What are Drag-Along Rights?
The drag-along rights clause gives 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. There may also lie some contingency at the end of minority shareholders, which can cause delays in the finalization of the deal.
The drag-along rights clause may seem beneficial in different ways to all the parties involved in the transaction; however, there are a lot of critical 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 with any such transaction.
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Drag-Along Rights Explained
Drag-along is a legal concept in corporate law where the shareholder with a majority in the company sells their stake, and also has the right to influence the other shareholders to join the same deal.
The majority and preferred shareholders enjoy a disproportionate benefit from the drag-along rights clause at the expense of the other shareholders such as common and minority shareholders. Nevertheless, minority shareholders are promised the exact same deal in terms of the price and conditions of the sale.
The drag-along rights clause has come into existence because of its benefits and the drag-along rights clause has come into existence because of its benefits and monopoly posed by most 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 a particular price for their shares from the majority shareholders.
- By mentioning the term “majority shareholders” repeatedly, we refer that the minimum ownership in the company should be at least 51%.
- The majority of shareholders need to notify the minority shareholders in advance of the sale event to occur. Once the sale agreement is ruled, drag-along rights cannot be exercised.
- Along with benefits, there is a significant concern for the minority shareholders. A situation may arise when the shares purchased by them become illiquid in markets, or the shares they bought are preferred stocksPreferred StocksA preferred share is a share that enjoys priority in receiving dividends compared to common stock. The dividend rate can be fixed or floating depending upon the terms of the issue. Also, preferred stockholders generally do not enjoy voting rights. However, their claims are discharged before the shares of common stockholders at the time of liquidation., that 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 cannot discover the real price at the time of any transaction in the company or when drag-along rights are being exercised. To avoid such a scenario, shareholders should always watch the markets and where their shares are floating regularly.
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Drag-Along Rights Video Explanation
Let us understand the concept of drag-along clause with the help of a couple of examples.
ABC Corporations is listed on the exchange. A larger company, XYZ, has managed to purchase more than 51% of ABC’s shares from the markets and other owners of the firm, due to which there is an acquisition cited in the future for ABC by XYZ. However, XYZ wishes to own the company ABC “fully,” which means they wish to hold a 100.0% stake in ABC without sharing any ownership with minority shareholders.
In this case, most shareholders would force the minority shareholders to sell their stakes. In other words, the majority of shareholders are exercising their drag-along rights clause.
Anupam Mittal along with two others founded People Interactive (India) Private Limited. In 2014, Navin Mittal, one of the partners, who held 44.38% of the company’s shares, resigned from his post of director and sold all shares.
As a result, Westbridge, a company purchased those shares and earned the right to put forth their nominee for the new director according to the Shareholders Agreement (SHA). However, in 2017, Westbridge made it clear that according to their SHA, if the company did not complete the formalities for the Initial Public Offering (IPO) within five years of the SHA in 2014, they would exit the company and exercise their rights in the drag-along rights terms sheet.
The drag-along rights clause is significant both for the issuing company and the buyer. Some significant points are:
- At a merger and acquisitionMerger And AcquisitionMergers and acquisitions (M&A) are collaborations between two or more firms. In a merger, two or more companies functioning at the same level combine to create a new business entity. In an acquisition, a larger organization buys a smaller business entity for expansion., the issuing company may want to sell its ownership to the new buyer firm. For this, the majority of shareholders would already have decided to sell their shares, but what about the remaining shares 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 shareholdersMinority ShareholdersMinority interest is the investors' stakeholding that is less than 50% of the existing shares or the voting rights in the company. The minority shareholders do not have control over the company through their voting rights, thereby having a meagre role in the corporate decision-making., while forced upon with this right, are offered 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 shareholdersMajority ShareholdersA majority shareholder or controlling shareholder is an individual or a corporation that owns the majority of the company's stock (more than 50%) and therefore enjoys more voting power than other shareholders. These shareholders are in a position to influence the company's decisions. as for any other buyer in the market.
- The drag-along rights clause is a plus for the potential buyer of the firm since he gets the entire ownership of the firm. It helps them to run the firm as per their policies.
- Terms and conditions regarding the exercise of the drag-along rights clause are generally mentioned in the offer documents at the time of the issue of securities. Thus, the investors should be well-versed with the conditions of their stake in the company before any investments.
While this right has its significance, it has certain benefits too. Some benefits for the parties according to the drag-along rights terms sheet are:
#1 – Majority Shareholders
The majority of 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 is 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. The owners may receive more by exercising these drag-along rights in such a case.
#2 – Minority Shareholders
A clause protects the rights of minority shareholders as per which they shall be paid the same amount for selling their stake in the company that any other seller would have paid in the market.
#3 – Buyers of the Company
For the buyers, the biggest benefit is that they get 100% ownership of the firm. It 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.
This article has been a guide to what are Drag-Along Rights. Here we explain the examples, features, and benefits of shareholders, and the buyer. You may learn more about Private Equity from the following articles –