Reading: Exit Provisions

The third set of exit provisions, in addition to the redemption and the registration rights, are the participation rights. In the context of exit, the following two participation rights are generally relevant:

• Co-Sale Right (Tag-Along Right)
• Drag-Along Right

We have already discussed Co-Sale Rights in an earlier section that focused on participation rights during the investment period. Here, we shall briefly discuss the the so-called drag-along rights.

With a drag-along right, investors can force all other shareholders to vote in favor of (or otherwise agree to) the sale, merger, or other "deemed liquidation" of the company. 

Before discussing this provision in more detail, let us look at a typical formulation of such a clause:

Drag-Along Provision:

Holders of Preferred Stock and the Founders shall be required to enter into an agreement with the Investors that provides that such stockholders will vote their shares in favor of a Deemed Liquidation Event or transaction in which 50% or more of the voting power of the Company is transferred and which is approved by the holders of 50% or more of the outstanding shares of Preferred Stock, on an as-converted basis (the “Electing Holders”).

Clearly, the drag-along provision is potentially very draconic. Under the formulation above, all it takes is a majority of the outstanding shares of Preferred Stock to trigger the provision. For example, if the preferred stockholders hold 20% of the common stock on an as-converted basis, as little as 10% of the capital can force all remaining shareholders to sell!

While investors view such provisions as an important protection (especially for cases where they seek to sell the company for a price that is lower than the amount of their liquidation preference), founders will generally push back because the drag along clause factually robs them any say in the future of the company.

In the founders can't eliminate the drag-along provision in the negotiations, they should at least try to make it a bit less severe:

• Higher approval threshold: Ask for more than a simple majority of Preferred (e.g., 2/3) and maybe even board approval. Alternatively, founders could also ask for approval by a majority of Common Stocks to trigger the provisions. If the investors object, the founders could offer the investors to lower the conversion ratio of their preferred securities such that they obtain a majority of common stock upon conversions. While this provision will still give the investor the possibility to trigger the provision unilaterally, preceding conversion implies that preferred stockholders will not enjoy a liquidation preference on the exit value of the company. The founders will therefore at least get a pro-rata share of the sales price.
   
• Minimum sales price: Another concern with the standard drag-along clause is that the investors could force the founders to vote in favour of a transaction with a sales price that is lower than the investor's aggregate liquidation preference. In such a scenario, the founders would be forced out of the company empty handed. To avoid such unpleasant exit, founders should push for a minimum sales price to trigger the drag-along provision (e.g., at least 2 times the aggregate liquidation preference).
   
• Limit legal obligations (reps and warranties): Finally, the founders should make sure that reps and warranties that they have to accept in the sale of a company are limited.
  • For example, they should avoid a situation where they become liable for misrepresentations of other sellers. They can do so by asking for "several" (not joint) liability.
  • Also, they should make sure that they limit their pro-rata portion of any claim to an amount that does not exceed the value of the consideration they actually receive from sale of the company.
  • Otherwise, a scenario could arise where the founders do not participate in the sales proceed (see previous point) but are financially responsible for misrepresentations of one of the investors.

Taken together, drag-along provisions are a valuable tool to avoid a situation where individual small shareholders can hold up a transaction that is supported by an overwhelming majority of all other shareholders (founders and investors). However, founders should avoid at all costs to agree to a drag-along provision that grants a small group of investors the unilateral right to force a sale against the foulders' will (and financial interests).