NOTE: This is the sixteenth post in our series about standard terms in early stage equity financings. These posts refer to the model Series A Term Sheet put out by the National Venture Capital Association (NVCA) and available for download here.
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Drag Along
A Drag Along provision (also known as a “Bring-Along”) compels a group of stockholders to vote in favor of a transaction approved by another group of stockholders and/or the company’s Board of Directors. A Drag Along is most often used to “drag” minority stockholders and can be particularly important in a transaction, such as a merger or a stock tender offer, where approval by all or almost all stockholders may be imperative. It can also be used, however, to allow a minority of stockholders to drag the majority; which is often the case in the context of a financing where the Drag Along may require most or all stockholders to vote in favor of any Deemed Liquidation Event or other sale transaction approved by the investors.
Venture capitalists typically insist on a Drag Along right because it facilitates a potential exit by preventing the common stockholders from thwarting a sale of the company. The Drag Along is most likely to be exercised if a company is presented with a modest acquisition offer where the common stockholders would receive little or nothing from the transaction after payment of the investors’ Liquidation Preference, but it might be exercised anytime the differing business and economic goals and incentives of the investors’ and common stockholders cause them to disagree about the merits of a potential acquisition. In such a scenario, the investors want the ability to compel the common stockholders to approve the transaction if the investors conclude it is in their (the investors’) best interest. In essence, the Drag Along gives the investors the ability to impose their outlook for the company on the common stockholders.
A Drag Along provision can be a tough pill for founders to swallow, but it has become commonplace (though not universal) in venture deals and is likely to be even more important to investors after the recent economic downturn because they will be extra sensitive to the need for potential exits. There are a number of ways, however, that a standard investor Drag Along right may be modified to make it less draconian. At the term sheet stage, the primary means of softening the Drag Along right are: (1) providing that exercise of the right requires a vote of all stockholders, not just the investors; (2) setting a higher threshold for such a vote (the threshold typically ranges from a majority to 67% of the stockholders entitled to vote); and (3) providing that approval of the companies Board of Directors is also required to trigger the Drag Along (but recall from our post on Election of the Board of Directors that investors can have significant influence on the Board). Other limitations on the Drag Along, usually negotiated by the lawyers during the drafting of the transaction documents, may restrict the terms and conditions of a transaction in which the Drag Along is exercised.
Note that if the investors agree to require a vote of all stockholders to trigger the Drag Along, the threshold should not be set so high as to allow a small group of common stockholders to thwart a transaction.