This post originally appeared as part of the “Ask the Attorney” column I am writing for VentureBeat. Below is a longer, more comprehensive version, which is part of my ongoing series on venture capital term sheets. Here are the issues I have addressed to date:
- common mistakes dealing with VC’s
- liquidation preferences
- stock options
- exploding term sheets and no-shop provisions
- anti-dilution provisions
- Board control
- protective provisions
In today’s post, I examine “drag-along” or “bring-along” provisions, which can be very tricky.
What Are Drag-Along Provisions? Drag-along provisions grant the investors the right to compel the founders and other stockholders to vote in favor of (or otherwise agree to) the sale, merger or other “deemed liquidation” of the company. Investors view such provisions as an important protection, particularly if they seek to exit their investment and sell the company for a price less than the amount of their liquidation preference.
If the founders have strong negotiating leverage, they can push back and knock-out the drag-along provisions; if not, they should push to insert certain reasonable protections (as discussed below), which will make such provisions less draconian.
What Is a Typical Drag-Along Provision? Here’s what a typical drag-along provision may look like in the initial draft of the term sheet:
The holders of the Common Stock shall be required to enter into an agreement with the holders of the Series A Preferred that provides that all such holders of Common Stock and the remaining holders of the Series A Preferred will vote their shares in favor of a transaction in which 50% or more of the voting power of the Company is transferred or any other Deemed Liquidation and which is approved by the holders of 50% of more of the outstanding shares of Series A Preferred, on an as-converted basis.
What Are Some Key Issues for Founders? There are several key issues founders should focus on. First, the founders should require a higher threshold than a majority of the Preferred Stock to trigger the drag-along (e.g., 2/3 of the Preferred Stock) and also perhaps Board approval (though recent Delaware case law may make this problematic). Founders should also push for approval by a majority of the Common Stock. If the investors object, a reasonable compromise would be to allow the investors to convert their Preferred Stock to Common Stock to create a majority (which would lower the liquidation preference).
Second, to avoid a situation where the founders receive no consideration because they are forced to vote in favor of a transaction at a sales price less than the aggregate liquidation preference, the founders should push for a minimum sales price to trigger the drag-along (e.g., a price greater than 2 times the aggregate liquidation preference). Obviously, the investors will push back hard on this.
Third, founders should push for certain limitations with respect to the representations, warranties and covenants they are required to make in the definitive acquisition agreement. For example, founders should push for what is called “several” (not joint) liability – to avoid a situation where they are liable for misrepresentations of any other sellers; and they should also push to limit their liability to their pro rata portion of any claim and, in any event, to an amount not in excess of the cash (or the value of the consideration) they actually receive.
Exhibit A: FilmLoop. Michael Arrington of TechCrunch reported a few years back on how drag-along rights can play-out in the real world when he reported on the FilmLoop story. As Mike pointed out:
The FilmLoop founders made it clear that they thought they had a good chance at success and did not want to sell. However, ComVentures’ ownership percentage, plus certain rights they have (called “drag along rights”), can force the other investors and the company founders to sell.
Mike also added some solid advice for founders at the end of his post: “make sure you read those drag along and liquidation preference clauses carefully before signing.” And I would also add — get input from experienced corporate counsel because such clauses can indeed be complicated.
Drag-along provisions are an important housekeeping tool to avoid a situation where a few minority stockholders are holding-up a transaction approved by a super-majority of the stockholders — thus requiring, for example, a freeze-out merger; in fact, it is good practice for companies to include a similar provision (and a waiver of dissenter’s rights) in its stock option agreements. However, a drag-along provision that is designed to grant the investors the unilateral right to force a sale without the founders’ approval is a big red flag.