Industry insight article - fundraising 101: Drag-along rights

By Faith Sing, Kelvin Ho and Haoming Ng

This article answers some basic questions founders may have about drag-along rights.

1. What is a drag-along right?

A drag-along right allows the shareholder, or a group of shareholders, of a company which hold that right (“dragging shareholder”) to sell up to 100% of the shares of the company by requiring all or some of the other shareholders (“dragged shareholder”) to sell their shares to the buyer at the same price, if not on the same terms, as the drag-along right holder.

2. Why is a drag-along right important to an investor? 

A drag-along right allows the drag-along right holder (which is typically the investor or includes the investor) to deliver up to 100% of the company to the buyer, which may be critical in securing an additional “control” premium in the sale price or securing a sale at all. This facilitates a smoother exit strategy for the investor and other dragging shareholders by allowing them to maximise the company's sale price.

In addition, where there are certain minority shareholders in the company who are generally unresponsive or uncooperative, having such a right to sell their shares to a buyer acquiring 100% of the company may potentially reduce any delays in completing the sale by preventing such minority shareholders from delaying or obstructing the sale process.

3. Why should a founder be concerned with a drag-along right?

Forcing a sale of shares at a price and time which is out of a shareholder’s control is a serious matter. Potential dragged shareholders should not agree to a drag-along right without considering it carefully.

It is not uncommon for a founder to be part of the deciding threshold for triggering the drag-along right, although this also depends on the stage of development of the company, the number of founders and the relevant shareholding of the founder at that time.

Therefore, if a founder does not have a veto on the use of the drag-along mechanism, it is paramount for the founder to consider the range of other options for ensuring that a drag-along right is only used where the founder is likely to be content with the sale.

4. What is the range of options available to a drag-along right?

There is a wide range of options for customising a drag-along right.

One way of thinking about this is by looking at the drag-along provisions in the model Shareholders’ Agreement put out by the Singapore Venture and Private Capital Association and the Singapore Academy of Law as part of their suite of Venture Capital Investment Model Agreements 2.0 (VIMA 2.0) documents available here.

Option 1 – What type of share sale might the drag-along rights apply to?

The first customisable option in a drag-along right is the percentage of shares that the buyer offers to buy before the drag-along is triggered. Should such rights only be triggered when the offer is to buy 100% of the company or a lesser percentage? For example, should the drag-along right be exercisable for a sale of 51% of the shares? In both cases, the drag-along sale price theoretically includes a “control” premium, as a sale of more than 50% of the voting power of a Singapore company effectively passes control of the company on many matters to the buyer.

However, even if some of the shares of the minority dragged shareholders are sold in the transaction and they are able to enjoy part of the “control” premium, there may be a worry that they will remain invested or stuck in the company with the new controller which they have no say over.

Further, if the drag-along right is for less than 100% of the shares in the company, how will allocations of the sale of shares be made? Will sales of shares be proportionate (to each individual’s shareholding percentage), or will some shareholders have a first right to sell their shares?

In the VIMA 2.0 Shareholders’ Agreement, drag-along rights may only be triggered if there is a sale of 100% of the shares of the company.

In addition, such a sale must be to a bona fide buyer who has made an offer on arm’s length terms. That limits the use of the drag-along right as a mechanism for restructuring the company and offers additional comfort to dragged shareholders that a forced sale is on arm’s length terms.

Option 2 – Who has the benefit of the drag-along rights?

The second key term in a drag-along right is who may exercise, or initiate the use of, the drag-along right. This is usually a subset of shareholders and may include some named investors too.

In the VIMA 2.0 Shareholders’ Agreement, drag-along rights may only be exercised by a super majority of the shareholders (i.e. shareholders holding at least 75% of the shares of the company), which must include the investor majority.

Oftentimes, shareholders will want to review the company’s capitalisation table to understand if:

• they may be “dragged” and forced to sell their shares;
• their holdings of shares are sufficient, at that time, to veto the use of the drag-along; or
• shareholders’ whose judgement they trust have holdings of shares which are effectively blocking stakes.

Shareholders may also want to consider carefully if one or more shareholders has a named right in the drag-along right. For example, it may be that their consent is required for the drag-along to be exercised. This may not be an issue at the early stages of the company’s development when a named right holder is likely to hold a majority of the shares of the company. However, this may become more critical at later stages if the holding of a named right holder is diluted with further investments in the company.

One variation to consider including is an additional level of approval such that drag-along rights may only be exercised if the sale of shares has been approved by the board of directors of the company. However, as directors must act in the best interests of the company or in certain cases in the interests of all shareholders, this additional level of approval may put them in a difficult position.

Option 3 – What price do shareholders sell at?

The VIMA 2.0 Shareholders’ Agreement stipulates that the sale proceeds are to be distributed in accordance with the liquidation preference provisions.

Sometimes, this fine print is missed and the drag-along right specifies distributions on the same terms and conditions as the sale of the shares of the dragging shareholders.

This point is particularly critical in a situation where the company is performing poorly. Shareholders may have to choose between a fire sale price or a winding up. Without the liquidation preference provisions clearly applying to a drag-along transaction, preference shareholders may be incentivised to support a winding up instead, even if it results in a lower price for the business.

On the other hand, dragged shareholders may complain that this means they potentially end up with nothing for their shares after a forced sale if the liquidation preference waterfall applies to a drag-along too.

More on liquidation preference provisions and how they are used in the VIMA 2.0 Shareholders’ Agreement can be found in an earlier article here.

Option 4 – Do all shareholders sell on the same terms?

The VIMA 2.0 Shareholders’ Agreement specifies that the dragged shareholders are not required to provide representations and warranties as part of the drag-along sale, except as to their authority and capacity to enter into transaction documents and ownership of and title to their shares.

This is because the dragged shareholders are not privy to the discussions and negotiations between the purchaser and the dragging shareholders and have not had an opportunity to negotiate these representations and warranties.

Option 5 – What happens if dragged shareholders refuse to sign transfer documents?

Implementing a drag-along transaction is likely to require signature of transfer documents. However, there may be times when the dragged shareholders are uncooperative or uncontactable.

The ultimate solution is to head to court to enforce the dragging shareholders’ drag-along rights. That can take time and involve legal costs. It may also introduce uncertainty that results in a lower offer price or an aborted transaction.

Another solution is to have express provisions dealing with such scenarios.

For example, if a dragged shareholder fails to deliver the necessary transfer documents, an agent or attorney may be appointed with authority to do all things necessary to effect the transfer. That authority is given at the time shareholders agree to become parties to the shareholders’ agreement.

Powers of attorney always look like a technical point and overkill. On a drag-along mechanism, it actually has significant practical repercussions. However, signing a power of attorney is usually in the form of a deed with special execution formalities. As a result, the VIMA 2.0 Shareholders’ Agreement does not include such a power of attorney provision, although it does require the dragged shareholders to provide an irrevocable undertaking to do all things necessary and execute all documents to give effect to the drag-along transaction.

5. Conclusion

The five options explored above for drag-along rights are only the tip of the iceberg – there are other nuances in drag-along provisions which each party should look out for, and most of these do have a significant impact on the actual workability and enforceability of drag-along provisions.

As alluded to at the beginning of this article, drag-along provisions concern investors, founders and especially minority shareholders, and the interests of these groups may not always be aligned. It is crucial that each party takes a closer look at these provisions to ensure that their interests are well protected.

About the authors:

Faith is ranked as a leading lawyer including by Chambers and asialaw Profiles. She has over 25 years' experience completing transactions with a combined value exceeding US$30 billion. She founded FSLAW LLC, a firm that is ranked by Chambers, Legal 500, asialaw Profiles and IFLR1000.

Kelvin is a corporate and commercial lawyer, working with FSLAW LLC since September 2016. Kelvin has assisted clients on corporate transactions, including equity raising through venture capital Series A and B fundings, and corporate restructuring exercises. Kelvin is a graduate of the National University of Singapore’s Faculty of Law and was called to the Singapore Bar in 2018.

Disclaimer: This article is intended for general information only. It is not intended to be, nor should it be, regarded as or relied upon as legal advice. Readers should consult qualified legal professionals before taking any action or omitting to take action in relation to matters discussed herein. This article does not create an attorney-client relationship and is not attorney advertising. Neither the Singapore Academy of Law nor any of the VIMA 2.0 working group members or contributors takes any responsibility for the contents of this article.