Drag-Along Rights

What are drag-along rights?

Drag-Along Rights (German: Mitveräußerungspflicht) oblige the remaining shareholders to sell their shares to an acquirer on the same terms if an agreed majority sells the company. The obligation is also called Mitverkaufspflicht in German and, from the majority's point of view, Mitnahmerecht. Contracts mostly speak of the drag-along clause, and the singular drag-along right means the same. The arrangement makes it possible to sell all shares even though not all shareholders agree.

Acquirers generally want to take over 100% of the shares. A remaining minority would keep its shareholder rights, such as information rights and the right to challenge resolutions in court. That would make integration, restructurings and a later onward sale more difficult. Without a drag-along obligation, each individual shareholder could prevent a sale or make consent conditional on special advantages. In German growth companies, the clause is found in the shareholders' agreement, a contract of all shareholders alongside the articles of association. It is concluded in a funding round together with the participation agreement, which governs the investor's entry. Its key points are usually already in the term sheet, the declaration of intent at the start of the negotiation.

Process of a drag-along sale

The drag-along obligation is the counterpart of the tag-along right (Mitverkaufsrecht), and both clauses usually stand side by side in the same agreement. The process follows a fixed pattern:

1. An acquirer submits an offer for all shares.
2. The dragging shareholders check whether the agreed majority and the other conditions are met, in particular an agreed minimum price.
3. They send the remaining shareholders a written notice (drag notice) stating the acquirer, the price per share, the main contract terms and the planned closing date.
4. The obliged shareholders conclude the purchase agreement on the same terms within the agreed period and assign their shares.
5. The proceeds are divided among all sellers according to the agreed distribution of proceeds.

Trigger threshold and minimum price

Who may trigger the sale

The core of the negotiation is the question of who can trigger the obligation. A combination of a capital majority and the consent of the investors is widespread, for example a majority of 50 to 75% of the share capital (Stammkapital, the sum of the nominal amounts of all shares). This majority must at the same time include the majority of the investors' shares. Founders often additionally demand the consent of a majority of the founders' shares for as long as they are operationally active. A threshold that is too high returns to individual shareholders the blocking position that the clause is meant to remove.

Some agreements lower the threshold if no sale comes about within an agreed period after the funding round. Founders view such time-based scales particularly critically because they remove the timing of the exit from their decision.

Minimum price and equal treatment

The most important protection for the obliged shareholders is a minimum price (floor). The obligation then applies only if the purchase price reaches an agreed minimum valuation or secures every investor a certain multiple of the capital invested. The second protection is the principle of equal treatment: all sellers receive the same consideration on the same terms for each share of the same class. Special advantages only for the dragging shareholders, for example a highly paid consulting contract, are excluded or included in the distribution of proceeds.

Drag-along and liquidation preference

The drag-along obligation determines that a sale takes place. How much each shareholder receives follows from the distribution of proceeds in the shareholders' agreement. If investors have a liquidation preference, that is, a contractual priority in the distribution of proceeds, they receive their preferred amount first. Only the remainder is distributed to the other shareholders. The purchase agreement therefore often states a total price, which the sellers divide among themselves according to the agreed ranking. Equal treatment then applies per class of shares: shares with equal rights receive the same amount.

With low purchase prices, this shifts interests considerably. Investors get their capital back through the preference, while little remains for founders and business angels (private individuals who invest their own money early). The minimum price protects against this situation. A waterfall analysis calculates, step by step, how proceeds are distributed among the shareholders. For several purchase prices, it shows before signing from which price the clause is tolerable for which group.

Drag-along rights under German GmbH law

Notarisation and transfer restrictions

The obligation to assign shares in a GmbH (German limited liability company) requires notarisation under Section 15(4) of the German Limited Liability Companies Act (GmbHG). Because the drag-along obligation creates such an obligation, the shareholders' agreement is notarised, and in full. The formal requirement covers all arrangements that form a single transaction with the obligation to assign. The later assignment itself must also be notarised under Section 15(3) GmbHG.

Many articles of association also contain a restriction on transfer (Vinkulierung) under Section 15(5) GmbHG: every transfer of shares then requires consent, for example of the company or the shareholders' meeting. The shareholders therefore undertake to give the necessary consents in the event of a sale. They also waive their pre-emption rights, that is, the right to buy the shares of a selling fellow shareholder themselves.

Powers of attorney and enforcement

If an obliged shareholder refuses to cooperate, the only recourse would be an action for the necessary declarations, and hardly any acquirer waits for that. Practice therefore secures the obligation by powers of attorney. In the notarised agreement itself, the shareholders authorise the dragging shareholders or a trustee to conclude the purchase agreement and assignment in their name in the event of a sale. The power of attorney is granted irrevocably for this purpose and limited to the content of the clause.

Limits arising from the duty of loyalty

The exercise of the drag-along obligation is subject to the shareholders' duty of loyalty (Treuepflicht), that is, the duty of every shareholder to take appropriate account of the interests of the company and of fellow shareholders. A sale to a related party below value or with hidden special advantages can therefore be impermissible even if the formal conditions of the clause are met.

Worked example: drag-along with a liquidation preference

In a GmbH, founder A holds 40%, founder B 30%, a group of business angels 10% and an investor 20%. The investor has invested EUR 8 million and has a simple, non-participating liquidation preference. The investor therefore receives its capital back once in advance or, if that is more, its share of the proceeds, but not both. The drag-along obligation can be triggered by shareholders with at least 60% of the share capital, provided that the investor is among them. An acquirer offers EUR 30 million for all shares.

• Threshold: founder A and the investor together hold 40% + 20% = 60%. The obligation can be triggered even if founder B and the business angels do not agree.
• Investor: it receives the higher amount of the preference (EUR 8 million) and the pro rata proceeds (20% × EUR 30 million = EUR 6 million), that is, EUR 8 million.
• Remaining proceeds: EUR 30 million minus EUR 8 million = EUR 22 million for the other 80%, which is EUR 0.275 million per percentage point.
• Founder A: 40 × EUR 0.275 million = EUR 11 million. Founder B: 30 × EUR 0.275 million = EUR 8.25 million. Business angels: 10 × EUR 0.275 million = EUR 2.75 million.
• Check: 8 + 11 + 8.25 + 2.75 = EUR 30 million.
• Variant with a purchase price of EUR 12 million: the investor again receives EUR 8 million; pro rata it would be only EUR 2.4 million. For the other 80%, EUR 4 million remain, that is, EUR 2 million for A, EUR 1.5 million for B and EUR 0.5 million for the business angels.

With 20% of the shares, the investor receives about 27% of the proceeds at EUR 30 million and two thirds at EUR 12 million. Without a minimum price, founder A and the investor could also enforce the second offer against the will of founder B. A minimum price of, for example, EUR 20 million would have exempted the offer of EUR 12 million from the obligation but not the offer of EUR 30 million.

Distinctions: drag-along, tag-along and squeeze-out

• Tag-Along Right: the minority's right to join a sale. The drag-along obligation is the obligation to sell along at the request of the majority.
• Change of Control: denotes the event of a change of control, to which other contract clauses are linked. The drag-along obligation is a tool with which a change of control is carried out for all shares.
• Squeeze-out: the statutory exclusion of minority shareholders of an AG (German stock corporation) by a majority shareholder with at least 95% under Sections 327a et seq. of the German Stock Corporation Act (AktG). No such procedure exists for the GmbH, hence the contractual solution.
• Protective Provisions: the investors' catalogue of consent matters, often also for the exit. It regulates whether a sale may take place; the drag-along obligation regulates that all then sell along.

Common mistakes

• Trigger threshold too low. If a minority of the shares can trigger the obligation, the company can be sold against the will of the majority of the shareholders.
• No minimum price. Without a lower limit, the clause also forces a sale in which hardly any proceeds remain for the common shares after the preferences have been served.
• No rule on special advantages. Consulting contracts, reinvestments or retention bonuses for individual sellers are economically part of the purchase price and must be disclosed and regulated.
• Formal defects. If notarisation is missing, the drag-along obligation is not enforceable, and the formal defect can affect the entire shareholders' agreement.
• Unclear ranking against consent requirements. If the drag-along obligation and consent requirements for the exit stand side by side unconnected, it is open which rule takes precedence. It is usual to clarify that consent is deemed given where the obligation is validly exercised.

Frequently asked questions

What does a drag-along clause regulate?

It determines who may trigger the sale along, from which price the obligation applies and on what terms the remaining shareholders must sell. In addition come the form and deadline of the drag notice, a power of attorney for the purchase agreement and assignment, and limits on the liability of the dragged shareholders. A general template helps little because threshold and minimum price depend on the shareholder structure and the distribution of proceeds.

Are drag-along rights effective in a GmbH?

Yes, if they are implemented correctly. The obligation to assign must be notarised, and the clause must be coordinated with the articles of association, transfer restrictions and pre-emption rights.

How are minority shareholders protected under drag-along rights?

Above all by the clause itself: a trigger threshold that, alongside the capital majority, often requires the majority of the investors, a minimum price and equal treatment per class of shares. The shareholders' duty of loyalty also applies. A sale below value to a related party therefore remains open to challenge despite the clause.

Do all shareholders receive the same price in a drag-along?

The same price per share of the same class, but not necessarily the same proceeds per percentage point of the holding. Liquidation preferences rank first, so that at a low purchase price a founder often receives considerably less than their percentage corresponds to.

Must a dragged shareholder give warranties?

As a rule only for their own shares, that is, as to existence, freedom from encumbrances and power of disposal. Warranties on the business are usually given by the founders and the management, in part supplemented by a warranty insurance. The liability of the dragged shareholders is usually limited pro rata and to their proceeds.

Does the drag-along obligation also apply to employees with virtual shares?

No. Holders of virtual shares are not shareholders and have no shares to sell. Their payment entitlement in the event of a sale follows from the participation plan, which usually itself defines the exit as a payout event.

The Roemer Capital view

Roemer Capital calculates the drag-along obligation against the distribution of proceeds before a funding round is signed. For several purchase prices, a waterfall calculation shows what reaches founders, business angels and investors. From this, Roemer Capital derives with the client which trigger threshold and which minimum price are economically defensible. The company's law firm is responsible for the wording and notarisation.

In a sale process, Roemer Capital examines early whether the clause supports the actual shareholder structure: whether the necessary majority is in place, whether the powers of attorney are complete and whether individual shareholders are hard to reach. An acquirer expects all shares to be available at closing. Open points on this cost time in a sale process of 6 to 12 months, which preparation can avoid.