Understanding Drag-Along Rights in Shareholder Agreements

What is “Drag Along” clause in Share Holding Agreement/ equity funding term sheets?

Drag-along rights allow majority shareholders to compel minority shareholders to sell their shares in the event of a third-party sale. The intent is to avoid minority shareholders blocking a sale and to secure higher valuation and strategic benefits for the selling majority shareholder.

What is the Background/History of Drag along rights?

Drag-along rights, originated in common law jurisdictions, primarily the United States and the United Kingdom. These rights emerged as a solution to challenges faced by majority shareholders or investors during exit transactions, especially in private companies where minority shareholders could block a sale.

In the early days of venture capital (VC) and private equity (PE) investments, majority investors often encountered roadblocks when minority shareholders refused to sell their shares during an exit event. To address this issue, drag-along rights were introduced in shareholder agreements and investment agreements. These rights allowed majority shareholders to “drag” minority shareholders into a sale, ensuring the smooth transfer of the company’s shares to the buyer.

What is the legal framework with respect to the Drag along rights in India?

Drag-along rights are contractually binding as they are incorporated into SHAs, which are governed by principles of contract law and to make it enforceable, drag-along rights must also be incorporated into the company’s Articles of Association (AoA), as the AoA governs the internal management and shareholder rights in the company. In cases of foreign shareholders, drag-along rights must comply with the pricing and reporting requirements of the Reserve Bank of India (RBI). However, during the execution a fair valuation should be given to the minority shareholders and clause should not be drafted in a manner to oppress or supress the rights of minority shareholders.

Drag-along rights aimed at balancing the interests of majority and minority shareholders. They reflect the need for efficient exit mechanisms in private companies, fostering trust and predictability in transactions.