Imagine you and a few friends are ordering a pizza. Almost everybody agrees that Italian sausage and Vidalia onion is the winning combo. However, Gary, a friend of a friend, insists that the pizza come with pineapple and anchovies. In fact, he’s not even sure pizza is the right move at all, he wants to get this deep-fried sushi he’s been hearing about. You’re arguing and arguing, and after an hour the only decision you’ve made is to never invite Gary over again.
With snacking, this scenario is annoying. Now what if instead of ordering a pizza, you were orchestrating the sale of a company, and a minor investor was trying to scuttle the entire deal? It would be much more contentious. Luckily, you can negotiate an investment provision to prevent this exact scenario: drag-along rights.
What are drag-along rights?
A drag-along right gives a majority shareholder the right to force a minority shareholder to join in on a sale. If, for example, a potential buyer wants the entire company (i.e.,100% of its shares), having a drag-along right allows the majority shareholder to orchestrate that sale without having to get the express consent of the minority shareholder. However, the minority shareholder is entitled to the same price, terms, and conditions of the sale as every other shareholder.
Why would majority shareholders care about drag-along rights?
Consider the pizza scenario above. Because there is not yet a strong-enough case body of pizza law, Gary and his...ways...can continue unchecked. However, with drag-along rights, if a CEO wants to sell the entirety of the company she built and owns an 70 percent stake in, she doesn’t have to convince an intransigent investor that the sale is a good idea. This makes having a controlling interest in the company significantly more appealing.
Why would minority shareholders care about drag-along rights?
The provision that minority shareholders get the same terms that all other shareholders protects them from being taken advantage of. In fact, this sometimes gives them access to sale terms that such small investors may not have access to otherwise.
What are tag-along or co-sale rights?
Even better for minority shareholders are tag-along or co-sale rights. It’s all of the benefits of drag-along rights (access to the same terms as the majority shareholders) with none of the drawbacks (forced obligation to sell). With such rights, the minority shareholder can decide on a case-by-case basis whether they’d like to join in on a sale, at the same terms as the majority shareholders. To put it into pizza terms, Gary can wait until a decision is reached on toppings without him, and then decide if he’s willing to eat that sausage and onion slice after all.
Interested in learning more about the templates you’ll encounter in an equity financing? Check out this explainer post on our blog.
Fidelity does not provide legal or tax advice. The information herein is general in nature and should not be considered legal or tax advice. Consult an attorney or tax professional regarding your specific situation.
Sample scenarios are for illustrative purposes only.
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