What is Drag-Along Rights?

Drag-along rights are defined as the facility wherein the shareholder having a majority stake can influence the shareholder having a minority stake to come along in the sale of the business or company. The majority of shareholders offer the same price, covenants, and terms to stakeholders having a minority stake in the company. These rights help in the safeguarding of major stakeholders.

Types of Drag-Along Rights

The various types are given below:

Drag-Along Rights During Mergers

In the merger deal, there could be an incorporation of new drag-along rights. During the merger, the majority of stakeholders of the merging unit may exercise these rights which drag minority stakeholders to complete the deal of merger with the bigger unit. The majority and minority stakeholders share similar and homogenous terms and conditions along with the price for the deal undertaken.

Drag-Along Rights During Acquisitions

In the deal of acquisitions, the majority owners exercise drag-along rights to drag minority shareholders to participate in the acquisition of a new unit. Under such deals of acquisitions, the minority stakeholders get similar ownership and rights as the majority stakeholders when participating in the acquisition of a new business unit.

Components of Drag-Along Rights

Top 5 Important Components are:

1. Shareholder Agreement

The shareholder agreement is defined as the agreement which jots down the ground rules for a shareholding pattern in the business. It describes the rights and liabilities of each shareholder in the business. It also details the provision and tag-along rights.

2. Majority of Stakeholders

These are defined as the stakeholders that hold majority ownership of the business. Their ownership normally exceeds fifty percent towards the share ownership of the business.

3. Minority of Stakeholders

The minority stakeholders are the ones who carry residual claims or ownership of the shares of the business. There may be one or more minority stakeholders and the total ownership normally fall below the fifty percent ownership of shares.

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4. Offer Price

The offer price is defined as the price which has been offered by the buyer to the seller wherein the seller further agrees upon to sell off assets or the company to the buyer. Offer price tends to be homogeneous.

5. Deal Type

The type of deal for which drag-along rights are exercised becomes important. A deal could be a merger or an acquisition. If the majority ownership gets the potential buyer who is willing to purchase 100% ownership at the price acceptable to the majority owners then the majority owners can enforce the drag-along rights.

Examples

Suppose there are preference shareholders in the company. They additionally represent 30 percent of the common shares which could be fully diluted at a later stage of the business. The preferred stockholders are in touch with potential buyers.

They can potentially employ drag-along rights with relation to common shareholders and founders if the potential buyer offers a good deal. The preferred stockholders convey the offer terms and prices to the common stakeholders by exercising the drag-along rights to initiate the sale of the asset or the company.

Practical Example:

For the period of 2019, there was a merger deal with the Bristol-Myers and Celgene Corporation. Under this deal, the former company would acquire a stake in the latter company. The deal of $74 billion was accomplished through the stock transactions and cash transactions.

Under the term of deals, the drag-along rights were to be exercised so the minority shareholders were dragged along with the majority stakeholders to gain in the majority ownership of the combined unit.

Advantages and Disadvantages

Some of the advantages and disadvantages are given below:

Advantages

The drag-along rights are formulated to safeguard the rights of majority shareholders.
It also becomes useful for minority stakeholders.
These rights help in making the terms and offer price of the deal favorable and homogenous.
The rights are brought into action during the negotiations of investment that took place between the minority stakeholder and majority stakeholders.
The drag-along rights, when exercised, replace the governing rights and non-controlling interests of the stakeholders having a minority stake.

Disadvantages

The minority stakeholders may always end up with illiquid assets on the completion of the deal.
The minority stakeholders may become unsupportive or refuse to comply with the deal pursued by the majority of stakeholders.
The majority of stockholders must ensure statutory requirements when they act on behalf of the shareholders who have minority ownership.

Limitations

Limitations of Drag-Along Rights are:

Once the business goes for an initial public offering, the drag-along rights tend to cease.
The minority stakeholders can execute a phase of back-out wherein drag-along rights are delayed.
The majority of stakeholders would have to look up for proxy rights irrevocable in nature if the minority stakeholders fail to support the deal.

Important Points to Note

Some of the important points are:

Whenever a company formulates articles of association, the terms and tag-along rights are mentioned in them.
The drag-along rights and tag-along rights are made as to the part of the agreements of shareholders.
These are not classified as statutory rights.
The drag-along rights come to the limelight when there are investment negotiations in place between minority and majority shareholders.
The majority of stakeholders have to provide advance notice on the exercise of drag-along rights to the minority stakeholders which is to be done within the governing guidelines of shareholder agreements.

Conclusion

It helps in selling off the 100 percent ownership in the business to prospective buyers by eliminating the minority shareholders. Drag-along should not be confused with the tag-along rights as tag-along rights are rights that safeguard the minority stakeholders whereas the drag-along rights safeguard majority stakeholders. However, when the business decides to go for the initial public offering and wants to become public, the drag-along and tag-along rights are eliminated there and then.

The provisions are well documented in the shareholder agreements. To enforce a drag-along right, the majority shareholder must provide advance notice to the minority stakeholders.