Drag Along Rights Are Now Commonplace

As anyone who has been on either side of a venture capital deal knows, a fund raising agreement usually has so many provisions that someone inexperienced needs a glossary to read it.

Often one of these provisions discusses “drag along rights.” As Investopedia explains, these rights allow “a majority shareholder to force a minority shareholder to join in the sale of a company.”

The inclusion of drag along rights in VC agreements is becoming more common, according to data assembled by the law firm Cooley LLP. The figure below shows the share of venture capital agreements for which Cooley provided the legal work in which drag along rights were included. While the proportion of agreements with drag along rights never exceeded 50 percent before 2006, it has never fallen below 50 percent since then. And since the second quarter of 2009, it has exceeded 60 percent in every three month period measured.

Why the increased use of drag along rights? As venture capitalist Brad Feld explains in his blog, when the sale of a company occurs at a low price, common stockholders (who are often the founders) usually earn very little after they pay the venture capitalists’ liquidation preference. As a result, the entrepreneurs are often resistant to such sales. To ensure they can sell companies even when founders (or other shareholders) oppose the sale, venture capitalists put drag along rights into their financing agreements.

The greater use of drag along rights reflects a belief among investors that venture capital-backed companies may have to be sold relatively cheaply in the future.

Source: Created from data from the Cooley Venture Capital Report, various issues

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Scott Shane Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of nine books, including Fool's Gold: The Truth Behind Angel Investing in America ; Illusions of Entrepreneurship: and The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By.