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Drag Along Rights

A provision that forces the sale of minority interests in a company in a merger or acquisition

What are Drag Along Rights?

Drag Along Rights (also referred to as “drags” or drag-along provisions) are rights that give the majority owners the right to force minority owners to join in the sale of a company. The rights give the majority owners the ability to sell the entire company based on the terms and conditions desired by the owners.

In negotiating the terms of the sale, the minority owners seek protection from being disadvantaged during a drag sale. The majority owners must give the minority owners the same terms and conditions and price as other sellers. A drag along right is triggered in the event of a merger or acquisition by another company.

 

Drag Along Rights tug of war

 

During the sale of a company, the buyers are often looking for 100% control of the company. The goal of the drag along sale is to help eliminate the minority owners or bring them to the negotiating table and get them to agree to sell the entire company to potential buyers. Both parties – the majority and minority owners – approach the negotiating table with caution since the drag-along provisions implicate their rights in a future sale transaction. The logic behind the “dragging along” is that the majority owners have negotiated with the minority shareholders that the former has the right to sell the company, regardless of the form in which the sale is to occur. In the absence of drag along rights, minority shareholders may object to the sale of the company.

 

Triggering Drag Along Rights

Before majority owners can force minority owners to participate in the sale of the company, they should consider the following issues:

 

Types of transactions

From the majority owner’s perspective, a drag along transaction can be triggered by all types of sales: mergers, the sale of substantial assets of the company, sale of company securities, and acquisitions. In most cases, companies include drag along rights in the definition of “transfer.” For example, the term “transfer” may be modified to include “majority owners may trigger drag along rights during a transfer of a specified amount of its ownership stake.” If alternative types of sale transactions can trigger drag along rights, the obligations of minority owners should be extended to include whatever is required to allow such transactions.

 

Minimum ownership percentage required to trigger the drag along rights

A minimum ownership percentage of 51% can vote to trigger a drag-along sale. However, the exact ownership percentage can vary depending on the ownership mix and the bargaining strength of shareholders.

 

Notice of invoking drag along rights

The type of notice that majority owners issue to minority shareholders was the subject of a ruling in Halpin v. Riverstone National, Inc. at the Delaware Court of Chancery on February 26, 2015. The judge held that the drag-along right was not enforceable because the majority owners failed to comply with the drag along sale provisions contained in the governing agreement. The majority owners only notified the minority owners of the drag-along sale after it had already occurred. The governing agreement required that the majority owners provide an advance notice of the drag-along sale to the minority owners.

 

Restrictions by minority owners

Sometimes, minority owners may put restrictions on, delay, or block the drag sale from happening. They may impose a black-out period during which a transaction cannot take place. Minority owners may also require a guaranteed minimum price or return over a specified period before the drag right can be effected. They may push for a requirement that the board of directors must approve the drag sale. The board’s approval ensures that the sale is for a fair market value, and this compromises the majority owners’ ability to choose their own sale price.

 

Allocation of Sales Proceeds

The distribution of sales proceeds of the company is a contentious issue between majority owners and minority owners. Majority owners typically want as much flexibility as possible in negotiating the value of the sale. They may want to receive payments in the form of cash or other considerations such as securities in the acquiring company. On the other hand, minority owners can be allocated illiquid assets, despite the fact that they want to receive either cash or liquid securities that they can easily convert to cash.

The drag along rights provisions require that both the majority and minority owners receive similar prices, terms, and conditions in the sale. They receive the same price per share and equal allocations in case of any post-closing price adjustments. If the proceeds allocation is complicated or the company offers several classes of shares, the parties can agree to allocate the proceeds such that each party receives the amount they would’ve received during liquidation. To avert any disagreements in the allocation of non-cash considerations, both parties can specify the allocation and valuation of non-cash payments in the governing agreement.

 

Remedies if Minority Owners Fail to Comply

Due to the nature of drag sale rights, minority owners may be uncooperative or refuse to comply with the drag sale procedures. Majority owners may seek to include certain provisions in the drag-along right to avert any resistance by the minority owners to the drag sale.

The first remedy that majority owners can take is to request minority owners to grant an irrevocable proxy. If given, it allows majority owners to act on behalf of minority owners in any vote or action required to effect the drag sale. It includes signing documents on behalf of the minority owners. However, the majority owners must still comply with the appropriate statutory requirements while acting on behalf of the minority owners.

Another remedy that the majority owners can take is to agree with other parties to add provisions to the governing document requiring the company to automatically update its records to reflect the ownership transfer of a drag sale transaction. The governing documents may include a clause that requires the sales proceeds of a drag sale to be held in trust by a third party until the minority owners comply with the drag sale obligations. These provisions will force the minority owners to give up their ownership control interests to get a share of the sales proceeds.

 

Related Readings

Thank you for reading CFI’s guide to drag along rights. To learn more, see the following resources:

  • Sale and Purchase Agreement
  • Capital Structure
  • Divestiture
  • Corporate Structure

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