Drag-Along Agreements

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Drag-along agreements are important in the event of an acquisition. Under Delaware law, the general standard is that a majority of the outstanding shares have to vote in favor of an acquisition—common and preferred voting together, a majority of the stockholders have to vote in favor of selling the company. At the time of an acquisition, however, almost every acquirer will require a supermajority (usually 85–95% of stockholders) to vote in favor of the deal. A simple majority of 51% leaves the acquirer open to the risk of 49% of the company opposing the deal and creating trouble through lawsuits.

Definition Drag-along agreements (or the drag-along provision) require certain minority shareholders to comply with a transaction approved by a specified majority percentage of shareholders.* In the context of venture capital term sheets, VCs are often majority shareholders while founders are minority shareholders.* Transactions that commonly trigger drag-along agreements include a sale of the company to, or a merger with, another entity.

While drag-along agreements are primarily designed to protect majority shareholder rights and make companies more attractive for acquisition, they also benefit minority shareholders by ensuring they receive the same transaction terms as the majority shareholder(s).* However, founders should be careful with drag-along agreements because investors can use these agreements against them.

Since founders usually hold common stock and investors typically hold preferred, founders should make sure the triggers to drag include:

  1. A majority board vote.

  2. A majority of the preferred vote.

  3. A majority of the common vote.

caution Some investors try to remove the third provision, arguing that founders control the board, therefore protecting holders of common stock. The trouble with this is that the founders may lose control of the board at some point, and it will be very hard to then insert a new trigger to drag based on a majority of common shareholders’ votes.

TechCrunch details another provision founders can negotiate for when it comes to drag-alongs: common shareholders can require preferred shareholders to vote for liquidation if the sale would return them a certain multiple—say 3X—of their investment.

Dividends

Definition A dividend is a distribution of a company’s profit to shareholders. Preferred stock pays predetermined dividends,* while a company’s board of directors must authorize any dividends to holders of common stock.* Many established public companies and some private companies pay dividends on common stock, but this is rare among startups and companies focused on rapid growth.* Startups rarely pay dividends on common stock because they generally prefer to reinvest their profits into expanding the business.

caution Companies backed by traditional venture capital firms will almost certainly not ever issue dividends. Because of this, most founders don’t negotiate on dividend rights in term sheets. Venture capitalists are looking for fund-returning results, not 6–8% dividends. Negotiating on dividend terms at the Series A can be hazardous, as the company may inadvertently signal that they’re interested in becoming a cash-flow positive dividend-distributing business, not a venture-scale fund returner.

Dividends come in two major types: non-cumulative dividends and cumulative dividends.

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