As I have mentioned before, most entrepreneurs focus only on their valuation when raising capital, but there are many terms and conditions that are extremely important for you to understand, negotiate and give importance to. One of these terms is the Drag-along provision clause. In this post I will dissect this agreement and attempt to explain why it is important for investors and why it should be completely understood by founders.
In order to understand the Drag-along provision, we must first understand how a venture capital fund works.
First, VC fund managers (General Partners or GPs) invest other people’s (Limited Partners or LPs) money into startups. The fund does not see any dividends or payoffs until it sells its shares in those startups. Once it sells, it gives the LPs their money back, and only after they have given their LPs a financial return, then the managers can get paid. So, fund managers do not receive any money (carried interest) until they have sold their stock in the businesses they invest in and they must obtain sufficient cash as to pay the investors their entire investment (not just in that particular company, but in the fund as a whole). So, we have to sell our shares, we must exit.
Second, GPs charge a management fee for managing the fund. This management fee is an annual fee that is paid by the Limited Partners. This fee is computed into the return that must be paid to the LPs before the GP can receive their carried interest. Time plays against this possible return. As more time elapses, more fees are invested and less money is available for investments, consequently hindering good returns. The solution that the industry has come up with, is that venture funds have a limited time period: usually ten years. This means that if I invest in your company in year 3, I can only be in your company for 7 years. I cannot be there forever, as I would have to charge my LPs a management fee forever, and I would not have any money to invest in the first place. We have to sell our shares, we must exit.
Now that we have understood why a venture firm must sell and exit their investments, we can dig into the Drag-along.
Drag along provision allows certain shareholders to force others to sell their shares to a potential purchaser and it usually reads something like this:
The holders of all stock shall enter into a drag-along agreement whereby if X agrees to a sale of the Company, the holders of the remaining stock shall consent to and raise no objections to such sale.
This basically states that if the company receives an offer to sell the company and the terms of the acquisition are approved by X, the rest of the shareholders have two options: 1) Get the money from somewhere else (such as another investor or a leveraged buyout) and pay X what X would have received or 2) X will force you to join in the sell by selling your (and all) shares in the company to the acquirer.
This seems tough, doesn’t it? We are going to oblige you to sell your baby! We are going to force you to leave the company you started from scratch! This is, in my experience, the most difficult term to negotiate. You usually hear founders saying that “its not fair” for investors to decide if the company is sold or not. But it all depends on who X is and what conditions X is asking for. Note that nothing is standard, so “fair” is an irrelevant concept. In VC transactions the “who” is essential: who has the right to drag the other shareholders? It’s not the same that a family or friend, for example, usually with low return expectations and with no experience, has a drag-along right than a VC fund, with high return expectations and more experience. So, understand why the Drag-along exists, negotiate the details of the agreement and move forward. If you don’t like the terms, don’t sign.
In my experience (and being incredibly simplistic) there are two types of founders: those that build their companies to sell and those that build their companies for lifestyle. While both are great and admirable, we cannot invest in the latter. We need to invest in founder’s that understand that our business is not in receiving dividends but in selling our stock as expensive as possible, we make money in liquidation events, we only make money when we sell our companies. If we cannot sell, we cannot make money. If we invest in founders that don’t want to sell their business, it is going to be very hard for us to stay in business. So, we must legally bind founders to sell their shares when we believe a good opportunity exists. Please note, that when the Drag-along is well negotiated and given to a serious and experimented VC fund you as a founder will be benefited, otherwise the VC fund will sell its position in the company and you will remain with your full position not receiving any economic benefit from the exit of your investors.
However, there might be times when investors are selling for the wrong reasons, times when they are looking for their own well-being based on particular fund situations and founders must be ware. So, here are some tips for founders negotiating the Drag-along clause:
- I can’t state this enough: Remember that your investor has to exit, so don’t try to negotiate the deletion of this clause. This is a deal breaker for most serious VCs. If we don’t have a legal protection against founders that don’t want to sell, we are blocking our most important action: the exit. If you don’t want to sell, venture capital might not be for you. There are other sources of capital out there.
- Understand your investor’s situation. How many years are they into the fund? How many years do they still have left? What % of the fund are they committing to your company? These details will allow you to better understand their intentions and motivations and allow you to better negotiate the details of the drag.
- Negotiate time. For example, “DILA can’t drag during the first 18 months”.
- Negotiate percentages. For example, “DILA cannot drag us alone, you must have 75% of the preferred shares on board in order to drag”. Remember that who has the right is more important than the right itself.
- Try to get the Drag-along to pertain to following the majority of the common stock, not the preferred.
- Remember that VCs are looking for homeruns. We are not in this business to cap our downside: we are in it to maximize our upside. So don’t be afraid of us “selling your company cheap”. We are not looking to do quick flips. Do not over-complicate it with caps or valuations mechanisms that hinder the upside of all the shareholders, including your own.
It is important to mention that in VC, the Drag-along provisions apply in situations where a potential buyer is only willing to purchase 100% of the company’s shares, so don’t be worried about these clauses when selling part of your company.
I would like to also make a note to any lawyer reading this post: please draft Drag along clauses as simple as possible, otherwise their execution is hampered and might repel buyers from even analyzing the company.
On a final note I leave you with this thought: it is extremely important for founders to remember that the Drag-along agreement, or any term for that matter, is one of a basket of terms and conditions that are part of an overall negotiation. And, as in any deal (and life), there are always trade-offs. Choose your battles wisely.
Looking forward to your thoughts and comments.