Wednesday, 22. May 2024

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Drag-along clauses in small, privately held corporations

First of all, what does this term mean? Drag along clauses give one shareholder, who intends to sell his or her shares, the right to demand from the other shareholder to sell his or her shares, too. Typically, such drag along clauses are meant for the benefit of a majority shareholder. If he intends to sell his shares, the minority shareholder´s shares are, as the term suggests, dragged along.

Now, what is the purpose of such a clause? More often than not, a buyer is interested in acquiring the company as a whole, that means one hundred percent of it. He wants to be in full control of the object of his desire, not having to bother with what a minority shareholder´s interests may be. Therefore, the purchase price will be higher if the seller can offer the purchaser full control of the company and not just a majority share.

On the other hand, the risks and disadvantages to the minority shareholder are also obvious: He has no control as to when he must exit the company and under what conditions. Neither can he choose the purchaser nor the purchase price. His shares are simply dragged along under the terms that the majority shareholder has agreed upon with the buyer.

From a legal point, it is unclear whether such drag along clauses are valid or not under German law. They can often be found in a „professional“ context, for instance in venture capital financing and joint-venture deals. In order to avoid abuse, however, even in such contexts certain preconditions should be met. Above all, there should be a minimum purchase price that has to be paid per share.

The prevailing legal opinion in Germany seems to be that such clauses are basically valid, unless the seller abuses his position to the detriment of the minority shareholder.
Nevertheless, the question should be asked whether clauses that may so easily be abused should be valid in the first place. It is quite easy to think of cases where the majority shareholder abuses his right to drag the minority shareholder along, for instance by agreeing upon a relatively low purchase price with the buyer. …

What is particularly interesting for lawyers working with small, privately or closely held corporations is whether drag along clauses should be considered valid at all in such a context. Such companies often have only a few shareholders who originally had the intention of working together for a long time on a basis of mutual trust. Unlike in venture-capital transactions, there is no need to provide one shareholder with an exit strategy solely intended for his own benefit. Think of the following case: Shareholder A and shareholder B have founded the company together and have worked together for 20 years. Now, shareholder A, who is 10 years older than shareholder B, intends to transfer his shares to his son, possibly for a purchase price that is considerably below the market value. What justification could there be to force shareholder B to also sell his shares to A´s son for the same price? I can think of none.

I would argue that in such a context drag along clauses are legally invalid in the first place, or  that there should be at least an assumption to that effect, and that someone who wants to rely on such a clause must prove beyond a reasonable doubt that his intentions are fair to the other shareholder.

Dr. Wolfgang Gottwald
Attorney at Law

Attorney at Law

Leopoldstraße 51
80802 München

Tel.: 089/383 293-10
Fax: 089/383 293-13