Private Equity Tutorials
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- Preemptive Rights
- Drag-Along Rights
- Types of Alternative Investments
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What are Drag-Along Rights?
Drag-along rights clause give power to the majority shareholders of a firm by which they can “drag along” the minority shareholders to sell their stake in the company at the time of a merger or acquisition.
For example, Company ABC is listed on the exchange. A larger Company XYZ has managed to purchase more than 51% of ABC’s shares from the markets and from other owners of the firm, due to which there is an acquisition cited in future for ABC by XYZ. However, XYZ wishes to own the company ABC “fully”, which means they wish to hold 100.0% stake in ABC without sharing any ownership with minority shareholders. In this case, the majority shareholders would force the minority shareholders to sell their stake. In other words, the majority shareholders are exercising their drag-along rights.
Features of Drag-Along Rights
Drag-along rights clause are significant both for the issuing company, as well as for the buyer. Some significant points are:
- At the time of a merger and acquisition, the issuing company may want to sell its ownership to the new buyer firm. For this, the majority shareholders would already have decided to sell their shares, but what about the remaining shares which are held by the smaller chunk of shareholders? The issuing company, in this case, can exercise its drag-along right and force the minority shareholders to sell their shares too.
- The minority shareholders, while forced upon with this right, are offered with the same price that the potential buyer of the firm or any other buyer in the market offered them directly. Thus, there is equal competition for the majority shareholders as for any other buyer in the market.
- Drag-along rights clause is a plus for the potential buyer of the firm since he gets the entire ownership of the firm. This helps them to run the firm as per their policies.
- Terms and conditions regarding the exercise of drag-along rights clause are generally mentioned in the offer documents at the time of issue of securities. Thus, the investors should be well-versed with the conditions of their stake in the company before any investments.
Benefits to the Related Parties
While this right has its own significances, it has certain benefits too. Some benefits for the parties are:
#1 – Majority Shareholders
The majority shareholders who also form a part or whole of the owners of the company exercise this right at the time of mergers and acquisitions, only because there lays a benefit to them. During M&As the buyer may pose a condition that they require 100% ownership in the acquired company, and may offer a little extra than that offered. In such a case, the owners may receive more by exercising these drag-along rights.
#2 – Minority Shareholders
Rights of minority shareholders are protected by a clause, as per which they shall be paid the same amount for selling their stake in the company that would have been paid by any other seller in the market.
#3 – Buyers of the Company
For the buyers, the biggest benefit is that they get 100% ownership in the firm. This eliminates disturbances from their procedures and policies to run the company. Even if they are required to pay a higher amount to acquire the concerned company, they are interested since it ensures a means to run the company better.
Some Facts about Drag-Along Rights Clause
Drag-along rights clause have come into existence because of their benefits and monopoly posed by the majority shareholders. However, there are a few facts that all shareholders of any company need to know, should they face any such situation with the shares they hold:
- The majority shareholders who would have already made a deal with buyers of the company in a situation of M&A may exercise this right on minority shareholders anytime and should understand their responsibility to protect their rights by offering the same price for shares.
- If the offer document does not read anything about the drag-along rights, the minority shareholders may object to the sale of the company. They may also delay the process or demand for a particular price to their shares from the majority shareholders.
- By mentioning the term “majority shareholders” again and again, we refer that the minimum ownership in the company should be at least 51%.
- The majority shareholders need to provide a notice to the minority shareholders in advance to the sale event to occur. Once the sale agreement is ruled, drag-along rights cannot be exercised.
- Along with benefits, there is a major concern to the minority shareholders. A situation may arise that the shares purchased by them become illiquid in markets, or the shares that were bought by them are preferred stocks, which are not openly traded in the markets. In such a case, the prices of such securities are not transparent to the public. Hence, prices are hidden, which means that the minority shareholders are unable to discover the real price at the time of any transaction in the company or at the time when drag-along rights are being exercised. To avoid such a scenario, shareholders should always keep an eye on the markets and where their shares are floating on a regular basis.
Drag-along rights clause may seem to be beneficial in different ways to all the parties involved in the transaction; however, there are a lot of key points that need to be taken care of by all stakeholders. There requires a lot of analysis by buyers and sellers of the company before proceeding towards any such transaction. There may also lie some contingency at the end of minority shareholders, which can cause delays in the finalization of the deal. One of the best ways to proceed with this situation is, to mention all intricate details in the offer document at the time of issue so that all the parties are well aware of the future prospects of the issue.
This has been a guide to what are Drag-Along Rights? Here we discuss the features of Drag-along rights along with its benefits to the majority shareholder, minority shareholders, and the buyer. You may learn more about Private Equity from the following articles –