Drag-along rights represent a legal mechanism that typically allows majority shareholders to compel minority shareholders to sell their shares to a third party under the same terms. This option has a significant impact on the dynamics among company members and can be crucial in situations requiring a swift and efficient sale of the entire company.
Drag-along rights are an important segment of the memorandum of association or shareholders’ agreement, allowing majority members to efficiently execute the sale of the company under the best conditions. When properly regulated, this option can accommodate the interests of both majority and minority shareholders and balance between them. It can also enhance the stability and attractiveness of the company to investors, especially if the long-term goal of the members is to sell the company. The importance of this clause is particularly evident in the formation of startups, where multiple members join to establish the company primarily for its development and sale once it reaches a certain value.
What Are Drag-Along Rights?
Drag-along rights are a subjective right agreed upon among members, typically allowing a majority shareholder to require other shareholders to transfer their shares to a third party if the majority shareholder finds a buyer for their own shares. This ensures that the potential buyer can acquire 100% of the company’s shares, which is often a crucial condition for many investors.
Although the Companies Act of the Republic of Serbia does not explicitly regulate drag-along rights, they can be incorporated through the company’s founding documents or, preferably, through a shareholders’ agreement. The law allows members to freely arrange their rights and obligations within the company’s agreement, provided such provisions do not conflict with imperative legal norms, thus allowing for the regulation of this type of relationship. Article 20 of the Companies Act of the Republic of Serbia permits founders to arrange their mutual relations in a manner they deem appropriate, unless otherwise specified by law, thus opening the door to include drag-along provisions.
Drag-along rights function by allowing one member to request that other members sell their shares to a third party under the same terms as the initiating member. The agreement can also stipulate that this request be presented, as an intermediate stage, at a session of the company’s General Meeting, where a decision is made by a specific majority of all members, potentially limiting its scope depending on who makes the request
To ensure the legal effectiveness of drag-along rights, it is necessary to, for example, provide the following:
Incorporation into a shareholders’ agreement or a memorandum of association: Drag-along rights should be clearly defined and included in the shareholders’ agreement or the company’s memorandum of association. The inclusion of such a clause must be precise and detailed to avoid potential legal uncertainties and interpretations.
A Notification to the Members: A member intending to exercise drag-along rights should formally notify the other members in writing of their intention, providing all relevant information about the potential buyer and the terms of the transfer.
For example, the agreement might stipulate that a member wishing to exercise their right must notify the other members in writing, detailing the identity of the potential buyer and the agreed terms. Subsequently, all members are required (unless otherwise determined by the general meeting) to conclude a transfer agreement with the third party within a specified period, for example an eight day period.
Like most options, drag-along rights in their basic form simultaneously protect the interests of one side of the members while placing others at an unenviable position. Typically, it is the majority members who negotiate the sale and invoke these rights. Consequently, minority shareholders must be aware of the risks they are exposed to. Therefore, the clause should ensure that the negotiation process is at least more detailed and transparent. The implementation of this decision internally also plays a crucial role.
Drag-along contractual clause
Agreements that regulate drag-along rights often include specific conditions that further define the members’ rights and obligations:
Minimum Company Valuation: A company member, for example, may only exercise drag-along rights if the agreed compensation for acquiring 100% of the shares equals the company’s asset value at the time of notification, which should not be less than a specified amount, or be tied to book value, EBITDA for a certain year, etc. Establishing a minimum value helps protect members who do not have this option.
Notification of Intent: A member intending to use drag-along rights must notify the other members in writing of their intent to transfer the shares, the identity of the buyer, the agreed terms and the method of the transfer.
Prospective general meeting decision: the company’s general assembly may make the final decision on the transfer of shares to a third party by a majority vote as prescribed by the founding documents. Once a decision is made, each member must proceed to conclude a transfer agreement with the third party under the same terms.
It is important to note that the obligation to transfer the shares exists regardless of the size or percentage of shares held by each member unless otherwise stipulated in the contract. All members are therefore obligated to undertake all necessary legal and factual steps to complete the share transfer.
Penalty clause (liquidated damages) and compensation for damages
In the event of a breach of the contractually stipulated drag-along rights, the contract may stipulate a contractual penalty. A member who obstructs the execution of drag-along rights or fails to comply with the assembly’s decision may be required to pay a penalty. Additionally, such a member might be obligated to compensate the company and other members for any incurred damages. These mechanisms provide additional protection and security for all company members, increasing the likelihood that contractual obligations will be fulfilled as agreed.
Origin of the legal concept
Drag-along rights originated in the Anglo-American legal system, particularly in the United States and the United Kingdom. These clauses are commonly used in company formation agreements to ensure efficiency in company sales and protect the interests of majority shareholders.
Drag-along clauses became popular in venture capital agreements during the 1980s in Silicon Valley. Venture capital investors began using these clauses to ensure exit strategies involving the sale of the entire ownership of startup companies.
Although drag-along rights are not explicitly regulated in most legal systems today, their application is widely accepted and adapted to the principles of contractual law.
This text is for informational purposes only and does not constitute legal advice in accordance with the terms of use of this web presentation.
