Understand the ‘drag along rights’ that an investor and promoter have to come to terms with while the former exits a company
When a promoter raises capital either from venture capitalists or from a private equity fund he is very clear that both parties, as financial investors, are concerned about an exit from the company they propose to invest in. Exits, formally termed liquidation preferences in term sheets dictate what the investors and promoters agree in order to assist the investor to make a return on his investment. Such exits usually have a timeframe. If the company fails to afford an exit to the investor within the bargained time period the investor can then choose to undertake further steps to liquidate his investment with or without the cooperation of the company/promoters. For instance, the investor could seek a third party purchaser for his stock at a price acceptable to him. Such a third party purchaser may want to protect himself from disagreeable minority shareholders and insist that the investor must be able to ‘drag’ certain shareholders to sell along with himself. Such minority shareholders are usually the promoters when a company raises a large sum of capital, usually a series C or D. This is in effect termed a ‘drag along right’ which is loosely the opposite of a tag along right.
If the price at which the investor is exiting his stock is lower than the price at which he expected to exit, it is likely that the investor is loosing money on the deal. In such a case he usually seeks to negotiate a right whereby he retains the power to ‘drag the promoters’ to a sale of their stock so it facilitates the investor’s exit from the company. The term sheet can contain a drag right for a specific percentage of the stock or in its entirety.
A Venture capitalist, in such a case where the liquidation preference he bargained for did not materialise, will pull out the insurance card in the form of a drag along clause. He would prefer to control his destiny and seek aligned interests so as to sell to the buyer at a price that suits him and such buyers would usually require that all factions of the shareholder pie be sold to them. A promoter will seek to oppose such a move since the pricing would mean that after the investors sell out there is very little left for him and the pricing does not benefit him. This is the dichotomy that arises between the unequal parties prior to a sale.
The drag along right can be softened by the company/promoters by negotiating that (1) the right requires a vote of all shareholders, not just the investors; (2) setting a higher threshold for such a vote (the threshold typically ranges from a majority to 75 per cent of those shareholders that are entitled to vote); and (3) board approval (however investors are likely to be majority on the board, nevertheless). Here, investors will be cautious of handing over the powerful right to thwart a deal to a small set of equity shareholders.
“The drag along right can be softened by the company/promoters by negotiating that (1) the right requires a vote of all shareholders, not just investors; (2) setting a higher threshold for such a vote (the threshold typically ranges from a majority to 75% of those shareholders that are entitled to vote); and (3) board approval”
Add to this cauldron, preference shareholders carrying voting rights (which is often the case). They could demand that their stock be liquidated first before the equity shareholders. They could hold the investor equity class to ‘ransom’. Such situations are precisely what the investor tries to protect himself from when he seeks a drag along clause.
The other side
On the other hand, I have heard some very dynamic promoters pose the argument that if he, the promoter has failed the company so much so that he has been unable to find a buyer, unable to increase the dividend flow to the investors, unable to move the company to the next level then the promoter should sell and thank the investors for finding him an exit. This is a very rare insight that not all promoters may agree on.
Negotiations usually turn ballistic when the term drag along is heard, however a promoter must remember that the drag works both ways, he could seek to ‘drag the investor’ should he choose to exit at some point in time however this is dependent on the shareholding percentages and some good negotiation. Further, a promoter must also remember that with a several forked negotiation strategy on the term sheet, this is but one clause and ultimately negotiation is to give and take.
This article first appeared in Smart CEO and was authored by Aarthi Sivanandh.