It is common practice for start-up and growth-stage companies to offer shares to employees, or options to acquire shares. Issuing shares is an inexpensive way, at least initially, for a new company to hire talented people before it can afford to pay market rate salaries, and helps to align the interests of the persons who are issued shares with the interests of the majority shareholders and the company.
Simply put, a shareholders’ agreement is a forward looking contract that attempts to structure or manage the relationship between the shareholders of a company. If you are starting a business and have a majority of the shares, you need a shareholders’ agreement that provides drag-along rights.
A drag-along right is a right that enables a majority shareholder to force a minority shareholder to join in the sale of the shares of a company (most often on the same price, terms, and conditions).
In the private company context, where equity investments in companies are not easily sold, a drag-along right is particularly important for a majority shareholder. The absence of a drag-along right greatly reduces the liquidity of a majority shareholder’s equity investment, which adversely effects its value.
In the absence of a shareholders’ agreement that provides for a drag-along right, a minority shareholder might prevent the sale of a majority shareholders’ interest in a private company. A company can always be sold by selling its assets, however share sales are often preferred, which further necessitates the need for drag-along rights.
In order to ensure that a majority shareholder of a private company can sell its interest and maximize the value to potential buyers, it is essential that a shareholders’ agreement, which provides for a drag-along right, is signed before issuing shares to employees or other persons. The drag-along is an important right, however there are many other rights or provisions that can be included in a well-drafted shareholders’ agreement to meet the needs of the founder or majority shareholder of a private company.