M&A
Drag-along - and its power in M&A-deals
A basic example of the consequences when the minority is forced to sell
The shareholders´ agreement might seem to contain boiler plate drag along rights. But when the day comes that the company gets an offer to be acquired, the drag along may turn out to be the deal maker and lead to harsh effects for the minority that entered into the startup at a valuation higher than the founders and the majority investors, or in any case where the majority investors (typically savvy VC investors) have preference shares as down-side protection.
Introduction
This article will get right to the point by providing an example of when and how the drag-along can lead to a minority shareholder being forced to sell even if the shareholder will make a significant loss and even if the shareholder still believes in the company and that the valuation will increase if he/she stays invested.
Read up on the drag-along and tag-along clause and also check-out Youtube channel Business Law Toolbox for more on the topic and other business law matters.
This is not to say that the drag-along and its function to ensure that the company can be sold as a whole without hold-ups from minority investors is per se a negative - it is only to illustrate its power and how negative it can be in an individual case for individual minority shareholders - and that it is very important to not shy away from such facts when discussing shareholder agreements and the power dynamics between the minority and the majority.
A concrete (and realistic) example
The milestone VC investment
The Startup Star LLC gets a great start and attention from VC-investors 5 years into their startup journey. A well-renouned VC invests 20 million USD at a post-money valuation of 200 million.
VC investment: 20 million
Post-money valuation: 200 million
Ownership stake: 10 % (20m invested/200m post-money valuation)
Founder ownership stake: 65 %
Minority ownership stake: 25 %
A share sale happens
As is often the case when VC invests a substantial amount, the company gets great PR and celebrates. The growth continues for the forthcoming 18 months with the company putting great efforts (and monies) into expansions in new regions. Hope, a reputed business angel gets an offer to buy shares on the secondary market for a total of 1 million. Company value 400 million. She jumps on the opportunity.
Hope: Secondary transfer of 1 million
Ownership stake: 0.25 % (1m invested/400m valuation)
The decline with time
Then, as is also typical in the startup world; the company growth loses momentum. Nothing happens, and the company even starts to “decline” for a period of 3 years whereas the markets in general are seeing challenge after challenge.
An opportunistic buy offer
At this point the majority shareholders, the VC and the founders, gets an offer from a strategic buyer the be bought for a 100 million (this is fair market value at that point in time).
The VC and the founders controlling 75 % want to sell because the VC just wants its down-side protection so it can shift the investment to a more fast growing company and the founders have not put any cash into the company so the exit is attractive also for them.
So they trigger the drag along forcing Hope and the other minority shareholders to sell as well.
The result of the EXIT
What will then the result of the transaction be?
Acquisition price: 100 million
VC: Gets its 20 million back (preference shares means they get their investment back first, this is their down- side protection)
Founders: (65 % of the remaining 80 million)= 57,8 million
Minority shareholders: 22,2 million is left for the minority
Hope gets (0,25%/0,9)*80 million=222 222 USD
So the result for Hope who was FORCED to sell through the drag-along is;
She invested 1million – forced to sell for 222 222 USD = made a loss of - 787 778 USD
What can we learn about the drag-along right?
The different timing, valuation and share classes will mean that the incentive and results of a sale will be completely different and the triggers to force someone to sell or to have a right to tag along when someone wants to sell can therefore be extremely powerful and also dangerous. So make sure you have a realistic understanding of the incentives and hurdles that the controlling shareholders have and if those hurdles are harmful for your investment.
London, 2024-09-23
Author, Kat Strandberg
Email: kat@stgcommerciallaw.com
Introduction
This article will get right to the point by providing an example of when and how the drag-along can lead to a minority shareholder being forced to sell even if the shareholder will make a significant loss and even if the shareholder still believes in the company and that the valuation will increase if he/she stays invested.
Read up on the drag-along and tag-along clause and also check-out Youtube channel Business Law Toolbox for more on the topic and other business law matters.
This is not to say that the drag-along and its function to ensure that the company can be sold as a whole without hold-ups from minority investors is per se a negative - it is only to illustrate its power and how negative it can be in an individual case for individual minority shareholders - and that it is very important to not shy away from such facts when discussing shareholder agreements and the power dynamics between the minority and the majority.
A concrete (and realistic) example
The milestone VC investment
The Startup Star LLC gets a great start and attention from VC-investors 5 years into their startup journey. A well-renouned VC invests 20 million USD at a post-money valuation of 200 million.
VC investment: 20 million
Post-money valuation: 200 million
Ownership stake: 10 % (20m invested/200m post-money valuation)
Founder ownership stake: 65 %
Minority ownership stake: 25 %
A share sale happens
As is often the case when VC invests a substantial amount, the company gets great PR and celebrates. The growth continues for the forthcoming 18 months with the company putting great efforts (and monies) into expansions in new regions. Hope, a reputed business angel gets an offer to buy shares on the secondary market for a total of 1 million. Company value 400 million. She jumps on the opportunity.
Hope: Secondary transfer of 1 million
Ownership stake: 0.25 % (1m invested/400m valuation)
The decline with time
Then, as is also typical in the startup world; the company growth loses momentum. Nothing happens, and the company even starts to “decline” for a period of 3 years whereas the markets in general are seeing challenge after challenge.
An opportunistic buy offer
At this point the majority shareholders, the VC and the founders, gets an offer from a strategic buyer the be bought for a 100 million (this is fair market value at that point in time).
The VC and the founders controlling 75 % want to sell because the VC just wants its down-side protection so it can shift the investment to a more fast growing company and the founders have not put any cash into the company so the exit is attractive also for them.
So they trigger the drag along forcing Hope and the other minority shareholders to sell as well.
The result of the EXIT
What will then the result of the transaction be?
Acquisition price: 100 million
VC: Gets its 20 million back (preference shares means they get their investment back first, this is their down- side protection)
Founders: (65 % of the remaining 80 million)= 57,8 million
Minority shareholders: 22,2 million is left for the minority
Hope gets (0,25%/0,9)*80 million=222 222 USD
So the result for Hope who was FORCED to sell through the drag-along is;
She invested 1million – forced to sell for 222 222 USD = made a loss of - 787 778 USD
What can we learn about the drag-along right?
The different timing, valuation and share classes will mean that the incentive and results of a sale will be completely different and the triggers to force someone to sell or to have a right to tag along when someone wants to sell can therefore be extremely powerful and also dangerous. So make sure you have a realistic understanding of the incentives and hurdles that the controlling shareholders have and if those hurdles are harmful for your investment.
London, 2024-09-23
Author, Kat Strandberg
Email: kat@stgcommerciallaw.com