‘The VC Series’ is a series of articles aimed at founders who are thinking of raising funds from VCs. Further information about The VC Series can be found here.
Following our previous instalment of the VC Series which looked at the right of first refusal, co-sale and tag along rights, this article looks at another key provision that relates to the transfer of shares – drag along rights.
A drag along provision is something that you will see included in all articles of association following an investment by a VC.
In circumstances where a certain percentage of shareholders (or specific shareholders acting together) wish to sell their shares to a third-party buyer, a drag along provision allows those shareholders to compel the non-selling shareholders to sell their shares on the same terms – i.e., to ‘drag’ them along in the transaction.
This protection is crucial in ensuring that a minority shareholder is not able to exercise disproportionate influence by getting in the way of a potential exit (on the basis that any acquirer is likely to want to buy all the shares and won’t want responsibility to any minority shareholders post-acquisition).
It is common on an exit that different shareholders are offered different forms of consideration – for example, a buyer might want certain management shareholders to be involved in the business post-completion and to therefore take some or all their consideration by way of equity in the acquiring vehicle, whereas the expectation will be that financial investors will have to exit for cash only.
Care therefore needs to be taken with the drafting to ensure that, whilst all shareholders should receive the same value per share sold, there is flexibility for different shareholders to receive different forms of consideration.
To deal with the scenario whereby a minority shareholder refuses to comply with the drag along provisions (i.e. by signing a stock transfer form), the drafting should provide that each shareholder appoints any director of the company to act as its agent. This then allows for a director to sign the necessary documents on behalf of the offending shareholder.
Again, care needs to be taken with the drafting to make sure this is enforceable.
You would expect a VC to strongly resist any circumstances in which they can be compelled to transfer their shares, on the basis that they are responsible to their own investors and cannot have a scenario where they are forced to sell at the wrong time or wrong price.
This can though be the subject of negotiation – for example, it might be that a VC cannot be dragged for a certain period following completion of their investment, and/or can only be dragged if a certain return has been achieved on their investment.
You can find details of all the different articles in the VC Series here.
If there is anything that we have not covered which you would find useful, then please let us know.