Drag-Along Rights – Why Investors Use Such Agreements

Frankly I am often puzzled as to why investors simply buy common stock, all too often taking what the market offers them. It’s no secret that the majority of what we do right now is investing in private equity. Today I’m going to provide yet another reason why getting involved in private rather than public equity is a step any rational investor should consider.

The primary reason is control. Firstly, I present a typical drag-along agreement so you have some idea of what it is I’m talking about and how this pertains to investing in private equity.

“Drag-Along Agreement: The [holders of the Common Stock] or [Founders] and Series A Preferred shall enter into a drag-along agreement whereby if a majority of the holders of Series A Preferred agree to a sale or liquidation of the Company, the holders of the remaining Series A Preferred and Common Stock shall consent to and raise no objections to such sale.”

Why would early stage investors (us) consider using such agreements?

There are many reasons, but certainly one of the most important is liquidity. Investors want a return on capital. Holding onto a company’s equity, even when it is unbelievably profitable doesn’t always pay early-stage investors, especially if there is no dividend policy. Thus when an opportunity arises for the company to exit via a trade sale, investors want to be able to control their ability to compel other shareholders to support a transaction which is deemed to be advantageous to all shareholders.

This obviously takes a certain level of power out of the hands of the founders, and as such I’ve had discussions where founders have felt that this “isn’t fair”. The flip side of course is that it can be said not to be “fair” for investors to risk their capital without such a clause.

There are trade-offs in any and every deal, and there are always, or at least there should be, negotiations conducted accordingly. The important thing is to understand what a drag-along right does and doesn’t do. As I often say, and this goes for both investors as well as founders, If you don’t like the deal, don’t do it.

Often drag-along only pertains to common and not preferred stockholders. This can be useful for preferred stockholders since preferred can always convert to common and thereby create a majority in order to enforce a drag-along.

Lastly, it goes without saying that if you are buying say 1% of the company it won’t matter, so don’t worry about it. If a buyout is being negotiated no buyer will consider you for your 1%.

If however you’re part of a syndicate that is going to make up say 20% of the company, and you personally are only putting in 1%, then it is very valuable.

– Chris

 “Drag along rights…oh yeah I know about those. You married me, now I get to drag you along.”– My Wife

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