This article is written by Prince Pathak, pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from lawsikho.com.

Introduction

The Shareholders Agreement is an essential legally enforceable arrangement between the shareholders and the company as well as between the shareholders themselves. There is one clause that has been provided in the shareholder agreements in the form of exit rights such as Drag-along right. Exit right plays a vital role for financial investors, and they always seek the way to exit from the venture after earning profits. These rights have usually been found in a shareholder agreement and can be triggered by various kinds of sales such as a merger, acquisition, and sale of substantial assets. In this article, the author tries to explain one of the exit rights, i.e. Drag-along right, its importance in the shareholder agreement with its shortcomings.

What is a drag along right

Drag along right is an essential right under the corporate agreement. This right allows the majority shareholder to force the remaining minority shareholder to join in the sale of a company on the same price and condition that offered to majority shareholders. In other words, drag along right enables the majority shareholder to drag the minority shareholder in the sale of the company, and majority shareholders must have to offer the minority shareholders the same price that the third party has offered the majority shareholders. So, through this right majority shareholder can drag along the minority shareholder in the sale of the company.

For example- ABC Pvt. Ltd. has four shareholders; they are Mr P, Mr Q, Mr R, and Mr S holding 30%, 30%, 30% and 10% respectively. Mr P, Mr Q and Mr R want to sell the company to Mr X, and Mr X wants to acquire 100% shares of the company and when Mr S, has not given his consent to this particular deal. In such cases, if there is drag along right in the shareholder agreement between the Mr P, Mr Q, Mr R, and Mr S. Then through this right, these three majority shareholders can drag the minority shareholder, i.e. Mr S in this deal and can force him to sell his shares. However, majority shareholders Mr P, Mr Q, and Mr R must have to offer the minority shareholder (Mr S) the same price that a third party (Mr X) has offered them.

Why is a drag along with right important

Drag Along tight, also known as bring along right^[i]. It empowers the majority of shareholders to sell a company to the third party without the consent of minority shareholders. However, minority shareholders still, in this case, receive an equal sale price that the third party has offered to the majority shareholders, and that’s why the drag-along right is a win-win situation. Following are the importance of drag along right in an agreement.

1. Drag along right encourages the sale and helps to get complete ownership of the company. An investor in a company always negotiates a drag-along right during the agreement. In the field of Merger and Acquisition (M&A) drag along plays a crucial role and helps to get complete ownership.
2. Drag along right also make possible for majority shareholders to identify a prospective buyer to effectively conclude a transaction as they give guarantees to the buyer that the execution of the offer does not need further shareholder approval until the majority shareholder is on board
3. From the perspective of the majority shareholder, it eventually secures a higher “premium for control” share valuation by providing the entire interest in the target company to the prospective buyer.^[ii]
4. Drag along right is indeed so beneficial for a majority shareholder. However, it is also helpful for a minority shareholder to get an equal sale price, terms, and conditions the same offered to the majority shareholders that they may usually not get in an ordinary transaction.
5. This clause also ensures that minority shareholders should be treated fairly even when they are forced to give consent on the deal.
6. The drag-along right and tag along the right are very useful for balancing the act of a majority shareholder and minority shareholder.

Reasons to consider using a drag along right        

Before adding a drag-along right in an agreement, it is crucial to understand the nuances of drag along right before signing a deal. The following are the reasons that we should keep in mind before using a drag-along right.

1. A drag-along can be added in various types of transactions, such as those transactions that transfer 50 percent of voting power and sale of the company’s assets. It is also found in a lease document. Further, merger and acquisition transactions also allow the drag-along right. 
2. A significant loom that can trigger a drag-along right? Basically, drag along rights can be triggered by majority shareholders of a company or shareholders having 51% shares minimum are allowed to trigger a drag-along right. In other words, 51% is the minimum percentage that is required to trigger the drag along right.
3. Drag along rights is essentially a buy-sell agreement between the shareholders that mandate the sale of shares. Drag along right does not infringe the rights of minority shareholders or third parties, as they are entered into between consenting shareholders. 
4. Drag along and tag along right are exit rights that benefit the shareholders to dispose of their shares because usually, the company’s constitution restricts the shareholder to transfer their shares. 
5. It is prudent to review the company’s constitution and shareholder agreement to ensure that exits’ rights are properly drafted before investing in a company.  

Disadvantages and reasons not to consider using drag along rights

1. The main disadvantage with the drag along right is related to force sale transactions for the minority shareholder. Such a right would, therefore, make minority owners forfeit the potential gains which should have been gained if the company had not been sold. Consequently, the minority shareholders will, therefore, not obtain adequate equity for their share.^[iii] Even when minority shareholders would be dragged along, drag along right would offer many more pros than cons.
2. It is a well-settled principle for private limited companies to include drag along and tag along right in an agreement. However, in order to prevent potential abuse of drag-along rights and to save public interest involved in the company, it must ensure that these rights must not be used in an arbitrary manner^[iv].
3. Drag along, and tag-along rights are considerably new to India, and therefore overseas companies and foreign investors are concerned about the binding effect of such rights. In the case of public limited companies, these provisions were unlawful in India prior to 2013 because section 111A of the companies Act, 1956 required shares of a company to be freely transferable. However, after the judgment of the Bombay high court and the companies Act, 2013 section 58 (2) authorizes the shareholders to include drag along or tag along in a shareholder agreement to incorporate restrictions in the transfer of shares. In the case of private limited company drag along or tag-along right is enforceable in India as long as they are introduced by the shareholder in their’ shareholders agreement and Articles of association^[v]. Hence, due to the lack of specific provision over these rights, it needs a severe deliberation for shareholders before investing overseas.
4. Drag along rights could include general lock-up period, prohibiting the rights from being exercised until a certain period of time has passed.
5. When shareholders are concerned that they are being pulled there are a variety of provisions that could protect them such as, they might have the right of first preference to acquire the majority of investor shares on the same conditions negotiated by a third party^[vi].

Conclusion

Drag along right authorizes the majority shareholder to ‘drag’ the other shareholders in a sale. From the perspective of majority shareholder drag along right intends to ensure that the majority shareholder would be able to sell the whole company without any restriction. Drag along right makes the share more valuable because it lets the majority shareholder force others to sell the shares at the same price and on the same condition. However, minority shareholders should ensure that such a sell will not put them in a disadvantaged stage. Drag along right is different from tag-along right, which allows minority shareholders to join a company or firm action with the majority shareholders. Drag along right helps to eliminate minority shareholders and pave the way for majority shareholders to sell the whole company to the potential buyer. Nevertheless, while adopting drag along right in an agreement, the company or firm so adopting would have to provide for a notice regarding such adoption to the minority shareholders.

We all know the fact establishing a firm or company is an arduous task and it is a foremost important thing for shareholders and investors to include preventive measures while entering into a shareholder agreement in order to protect themselves from future disputes.

References

^[i] https://www.upcounsel.com/drag-along-rights

^[ii] https://www.lexology.com/library/detail.aspx?g=6c1a4968-6765-4660-bb45-b4a90c282d59                 

^[iii] https://lexforti.com/legal-news/everything-about-drag-along-rights/

^[iv]https://dealaware.blogspot.com/2020/07/drag-along-rights-tag-along-shareholder-agreement.html

^[v] https://dealaware.blogspot.com/2020/07/drag-along-rights-tag-along-shareholder-agreement.html

^[vi] https://singaporelegaladvice.com/law-articles/shareholders-exit-rights-what-you-need-to-know/

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