Drag-along rights allow a small set of investors, or potentially even a single investor, to force a sale of the company. Founders should pay very close attention to this deal point.
What Are the Benefits of Drag-Along Rights?
While drag-along rights can be controversial, they can also offer several benefits to majority shareholders and founders. Here are some potential advantages to consider:
- Facilitating a Sale or Merger. One of the most significant benefits of drag-along rights is that they can make it easier for companies to sell or merge with other businesses. These rights streamline the decision-making process by reducing the number of stakeholders involved. In situations where some shareholders may be hesitant to agree to a sale, drag-along rights ensure that those shares will still be included, making the deal more attractive to potential buyers.
- Attracting Investors. Investors are looking for companies with strong leadership and clear decision-making processes. Including drag-along rights in a term sheet signals to investors that the company has taken steps to prevent deadlock and ensure a smooth exit.
What Should Founders Consider Before Agreeing to Include Drag-Along Rights in Their Term Sheet?
This term is investor-friendly, so the best outcome for founders would be to negotiate it out of the deal. However, if investors insist on the term, which is common, the founder should negotiate for a broader set of shareholders to make the decision.
The most investor-friendly version of this clause allows the requisite holders, or a majority of investors in that round, to unilaterally decide to sell the company. This can be problematic if a lead investor takes 50% or more of that round of funding, as they could force a sale of the company that founders have dedicated their lives to.
To diffuse this decision-making power, founders should negotiate to add approval by the board of directors and holders of a majority of shares held by employees of the company. This group of decision makers would be known as the Electing Holders.
Since this term puts the life or death of the company in investors’ hands, it’s important for founders to negotiate it carefully as it may pose an existential threat to the company.
How Do Drag-Along Rights Differ From Tag-Along Rights, and When Might Each Be Used?
While drag-along rights and tag-along rights may sound similar, they serve different purposes and can have different impacts on shareholders.
Tag-along rights give minority shareholders the right to sell their shares along with majority shareholders if a sale is made. This ensures that minority shareholders are not left out of a deal and can receive the same price per share as majority shareholders.
On the other hand, drag-along rights give a certain set of preferred shareholders the power to force the other shareholders to sell their shares in the event of a sale. This can be useful for ensuring that all shares are sold together, which can make a company more attractive to potential buyers. However, it also means that minority shareholders may be forced into selling their shares even if they don’t want to.
When deciding whether to include drag-along or tag-along rights in a term sheet, founders should consider factors such as the size and composition of their shareholder base, as well as the potential impact on company culture and future fundraising efforts. As every company is unique, it’s important to seek legal counsel to help you make a smart decision. If you’re looking for legal counsel, feel free to reach out to us here.
What Are Some Real-World Examples of How Drag-Along Rights Have Been Used in Series A Rounds of Funding?
While drag-along rights can be a powerful tool for majority shareholders, they are not always used in practice. However, there are some examples of how these rights have been exercised in the context of Series A funding rounds.
One notable example is the case of Snapchat’s Series A funding round. In 2012, Snap Inc. (then known as Snapchat) raised $485,000 in a Series A round led by Lightspeed Venture Partners. At the time, co-founders Evan Spiegel and Bobby Murphy held a majority stake in the company and included drag-along rights in their term sheet.
In 2013, when Snapchat received an acquisition offer from Facebook for $3 billion, Spiegel and Murphy wanted to accept the deal but several minority shareholders did not agree with the decision. By exercising their drag-along rights, Spiegel and Murphy were able to force those minority shareholders to sell their shares along with majority shareholders. The acquisition ultimately fell through, but this example illustrates how drag-along rights can be used to facilitate deals even when all shareholders are not on board.
Another example comes from the world of venture capital. In 2017, Airbnb raised $447 million in a Series F funding round led by Alphabet’s investment arm GV. As part of that deal, GV reportedly included drag-along rights in its term sheet. This move was seen as a way for GV to protect its investment and ensure that it could exit its position if necessary without being blocked by minority shareholders.
These examples demonstrate how drag-along rights can be used strategically by majority shareholders and investors to protect their interests and facilitate deals. However, they also underscore the importance of careful consideration and clear communication when including these rights in a term sheet. By working collaboratively with all stakeholders involved, founders and investors can ensure that their governance structure promotes long-term success for everyone involved.
