From time to time I have written about so-called standard provisions. Standard provisions are often "standard" for a reason – that is they address concerns that people commonly have in a way that makes common sense in a particular context.
One problem is that sometimes parties assert that a particular provision is standard in a context that just isn't the kind of place where it belongs.
My current bug bear is the "drag – along" -- a standard feature of venture investments.
Well the "drag" is standard in venture investments because VCs typically own a controlling interest in the companies they invest in and they want to have more or less unfettered freedom to exit without regard to the structure of the exit. Here is the pure case:
VC owns 60% (or more) of the voting stock of EasyTech, Inc.. VC wants to be able to force an exit and is concerned that for some unforeseen and unforeseeable reason, the exit may have to be structured as a direct to stockholder transaction. That is to say the buyer may need to acquire the stock of Easy directly from the stockholders rather than through a merger (as is mostly done). This means that each stockholder will have to make his or her own decision and, if there is a holdout, it might queer the deal. So, the VC wants to be able to deliver all the shares (or almost all – not going to get into why not 100% at this time). The drag is a contract that permits him or her to do just that, if certain conditions are met. Those conditions are typically (1) board approval of the transaction and (2) approval of the holder of a majority of the preferred stock. In effect, the holders of common stock are required to sell – it does not matter what they think.
Well, this makes sense in the context described above. When the majority wants to sell why should the minority be able to hold them up, and why should it matter what form the transaction takes? That is why the drag is standard in these deals.
But, what about other contexts? Should an angel investor acquiring just 20% of the stock of a company have the same right to drag the holders of 80% of the stock as a VC who owns 60% of the stock? There are a lot of angel investors meeting this general description who present this type of drag as a standard provision, and there are a lot of entrepreneurs who simply accept it without further consideration.
So here are some things to consider.
First, the pure case (where the VC owns a majority): Why is the board part of this at all: From the director point of view it puts pressure on the directors to be extra careful from a fiduciary duty perspective because the only protection for the common stock is board approval. So, in theory, at least, the board may become subject to attack from a common holder who thinks the deal was not "good enough." Remember, the board, in this context, is likely to be dominated by representatives of the VCs and the deal may be a direct to stockholder deal that might not otherwise require a board vote. Why would a VC want this situation? In the pure case, it might make sense to have the drag be a contract between the preferred holders and the common holders and not involve the board.
Second, the minority investor case: Is it really the expectation of the majority that the minority can drag them into a sale they don't want? I don't think most entrepreneurs think that when they take on an angel (even a professional angel group) for a minority investment that the angel will have the legal authority to sell the business out from under the majority. So, in this case, it seems to me that the drag should require some vote of the common as well as the preferred – assuming it should exist at all. The argument for a drag that requires a common and a preferred vote in this context is that the collective majority should not be able to be held up by a pain in the ass minority stockholder. This type of drag is sometimes referred to as a "housekeeping drag" , and it makes a lot of sense to me, in the angel investment context. Again, putting the board in the middle seems to me to invite a potential problem for the directors. I wonder if it is not more consistent with the expectations of the parties that the drag be a purely contractual arrangement among stockholders and not subject to someone's interpretation of their fiduciary duties.
Another question is whether the majority should not be able to drag the investor. It seems highly unlikely than any investor would agree to such a thing on the grounds that they do not want to create a perverse incentive to sell early.
So, when would you put the board in the middle? How about when the drag becomes a bone of contention in a negotiation and you need some compromise to get over the issue?
For a variety of reasons, drag-along provisions don't tend to get a lot of thought. They are often treated as standard or boilerplate with results that sometimes don't really fit the situation.
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