Drag-along rights help steer private equity deals in the right direction by allowing majority shareholders to keep the deal moving, while minority shareholders are often in the backseat. In this article, we will discuss how these rights can help facilitate smoother business exits for all parties, and how Canadian lawyers can support clients regarding these rights.
What are drag-along rights?
Drag-along rights allow majority shareholders to compel minority shareholders to agree to the sale of the company. These are contractual rights, usually through the shareholders’ agreement, where the majority “drags” the minority in selling the company – hence, the name.
In other words, if most of the owners agree to sell the company, all shareholders must go along with the deal and join the sale on the same terms. These rights are common in shareholder agreements, especially in private companies and private equity deals. They can also apply in mergers and acquisitions (M&A).
The purpose of setting up these rights is to make selling a business much simpler. Buyers often want full control, so these rights help ensure the buyer can acquire 100 percent of the company’s shares. This prevents a small group from blocking the sale or merger, even if most shareholders support it.
Drag-along vs. Tag-along
A shareholder's drag-along right is usually compared with tag-along rights, which are essentially the flip side. In tag-along rights or co-sale rights, minority shareholders are given the right to participate in the sale of the company and sell their shares on the same terms.
Watch this video to learn more about drag-along rights, in relation to tag-along rights:
If you have questions about these rights and how they apply to your case as a shareholder, reach out to the best private equity lawyers in Canada as ranked by Lexpert.
How do drag-along rights work in private equity?
Since drag-along rights are contractual, it is usually the shareholders’ agreement that sets out the conditions for their exercise and when they are triggered. As such, the legal requirements for these rights are found in these agreements, along with the other rights that shareholders have.
Shareholders’ agreement
To enforce a shareholder's drag-along right, there must be a clear agreement in place. The shareholders’ agreement is that legal document that sets out all the rights of the shareholders, including their legal relationship with each other and the company.
Among other things, this agreement can include how these rights are enforced by the company and the majority shareholders. These rights are usually tied to how investments are returned to shareholders.
This video explains why a shareholders’ agreement is necessary for companies:
Have problems with your shareholders’ agreement? Consult the best Canadian law firms for private equity as ranked by Lexpert.
Instances when drag-along rights apply
First, the shareholders’ agreement will usually specify the percentage of shareholders that must agree to a sale before the drag-along rights can be enforced. It can be as high as 75 percent, or any percentage above a simple majority. In some cases, only certain majority shareholders have this power, depending on how the agreement is written.
Second, the agreement will also specify the types of private equity deals or other transactions where these rights can be enforced, such as in:
- M&A deals or take-over bids
- sale of substantially all of the company’s assets
- sale of the company’s securities
- changes of ownership, as specified in the agreement
Lastly, other details can be written in the shareholders’ agreement when it comes to the enforcement of these rights, along with the other conditions for each transaction.
Ways to enforce drag-along rights in private equity
Although the specifics depend on the shareholders’ agreement, companies can structure these provisions in different ways. Here are a few examples on how drag-along rights can be enforced in private equity:
- requisites for triggering the rights: the shareholders’ agreement must be detailed enough to state when its exercise will be triggered and how it will be exercised; one important detail is the percentage or threshold of shares needed that allows the exercise of this right
- notice of enforcement: to rid majority shareholders of allegations that they’re rushing things or disregarding due process in the sale of the company, notices can be sent to all shareholders, including the minority ones, before these rights are enforced and only if the conditions in the agreement are met
- prior board approval: another way to ensure broader agreement is in the vote to sell the company is to require that the board of directors also consent to the exercise of these rights by the majority shareholders; this requirement can be a pre-condition to sending of notices to the minority shareholders
- other details for the right’s exercise: this may include:
- the terms of the sale, which must not be unfair to minority shareholders and should address concerns of any parties who feel they’re not being heard
- the payment of the transaction, to ensure that all shareholders are paid on time, whether they’re part of the majority or minority
Example of enforcing drag-along rights
Suppose there is a private company where three shareholders own all the shares. Alex owns 80 percent, Ben owns 15 percent, and Chris owns 5 percent. The shareholder agreement says that if shareholders holding at least 75 percent of the shares want to sell the company, they can use drag-along rights to require everyone to sell it on the same terms.
Here comes David, a buyer, who offers to purchase 100 percent of the company. Alex wants to accept David’s offer, and this triggers the drag-along right. In this case, Ben and Chris must also sell their shares to David, even if it’s not what they want. The agreement also ensures that Ben and Chris get the same price and terms as Alex, so no one is treated unfairly.
Alex follows the steps in the agreement by giving written notice to Ben and Chris and sharing the sale details. If Ben or Chris refuse to sign, the agreement allows Alex to complete the sale on their behalf. This way, David gets full ownership, and the sale goes through without delay.
This example shows how this right can help majority shareholders (Alex) close a deal and make sure minority shareholders (Ben and Chris) get the same treatment in the sale. If there are clear rules in the shareholders’ agreement, the transaction can proceed smoothly and prevent disputes among these shareholders.
What are the benefits of drag-along rights?
Contrary to what it may seem, including a shareholder’s drag-along right written in the shareholders’ agreement does not create hostility within the company. When shareholders are aware of this right, it can help prevent future disagreements and allow them to plan their next steps.
Aside from preventing future disagreements, here are the benefits of these rights:
- makes it easier to sell a company: these rights prevent a small group of shareholders from blocking a sale that most support; at the same time, buyers are confident they can acquire the entire company, making the business more attractive to purchase
- guarantees equality among shareholders: this right ensures that minority shareholders get the same price and terms as that of the majority, everyone is treated fairly during the sale, and no one is left with shares in a company under the new ownership
- faster process of selling a company: for private equity deals, the rights speed up the process (whether it is a sale or M&A), plus it also reduces the risk of delays and disputes (whether between shareholders or against the potential buyer), so deals can close on time
How can lawyers help clients with drag-along rights?
Private equity lawyers are helpful not only when disputes arise, but also in preventing them. Here are some ways lawyers can help with a shareholder's drag-along right:
- draft a clear shareholder agreement that has all possible terms
- review and negotiate shareholder agreements to clarify terms
- explain shareholders’ rights considering the transaction
- guide shareholders on the agreement’s rules (e.g., notice, timing, and payment)
Moving forward: Drag-along rights and keeping deals on track
Drag-along rights give private equity deals a clear path forward. They help the majority shareholders close sales without roadblocks and ensure everyone leaves on the same terms. For business owners and investors, knowing how these rights work can prevent surprises when it’s time to sell. Consulting with private equity lawyers right from the start can prevent any future complications when it’s time to sell the company.
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