This post is the thirteenth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet.
In the prior twelve posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions, discussed valuation, cap tables, and the price per share, discussed dividends on preferred stock, explained how liquidation preferences work, discussed the conversion rights and features of preferred stock, examined voting rights and investor protection provisions, analyzed anti-dilution provisions, looked at anti-dilution carve-outs and “pay to play” provisions, described redemption rights, examined registration rights, looked at management and information rights, and explained preemptive rights. In this post, we will discuss drag-along rights.
A “drag-along” provision requires the founders and certain other stockholders to enter into an agreement with the venture capital investor that will allow the investor (perhaps acting with certain other stockholders) to force a sale of the company if certain conditions are satisfied. This is a very key provision for consideration by founders and should be carefully reviewed.
There are several important concepts founders should understand with respect to the “drag-along” provision, including the following:
- which stockholders can elect to trigger the drag-along provision;
- must the board of directors also approve the transaction;
- the types of transactions that will trigger the drag-along rights;
- any limitations on the applicability of the drag-along provision;
- the potential liability of stockholders in a drag-along sale; and
- how the sale proceeds will be distributed.
A brief summary of each of these concepts follows:
The NVCA model term sheet contemplates that the term “Electing Holders” (i.e., the stockholders who can trigger the drag-along right) is defined as holders of a certain percentage of the outstanding shares of preferred stock on an as-converted basis. Venture capital investors may commonly try to include 51% as the applicable percentage. For founders, this means that stockholders owning 51% or more of the preferred shares on an as-converted basis can force them to sell, even on terms that could be very unfavorable for the founders (as happened in the In Re Trados Incorporated Shareholder Litigation case discussed below).
Founders should carefully consider the definition of Electing Holders and may want to seek to require a higher percentage for approval (e.g., 66 2/3% of the preferred). In addition, founders may want to attempt to require some percentage of the common stock to approve the transaction as well (e.g., 66 2/3% of the preferred and more than 50% of the common). (Preferred stockholders may be able to convert some of their stock to common in order to make sure the required common vote is achieved, although they will usually lose some or all of their liquidation preference in doing so, which benefits the common.)
Drag-along provisions could include the requirement of board approval of a sale. However, as illustrated in the 2013 Delaware Chancery Court decision, In Re Trados Incorporated Shareholder Litigation, board approval of a sale can expose the venture investor-appointed directors to liability. In that case, a merger was approved for a price that was, in effect, below the preferred liquidation preference; i.e., the common stockholders received $0. The common stockholder plaintiffs claimed that the board breached its fiduciary duties to the company and the common stockholders by approving the merger. Eight years after the merger, the court ruled that the directors did not breach their duties because they were able to prove that the merger transaction was “entirely fair.” Although this case exonerated the directors, it highlights the issue that is raised when the board has to approve a transaction such as a “drag along” sale.
Founders should push for board approval in the drag-along provision. Venture capital investors may resist the board approval requirement due to potential liability concerns, but they can incorporate mechanisms to protect their directors from claims of breach of duty.
Types of Transactions Subject to the Drag-Along Provision
In the NVCA model term sheet, the drag-along provision comes into play when the Electing Holders (and the board, if applicable) have approved one of the following types of transactions:
- a merger or consolidation (other than one in which the company’s stockholders own a majority of the survivor or acquiror);
- a sale, lease, transfer, exclusive license, or other disposition of all or substantially all of the company’s assets; and
- a transaction in which 50% or more of the company’s voting power is transferred.
This list of transactions is fairly standard and would not typically be heavily negotiated.
A price limitation is one of the more important aspects for founders to consider. As discussed above under “Board Approval,” a sale at a price below the preferred liquidation preference results in the common stockholders walking away with nothing. To avoid that result, founders might try to push for a minimum purchase price before the drag-along provision is triggered. For example, the minimum purchase price could be twice the total preferred liquidation preference. Venture capital investors might be reluctant to agree to this, however, since a transaction in which they exit the company at a price that doesn’t leave much or anything for the common is exactly the type of situation in which they would need drag-along rights. Nevertheless, founders should carefully consider a minimum price requirement and seek to protect themselves from being “dragged” into a sale transaction that is very unfavorable.
Potential Stockholder Liability
When stock is sold, the sellers usually must give certain representations and warranties to the purchaser and the seller has liability for breaches of those representations and warranties. That liability can either be joint or several. Under joint liability, each of the stockholders would be liable for the entire amount of any liability to the purchaser. Under several liability, each stockholder is only liable for its pro rata share of any liability. Drag-along provisions are often structured so that the shareholders being “dragged-along” are only required to subject themselves to several, rather than joint, liability. This is obviously more favorable and founders should insist on including it. In addition, founders should push for capping their liability at the amount of consideration they received.
How Proceeds Are Distributed
The NVCA model term sheet conditions the drag-along rights on the allocation of sale consideration as if it were liquidation proceeds to be distributed under the company’s certificate of incorporation. The certificate of incorporation, which is amended in a venture capital transaction to reflect the rights and preferences of the new preferred stock, will describe how the proceeds from a liquidation of the company must be allocated to the common and preferred stockholders. For further discussion, see our previous post on liquidation preferences. This provision is also fairly standard and not generally heavily negotiated.
Founders should be aware that drag-along rights are increasingly common and very important to consider. Founders should pay very close attention to the drag along provision and should be prepared to negotiate the some of the key terms discussed above, particularly those concerning who can trigger the “drag along” provision and any minimum price requirement.
In the next post, we’ll discuss representations and warranties.
© 2014 Casey W. Riggs — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.