If you are a venture capitalist planning to invest in a new startup company, you must ensure that the company’s shareholder agreement contains the provision of drag-along rights.
What are Drag Along Rights?
Drag along rights under shareholders agreement is a provision that gives a majority shareholder the right to force minority shareholders to sell their shares if the majority shareholders decide to sell their shares. It is an agreement that is made with all the shareholders in a company.
The provision protects the majority shareholder from other shareholders who might wish to abandon the company. Instead of selling their shares, they would rather wait for a higher price.
This provision is called the drag along rights as it drags the decisions of the other minority shareholders to take the decision favored by those who hold most of the stake in the company.
Drag-along rights are usually included in a shareholder agreement to ensure that minority shareholders agree with any decisions made by majority shareholders. If shareholders do not want to be forced into selling their shares, they should ensure that there is no drag-along provision in the agreement.
Drag Along Rights and its meaning in Venture Capital Financings?
Investors usually have drag-along rights, which allow them to force other investors in the company to sell their shares when they want to sell theirs. The idea behind these rights is that if one investor wants out, it is better for everyone if they can all get out at once.
Drag-along rights for venture capital are typically found in agreements between venture capitalists and startup companies. They are used as an incentive for investors to invest in startups, because without this provision, investors may be less likely to invest in startups where there is a risk of losing control of the company.
In any venture capital transaction, the venture capitalist needs to ensure that there is drag along rights provisions in the shareholder agreement. Without this provision, if one of the shareholders decides to sell their shares, they will not be able to force other minority shareholders to sell theirs.
Drag-along rights allow the venture capitalists to compel the entrepreneurs to take actions they might not otherwise want to do, for instance, selling the company or selling their stake to another company.
What are the key terms of a typical VC Financing’s Drag Along Provisions?
The typical VC financing’s drag-along provisions are the following:
- the VC has the right to simultaneously force all the shareholders to sell their shares to a third party.
- if any shareholder does not agree with this sale, they will be bought out for what is called fair value.
- some VCs include a provision that if one shareholder agrees to sell their shares, this agreement will also apply to all other shareholders.
- in some cases, there might be an option for an early buyout before the company goes public.
How do Venture Capital Drag Alongs work in practice?
The drag-along clause is often used by venture capitalists who invest in companies with dual-class shares. Dual-class shares are shares that have more voting rights than other shares. A company may issue dual-class shares to founders, investors, and employees as part of their compensation packages.
The use of the drag-along provision can be contentious because it does not allow the company’s board of directors to stop the sale of an investor’s stake in the company if they do not want it to happen.
This provision is usually used when the majority shareholders want to sell their shares and needs approval from other shareholders.
Why do Investors use Venture Capital Drag-Along Rights to protect their investments?
In the world of startups, it is common to see investors invest in a company with the hope that they will make a return on their investment. However, not all investments are successful; sometimes, the company fails. When this happens, investors may be left with nothing to show for their investment. To protect themselves from this risk, investors use venture capital drag-along rights to ensure that they get some of the profits when an investment succeeds and some of the losses when an investment fails.
Investors can use venture capital drag-along rights to protect themselves from risk and ensure that they get some of the profits when an investment succeeds as well as some of the losses when an investment fails.
What Happens when you have Venture Capital Financing with Drag Along Rights?
Investors generally know that their investment will take at least 5 to 10 years to achieve adequate size to hold its IPO or may be sold for a considerable price. But there are chances that the companies may take longer to grow than anticipated, compelling the investors to decide to sell the company and invest in other ventures. There is a possibility that the investors may give adequate time to the founders and promoters to push along their decisions of selling the company through the clause of drag along rights before exercising them.
Thus, VC financing will start pushing the decision of selling the company to get an easy exit. It is done by giving the VC a preferential right to buy more shares if the company wants to issue more shares and giving them an option on all future offerings.
Venture capitalists will thus, try to exercise the majority threshold by a simple majority, which is more than 50.1% (this is the minimum, the numbers can be the super majority of 66.6% as well). VCs would try that this threshold should be highest so that the drag-along rights can be exercised easily, superseding the decisions of the rest of the shareholders.
What happens when One VC With Drag-Along Rights wants out?
When one VC with drag-along rights wants out, it can be a difficult decision for the other VCs. They need to either buy out the departing VC’s shares or find another investor who will take over their share of the company.
It can be costly and time-consuming for them if they decide to buy out the departing partner. They may have to pay a premium on top of their share price and incur transaction costs. It is also possible that they may be unable to find an investor willing to take over the shares in time.
What are the consequences of a Drag Along Right in Venture Capital Financing?
When venture capital financing is completed, the company and the investors benefit. The company gets more money to invest in its business, while the investors get an equity stake in the company. If a drag-along right is included in the agreement, then all the other shareholders are bound to follow suit and take part in future financings or the relevant decisions which go with the majority of the stakeholders. In case the negotiation of the drag-along provision is done by the preference stockholders then other stockholders and founder members of the company must mandatorily accept and sign it duly.
The consequences of drag-along rights are not always clear and can depend on the type of agreements between shareholders. Drag-along rights are not always equal for all shareholders. The clause may differ depending on the type of company, size, and whether it is public or private.
Drag-along rights can have negative consequences for venture capital companies where they are not exercised properly and end up hurting investors and entrepreneurs.
Can VCs exercise tag-along rights instead of drag-along rights?
Tag-along rights are often confused with drag-along rights. However, there is a substantial difference between both the provisions in the shareholder agreement. Tag-along rights and drag-along rights in India are two important clauses that affect the significant decisions of the VCs
Tag-along rights are a legal concept that grants the original shareholder in a company the right to purchase shares in an investment vehicle from an existing shareholder, such as a venture capital firm.
A tag-along right is a right that an investor must invest in a new financing round if the company chooses to do so. It is often included as part of the agreement when an investor agrees to invest in a company, which means they can participate in future financing rounds for the company.
Tag-along rights are not only exclusively for shareholders but also for other stakeholders. It’s a clause that allows investors with minority ownership stakes in a company to force their fellow shareholders into selling their shares if they choose to do so. It can be used by investors who have invested at lower valuations than other investors, who can then sell their shares at higher valuations, thus making up for their initial investment.
Drag-along rights are when the company is sold, and the shareholders want to sell their shares. They must ensure that other stakeholders, like employees and investors, have the same opportunity. The drag-along rights are used to influence the decisions of the minority stakeholders.
Final Thoughts
Drag-along rights and tag-along rights are important provisions in the stakeholders’ agreement, drag-along rights for Venture Capitalists can be complex and needs careful contemplation by investors and companies for reasonable negotiations.
