What is a drag-along provision?
Takeaway: A drag-along provision is a critical M&A tool that allows a majority of stockholders to "drag" the minority into a sale of the company, preventing a small number of holdouts from blocking a beneficial exit.
When the time comes to sell your company, you will need the approval of your stockholders. But what happens if the vast majority of your stockholders, including the board and your major investors, approve a great acquisition offer, but a small handful of minority stockholders refuse to sell? This "holdout" problem could potentially derail the entire deal, as most acquirers want to buy 100% of a company, not 80%.
To solve this problem, every standard set of venture capital financing documents includes a drag-along provision. This is a contractual agreement that ensures that if a deal is approved by the majority, the minority must come along.
How the "Drag" Works
A drag-along provision is a clause, typically found in the Voting Agreement, where all stockholders agree in advance to a specific condition. They agree that if a transaction that is approved by the Board of Directors and a majority of the stockholders (and often a separate majority of the preferred stockholders) is structured as a sale of the company's stock, then all other stockholders are contractually obligated to:
Vote their shares in favor of the deal.
Sell their shares to the acquirer on the same terms and conditions as the majority.
The majority effectively "drags" the minority along into the sale.
Why is a Drag-Along Essential?
It Provides Certainty to the Acquirer: The drag-along right gives a potential buyer the certainty that they will be able to acquire 100% of the company's stock. Without this certainty, many buyers would be unwilling to make an offer in the first place. It removes the risk of having to deal with holdout minority stockholders after the main deal is done.
It Protects the Will of the Majority: It is a fundamentally democratic provision. It ensures that a small group of stockholders cannot hold the entire company hostage and block a beneficial liquidity event that is in the best interests of the majority of the owners.
A Standard and Non-Controversial Term
It is important for founders to understand that the drag-along is not an aggressive or unusual term. It is a universal part of any standard venture financing. It is seen as a necessary governance tool for creating an orderly and efficient M&A process. It is the legal mechanism that ensures that when the right opportunity to sell the company arises, the deal can be executed cleanly and completely, providing a return for all the stakeholders who worked to build the business.
Disclaimer: This post is for general informational purposes only and does not constitute legal, tax, or financial advice. Reading or relying on this content does not create an attorney–client relationship. Every startup’s situation is unique, and you should consult qualified legal or tax professionals before making decisions that may affect your business.