Keeping Ownership in the Family: Part III, The “Drag Along” Provision

Part III of this three-part Keeping Ownership in the Family series will discuss at a high level the use of what is commonly referred to as a “drag along” provision – a very common provision found in buy/sell or stockholders agreements for closely held and family-owned companies. Part I of this series discussed rights of first refusal. Part II discussed co-sale or “tag along” rights. Along with those two, a “drag along” right can be one of the most useful provisions in a stockholders agreement. Unlike the other two, however, which serve as disincentives to any owner trying to sell outside of the ownership group, a “drag along” serves a different purpose. It ensures that, when the time is right, a sale of the business can be made completely and no family member can hold out or block that sale. In this way, it forces unity and alignment among the owners and ensures the ownership group can receive maximum value for its business, should it ever decide to sell.

A “drag along” provision requires the identification of the decision maker or decision makers. This is the person or group that will be able to decide if and when the family business should be sold. It can be the patriarch or matriarch of the family, the individual with the largest equity ownership, the owners collectively representing 51% of the equity ownership or any other person or combination of persons. If the company seeks out or receives a genuine offer from a third party to buy the company, the decision falls to the chosen decision maker. If the decision maker does not wish for the business to be sold, no one can be forced to sell. If the decision maker does wish for the business to be sold, that decision maker can compel all the other owners to sell their respective interests on the same terms and conditions as offered to the all other owners.

This is a very valuable tool. Many families aspire for their businesses to stay in the family for generations. Many businesses fulfill that aspiration. Others, however, reach a point where it makes the most sense for the business and the family to sell to a third party and allow the family to enjoy the sale proceeds and pursue other interests. But if there is not perfect unanimity among the family owners that selling is the right course, it can be very difficult. This is because most buyers in the market place are not interested in buying partial interests – even majority partial interests – in companies. If there is a brother, sister, aunt, or nephew that disagrees with the sale and refuses to participate, this refusal will frequently be enough to destroy any possibility of a sale. Certain financial buyers may buy less than 100% of a business, but only do so on the understanding that the remaining interest is held by a highly-motivated management team that will work hard to continue to grow the company. They are not interested in having 10% of their business held by a disgruntled family member who may or may not have been an active part of the company.

The protection against this unfortunate scenario is a “drag along” provision. If a decision maker has been appointed, that individual or group of individuals can decide if a sale makes sense. If so, exercising the “drag along” provision can compel everyone to participate so the company can actually be sold.

As with rights of first refusal and co-sale rights, there are numerous variations and nuances to a “drag along” provision and a skilled attorney can craft the provision to reflect the precise balance of equities and interests for a given family-owned business. The key, however, is the decision maker. Every business is different, and every family dynamic is different, so there is no “one size fits all” to this point. A family must balance the need for strong and centralized decision making with the desire to be as inclusive as practically possible without losing the benefit of the provision. Obviously, the role of decision maker for purposes of a “drag along” provision grants a tremendous amount of power to the person or persons selected. Without a “drag along” provision, though, every individual owner may have the practical ability to block a sale of the business that the rest of the family might want. Most families would rather put the power in the hands of a decision maker they agree on from the outset, rather than “wait and see” and hope there are no disagreements years down the road when the business reaches that crucial point.