The drag along clause

It is standard practice to include drag along clauses in investment agreements, especially in the case of selling a portion of shares rather than the entirety. The drag along clause plays a crucial role in the functioning of a company or startup. It is natural that investors, by injecting their capital into a company in its growth phase, are interested in securing their interests by obtaining influence over when and which share package may be subject to disposal when they decide to exit the investment.

What is a drag along clause?

The drag along clause, empowers a preferred shareholder (investor) to compel other shareholders to sell their shares in the company to a designated entity chosen by the preferred shareholder. This provision is triggered when the designated entity expresses interest in acquiring a larger share than what the preferred shareholder possesses. The terms under which the preferred shareholder can demand the sale of shares by other shareholders mirror those proposed by the preferred shareholder to the buyer or those offered to them by the buyer.

What should be remembered in the process of negotiating the drag along clause?

When negotiating a drag along clause in an investment agreement, it’s important to consider several key elements, particularly:

Timeframe for exercising the drag along right.

Considering that the company (startup) is still building its value, it’s essential to specify from which point onwards the drag along right can be exercised by the privileged shareholder. This is particularly significant from the perspective of the interests of other shareholders, to limit the investor’s ability to exercise the drag along right at any time. It’s also important to note that the capital obtained from the investor should contribute to the company’s value and its valuation post-investment. Time is needed to assess the extent of the investment’s impact on the company’s value and, consequently, the level of return on investment for the investor.

Conditions for exercising the drag along right.

It is imperative to address the determination of the conditions under which an investor can exercise the drag along right. It is advisable to specify in the investment agreement at least the minimum price per share at which the drag along right can be utilized. Another method of safeguarding against being dragged into selling shares at too low a price is for the parties to agree on a procedure for verifying the price of the shares, such as selecting independent appraisers who will determine the value of the shares in the event the investor exercises the drag along right.

It is also possible to include in the investment agreement the requirement for the privileged party to obtain a suitable offer, primarily concerning the attractive valuation of the shares, or to make the exercise of the drag along right contingent upon the occurrence of a specified event.

What impact can liquidation preference have on the exercise of the drag along right?

The drag along clause should not be negotiated independently of the liquidation preference clause, which guarantees the investor a specified level of return on investment (the liquidation preference clause will be addressed in a separate article). It should be remembered that under the liquidation preference clause, the privileged party is the investor. Failure to analyze the liquidation preference clause in connection with the drag along clause can, in the worst-case scenario, lead to a situation where the entire asset subject to division upon exit from the company will accrue to the investor.

Can the drag along right be limited by other provisions of the investment agreement?

Introducing into the investment agreement in favor of the remaining partners the right of first refusal or right of first offer can serve as a sort of protection against being drawn into a share sale transaction by the investor under the drag along clause. In such a situation, from the perspective of protecting the interests of the investor, it will be important to specify strict deadlines within which the partners will be able to exercise such right and the deadline for payment of the price.

In summary, effectively constructing and negotiating the drag along clause requires an understanding of the entire mechanism of the investment agreement, as exercising the drag along right and its protection may be interconnected and often linked to other clauses of the investment agreement.

We understand the complexity and nuances involved in this matter. Should you require legal assistance in navigating these complexities, we encourage you to reach out to Hoogells for expert guidance and support.