What is a drag along covenant?

This increasingly common clause in shareholder agreements can have a huge effect on majority and minority shareholders' fortunes.

When you secure significant funding for your growing business some of the terms used by institutional investors may be confusing.

These investors include venture capital firms, business angels and private equity investors.

They’ll normally have an exit date for their investment in your business planned and you’ll know the value of their exit is crucial to them.

Third time lucky with the shareholders agreement
Third time lucky with the shareholders agreement

So, to help increase their profitability when they exit, they can use what is called a drag along covenant (DAC), also known as a bring along covenant.

So, what exactly is this and why should you investigate further?

Put simply, a DAC is a provision in a shareholder agreement that gives the right to majority shareholders to force minority shareholders and holders of other types of stock to sell their shares when the majority shareholder agrees to exit.

This can make it easier for the majority shareholder (s) to sell the company down the line; normally either in a trade sale or to another institutional investor.

According to legal services company Net Lawman, DACs are becoming more common in shareholder agreements.

An example of a drag along covenant

One recent example of a DAC was the reported estimated £68 million sale of software company Huddle to private equity firm Turn/River in 2017. When the deal was signed, preferred shareholders, which included the company’s former chairman and institutional shareholders including Matrix Partners, Eden Ventures and Dag Ventures, benefitted from a payout but holders of ordinary shares received $100 each (£77) as a “goodwill gesture.”

Further reading on law

What’s in it for company founders?

Merlie Calvert, founder of legaltech start-up Farillio says DACs provide ‘optimum freedom’ for founders to sell their shares. But for minority shareholders without a controlling stake in the business ‘they may well want to alter the terms, to give themselves greater powers to say no,’ she explains.

Alan Bracher, chairman of law firm Bracher Rawlins says DACs are very common and extremely useful where there are three or more shareholders in a company and the majority shareholder (s) want to sell the company. He says the protection for minority shareholders is that they receive the same price per share as the majority shareholders.

He adds that the cost of drafting a DAC should be ‘relatively small.’

Calvert concludes, ‘The drag along clause is generally the product of negotiation and bargaining power.

‘It’s not at all uncommon to see conditionality creep into these clauses and it often comes down to commercial negotiating, not the lawyering.

Watch the below video on drag along rights for shareholders

 

Michael Somerville

Michael Somerville

Michael was senior reporter for GrowthBusiness.co.uk from 2018 to 2019.

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