Term Sheet Demystified: Drag Along Right De-Constructed

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Term Sheet Demystified: Drag Along Right De-Constructed

A drag-along right, as the name suggests, is the power of the investor to compel the entrepreneur to sell his equity stake in the event that a certain event (called the “trigger” takes place) . It is the most infamous of all investor rights, and is responsible for the rather unfair term “vulture capital” which is associated with private equity investors.

A typical drag along clause reads as follows:

The Founders shall consent to and raise no objections to such sale if at the end of [X] years, no exit opportunity has been presented to the investor

Obviously, the typical clause will have a lot more add-ons and conditions, but the essence of it has been communicated above. mouse_trap

What is Right

The essence of the right is to protect the investor against the risk of his investment becoming worthless. In venture capital terms, this is called “downside protection”. By having this right, at the end of say, 5 years, if the investor is unable to see the business growing and expanding, he is entitled to have the business sold off to a purchaser at whatever value the business is worth at that time.

Say for instance you are starting an e-commerce company, which is involved in the sale of lingerie. Because of intense competition and rivalry in this segment, your business fails to take off. Now, at the end of 5 years, the investor may not see a prospect for your business and may feel that it is better if the business is sold to a rival who has traction in the marketplace.

At this time, the investor will exercise the drag along right, and compel you to sell the business to that rival. You, having signed the agreement with the investor, will not be in a position to refuse and will have to agree with the terms of the offer. You can naturally voice an opinion, but do not expect to have much of a say.

So, isn’t the dice loaded against me here?

Yes and no. Yes because you may be compelled to sell the business at the end of a certain period depending on the way in which the right has been fleshed out.

And no because if at the end of a five year period, if you have not managed to get any traction, you might be better off finding a person willing to purchase the business, so that you get an exit. Finding a willing purchaser yourself might be much more difficult than if it were left to investors, who typically have a much deeper reach and wider network than the entrepreneur.

[About the author: Contributed by Hrishikesh Datar, founder of vakilsearch.com, online legal services provider (Legal Advice, Legal Documents & more).]

Also see: Understanding Termsheet: Right of First Refusal

» Read the series on Demystifying Term sheets

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