Term Sheets: What do I need to know about drag-along rights?
This week’s question: What do I need to know about drag-along rights?
Our answer: Drag-along rights are a standard provision (typically found in the Voting Agreement) that allows the majority stockholders to force (ie. “drag-along”) minority stockholders to participate in a exit transaction (e.g. as a sale, merger, or acquisition). These rights aim to prevent a minority stockholder from blocking an exit that the majority stockholders believe is favorable for your startup. Although drag-along rights are standard, our recommendation is to work closely with your startup counsel to draft rights that empower your ability as a a founder and startup to navigate an exit without undue investor influence by providing common protections such as board and common stockholder approvals, minimum valuation thresholds and equal terms for all stockholders.
Key Considerations
1. Approval Thresholds and Board Approval. Given the power of drag-along rights, you should negotiate for at least a supermajority (ie. 2/3rds) vote to trigger them You should also push for including common stock shareholders in the approval thresholds so that investors alone cannot force an exit. Depending on the board structure, you should also weigh requiring board approval to also prevent investors from unilaterally pushing an exit.
2. Equal Terms. The drag-along should require that all shareholders receive the same per share price and are subject to the same deal terms, so particular group of stockholders is disadvantaged, especially when it relates to contentious areas such as holdbacks and liquidation preferences.
3. Exemptions. There are certain exemptions to the drag-along right to be mindful. For example, initial public offerings (IPOs) generally do not trigger drag-along rights because there isn’t a buyer forcing the sale of your startup’s shares as part of a deal. You may also opt to set a minimum price for the exit or require there is cash consideration in the exit so that drag-along rights aren’t triggered for low-value exits.
Why It Matters
Drag-along rights are a common and important mechanism to ensure that an exit transaction can proceed without delay from minority shareholder holdouts. For founders, it’s critical that these rights are structured to reflect the intended balance of control, especially as investor control grows over time. When thoughtfully drafted with appropriate triggering thresholds and protections around equal treatment, drag-along rights can facilitate efficient exit events while preserving key founder and startup safeguards.