DRAG ALONG CLAUSE

In this post we will discuss what a drag along clause is, how it is triggered and its use in a shareholder agreement. A drag along clause is used when there are majority and minority shareholders. It usually favours the majority shareholder. A drag along clause is essentially a right that enables the majority shareholder to force a minority shareholder to join the sale of the company. As the term ‘drag along’ suggests, it allows the majority shareholder to drag the other shareholders along.  As a founder, while setting up your company, you should be aware of what options are available to you in the event of the sale of the company. At the time of drafting the shareholder agreement, it is crucial that rights, obligations and exit options are clearly defined. A drag along clause is usually found in the shareholder agreement.

What is a drag along clause?

A drag along clause is the clause in the shareholder agreement that allows a majority shareholder to force the minority shareholders to join in the sale of the company. The majority shareholder who triggers the drag along clause must give the minority shareholder(s) the same price, terms, and conditions as any other seller. The drag along clause is usually negotiated into a shareholders’ agreement by an institutional investor such as a business angel, venture capital investor or private equity investor for whom the exit from the investment is of particular importance. The power to trigger the drag along lies with the majority shareholder so that the minority shareholders are not able to hinder the selling process.

What is the purpose of the drag along clause?

The main purpose of the drag along clause is to prevent minority shareholders from refusing to sell their shares if a buyer who wants total ownership of the company makes an offer to the majority shareholder. It provides an option for liquidity to the majority shareholder. It is an exit strategy for the majority shareholder because a buyer will want to acquire 100 percent of the company and not the shareholder’s stake alone.

When is the drag along clause triggered?

The drag along clause is triggered when the investor has found a buyer who intends to buy 100 percent stake in the company. Most buyers of majority shareholdings do so in order to be able to change the direction of the business they are acquiring. They may wish to merge the company with another they own, sell some or all of the assets of the company, move the company’s location, or enter into new products or markets. Even though they have majority control, minority shareholders can still legitimately delay or frustrate plans to change the direction of the company

Who can trigger the drag along clause?

The party triggering the drag along clause is usually the one that stands to gain from it. The terms of the clause and the threshold at which it is triggered are different in every shareholder agreement. If a majority of ordinary share holders vote in favour of the sale, then owners of all other classes of shares will also be required to sell their shares. The majority could be defined as 51%, 75% or any other amount. However, it is possible for another class of shareholders to drag along ordinary shareholders, so a majority vote by preference shareholders could trigger the drag along. Option holders may also be able to drag or be dragged. Sometimes, the trigger is conditional on the additional approval of the board of directors.

In the case of Neurodyn Inc (Re)[1], the drag along clause in the shareholders agreement stated as follows:

“if any bona fide offer from a third party is made to purchase all and not less than all of the outstanding shares of the Target, and the holders of 70% of all outstanding shares are ready, willing and able to accept such offer, then the offer will be deemed to have been accepted by all shareholders of the Target, and authorizes the secretary of the Target to accept the offer on behalf of those shareholders who do not accept it.”

The five Target shareholders, holding 87.1% of the Class A common shares, 34.5% of the Class B common shares, and in total, 71.89% of all shares of the Target, agreed to sell their shares under the terms and conditions of the agreement.  As the drag along clause was triggered by the consent of the five Target shareholders, it was held that the other Target Shareholders have no decision to make in terms of whether to accept or reject the transaction.

What does a drag-along clause contain?

  • Parties subject to the drag-along.
  • A third party, acting at arm’s length that makes an offer to the majority shareholder.
  • The threshold at which the drag-along shall be triggered. The percentage to trigger and the group of shareholders that control the trigger are typically negotiated while drafting the shareholder agreement.
  • A provision that the offer may also need to match or exceed a minimum agreed price or minimum time period before the drag along right can be triggered.
  • A limited time period for the minority shareholder to match the offer and buy the majority shareholder’s shares itself.

Majority shareholders usually request a drag along clause in the shareholder agreement to protect their interests and to benefit from the sale of the entire corporate stock. The drag along clause can be an important tool to avoid a situation where a few minority shareholders hinder a transaction approved by the majority of the shareholders. It is important to consider whether you are willing to be dragged along, and if so, on what terms during the negotiating stage of drafting a shareholder agreement. As an owner it is important to consider all the mechanisms to protect your ownership interests.

 [1] 2012 CanLII 33797 (NS SEC)

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Authored by:

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Hari is a corporate lawyer with experience in Information Technology, Renewable Energy and Nuclear Energy. He has worked in Canada, the US, Denmark, the UK, and India. in addition to his big-law experience, he was General Counsel at an US based IT Services company supervising internal and external counsel in various jurisdictions.
Ruchika Shankar
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Ruchika is a lawyer with experience in General Corporate Law, Intellectual Property, Taxation and Consumer law.  She graduated from School of Law, Christ University in 2011.