The drag-along or bring-along provision forces a stockholder to vote in favor of a sale of company if a certain threshold of stockholders and/or the board of directors approve the transaction. Below is a typical term sheet provision.
“Drag–along” right: Subject to customary exceptions, if holders of % of the Preferred approve a proposed sale of the Company to a third party (whether structured as a merger, reorganization, asset sale or otherwise), [__________] will agree to approve the proposed sale. This right will terminate upon a Qualified Public Offering.
The items typically negotiated in the drag-along provision include:
- Parties subject to the drag-along. Generally, investors want common stockholders with significant holdings to sign up to the drag-along. This is especially important for companies that may be subject to the California long-arm statute, which would require the holders of a majority of common stock to approve the transaction. Major investors also typicaly want the other investors to be subject to the drag-along to ensure that minority investors also approve the transaction. If significant stockholders exercise dissenters rights, which would allow them to receive cash in the transaction, they could interfere with the tax-free nature of certain mergers.
- Threshold to trigger the drag-along. The trigger is typically a certain percentage of stockholders (such as 50% or 2/3 of the Preferred, or a specific series of Preferred) and sometimes board approval. The percentage to trigger and the group of stockholders that control the trigger are typically negotiated.
- Minimum price. Due to liquidation preferences, some stockholders (especially common and junior preferred) may not receive any proceeds in a merger. Forcing these stockholders to vote in favor of a merger in which they receive no consideration may be objectionable to them. Therefore, some stockholders may try to negotiate minimum price thresholds for the drag-along to apply. For example, a common stockholder may try to argue that the drag-along should only apply if the common stockholder receives at least a certain price per share (such as the Series A purchase price) or the valuation of the company is greater than a certain amount in the transaction. Investors will likely resist these modifications to the drag-along because the purpose of the drag-along is to force a vote in the event of a sale of company transaction that might not be entirely supported by the stockholders subject to the drag-along.
- Limitation to cash/freely tradeable securities. Many stockholders would object to having to vote in favor of (and waive dissenters rights in) a taxable merger transaction in which they receive illiquid securities. Therefore, some stockholders argue that the drag-along should only apply if the merger consideration is cash or freely tradable securities.
- Limitation on representations, warranties and covenants made by the dragged party. Some stockholders may argue that the drag-along should not force them to give representations, warranties and covenants in the transaction that go beyond ownership and authority to sell the shares. This is typically agreed to by investors.
Many acquirors will require a certain percentage stockholder vote in favor of a merger in order to minimize the risk of stockholders exercising dissenters rights. If the thresholds for the drag-along are set at a level where various stockholder constituencies are protected against transactions that are not economically beneficial to them, the drag-along provision serves a good housekeeping function to make sure that minority shareholders vote in favor of the transaction.
Occasionally, some savvy investors will also require the drag-along provision to be included in the company’s option agreement so that any optionholder that exercises and holds common stock will be subject to a drag-along.