deliver 75% of the shares.
In that case, the buyer can back out.
As you can see, without drag along rights, John can compromise or undermine the sale of the company even if it was approved by the majority shareholders.
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Drag Along Rights FAQ
What does drag along rights mean?
Drag along rights allow majority shareholders in a company to force the minority shareholders to accept an offer to purchase made by a third party.
In effect, the majority shareholders are “dragging” minority shareholders along in the transaction.
The objective is to enable majority shareholders to sell full control of the company without having to deal with minority shareholder effects.
Why are drag along rights used?
Drag along rights are generally used by majority shareholders to protect their right to exit the company or obtain liquidity through the sale of equity.
In M&A, buyers generally want to purchase 100% of the target’s shares without having to deal with dissenting minority shareholders or holdback investors.
As such, majority shareholders use drag along rights to protect themselves by preventing minority shareholders to lock them into the company.
How are drag along rights triggered?
Every company will define the specific triggers relating to the majority shareholders’ drag along rights in their shareholder agreement or company charter.
Typically, the drag along provision will establish the percentage of shares required to trigger the drag along rights which is generally between 51% and 75%.
The provision will also provide details as to the notice that minority shareholders are to be given and the procedure applicable to the sale of their shares.
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So there you have it folks!
What does drag along rights mean?
In a nutshell, drag along rights is a corporate law concept where the majority shareholders looking to sell their shares can force minority shareholders to join them in the transaction.
Drag along rights are provisions found in shareholder agreements or company charters where the company specifies the process and percentage of shares required to trigger the drag along right.
Fundamentally, drag along rights are designed to protect majority shareholders giving them the ability to sell the entire company without dealing with dissident minority shareholders.
However, drag along rights can also protect minority shareholders who are able to cash out at the same price and on the same terms and conditions as majority shareholders.
Now that you know what drag along rights refers to and how it works, good luck with your research!
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