The drag-along option, also known as the drag-along right, is a legal mechanism that, as a rule, allows the majority members of a company to compel the minority members to sell their shares to a third party on the same terms. This option has a significant impact on the dynamics of relations between members and can prove crucial where a quick and efficient sale of all shares in the company is required.

The drag-along right is an important part of the founding act or the members’ agreement (shareholders’ agreement), enabling majority members to carry out a sale of the company efficiently and on the best terms. When properly regulated, this option can take into account and balance the interests of both majority and minority holders of capital. In this way, it can further contribute to the stability of the company and its attractiveness to investors in the event of a disposal of shares, particularly where the long-term goal of the members is to sell the company. The importance of this clause is particularly evident when start-ups are set up, where several members establish a company primarily in order to develop it and sell it once it reaches a certain value.

What Are Drag-Along Rights?

The drag-along option is a subjective right agreed between members which, most often, allows the majority member of a company, if it finds a third party to buy its shares, to require the other members to transfer their shares in the company to that third party together with it. In this way, if all members are covered by the agreed obligation, the potential buyer can acquire 100% of the shares in the company, which is often a key condition for many investors.

Although the drag-along option is not expressly regulated by the Serbian Companies Act, it may be agreed on the basis of the provisions on the freedom of members to regulate their mutual relations, in particular Articles 15 and 140 of that Act. A drag-along clause may be provided for in the founding act or in a members’ agreement, in compliance with the statutory rules on the transfer of shares and other mandatory rules. A members’ agreement, however, has effect only between the members who have concluded it.

The drag-along option works in such a way that one member has the right to require the other members to sell their shares to a third party on the same terms as that member. The contract may also provide that exercise of the drag-along right is subject to a prior decision of the company’s general meeting adopted by the appropriate majority, but such a decision does not in itself create an obligation to sell shares for members who have not assumed such an obligation.

For this legal institution to have legal effect, the following, for example, needs to be ensured:

Incorporation into a members’ agreement or the founding act: the drag-along option should be clearly defined and included in the members’ agreement or the company’s founding act. Such a clause must be drafted precisely and in detail in order to avoid potential legal uncertainty and differing interpretations.

A Notification to the Members: a member intending to exercise the drag-along option should notify the other members in writing of its intention, providing all relevant information about the potential buyer and the terms of the transfer.

For example, it may be agreed that a member wishing to exercise its right must notify the other members in writing, stating the identity of the potential buyer and the agreed terms. Members who have assumed an obligation under the drag-along clause are required, once the agreed conditions are met, to enter into a share transfer agreement with the third party, in compliance with the applicable statutory rules and any restrictions laid down in the founding act.

When agreeing and exercising the drag-along right, account should also be taken of the statutory rules on the transfer of shares, in particular the right of pre-emption and any restrictions laid down in the company’s founding act.

Like most options, the drag-along option in its basic form protects the interests of one group of members while putting the other in an unfavorable position. It is usually the majority members in whose favour this option is agreed, who negotiate the sale of the company and who call on the others to join the sale. Members with minority shares must therefore be aware of the risks this option entails. This is why the clause should at least make the negotiation process more detailed and transparent. Much also depends on how this decision is implemented internally.

Drag-along contractual clause

Contracts regulating the drag-along option often include specific conditions that further define the rights and obligations of the members:

Minimum Company Valuation: if a minimum value has been agreed, a member may exercise the drag-along option only if the purchase price offered for all shares reaches that value. This value may be set as a fixed amount or on the basis of an appropriate methodology for valuing the company’s equity, including the use of financial indicators such as EBITDA. Agreeing a minimum value is one way of protecting members who do not have the right to trigger this option.

Notification of Intent: a member wishing to exercise the drag-along right must notify the other members in writing of the intended transfer of shares, the identity of the buyer, the agreed terms and the manner of transfer.

Prospective general meeting decision: the contract may provide that exercise of the drag-along right requires prior approval by the company’s general meeting, adopted by the appropriate majority. Such approval is one of the conditions for exercising the agreed right, while a member’s obligation to transfer its share arises from the relevant contractual arrangement.

The obligation to transfer shares may cover both majority and minority members, regardless of the size of their shares, under the conditions and to the extent provided for in the relevant contractual arrangement. Members bound by such an obligation are required to take the agreed steps necessary for its performance.

Penalty clause (liquidated damages) and compensation for damages: in the event of a breach of obligations under a drag-along clause, the contract may provide for a contractual penalty for non-performance or late performance of non-monetary obligations. In addition, a contracting party that suffers damage as a result of a breach of a contractual obligation may claim compensation in accordance with the law. If the damage suffered exceeds the amount of the contractual penalty, the creditor is entitled to claim the difference up to full compensation. These mechanisms provide additional legal protection for the contracting parties.

Origin of the legal concept

The drag-along clause developed in international contractual practice, particularly in agreements between members of companies and in investment agreements. It is especially common in venture capital investment agreements and other transactions where it is important to regulate in advance the possibility of a joint sale of shares.

Although the drag-along right is not expressly regulated by the Serbian Companies Act, it may be agreed in accordance with the general rules of contract law and the relevant provisions of that Act.

If you need to agree a drag-along clause or align it with the company’s founding act, see our contract drafting service.

See also: Tag-along rights, Call option, Put option

This text does not constitute legal advice and is for information purposes only, in accordance with the terms of use of this website.