Drag-Along Rights and Founder Exits

Most drag-along clauses are drafted in the heat of a financing round and re-read for the first time at the term sheet stage of an exit. By then it is usually too late to change them. The clause that seemed like boilerplate at Series B becomes the clause that determines whether the founder receives a meaningful payout in a difficult sale.

Three carve-outs are worth fighting for at the time of issuance: a cap on indemnification exposure, a prohibition on disproportionate consideration, and a meaningful tail period on post-closing covenants.

The indemnification cap is the most consequential. A drag-along that obligates the founder to support a sale 'on the same terms' as the lead investors looks neutral on the page; in practice, it can require the founder to give individual indemnification representations and to commit personal proceeds to escrow on a basis that is materially worse than the institutional investors face. The right answer is a clause that limits the founder's indemnification exposure to a defined percentage of the founder's proceeds, with carve-outs for fraud and for breach of personal representations only.

The disproportionate-consideration prohibition is conceptually simple and routinely poorly drafted. The principle is that the consideration paid for each share of a given class should be the same, regardless of who holds the share. The drafting work is in defining what counts as consideration - including side payments, employment arrangements, transaction bonuses, and equity rollovers - and in defining the comparison group with enough precision to prevent the institutional holders from receiving structured value that the founder does not.

The post-closing-covenant tail is the most underappreciated of the three. A founder who sells in a drag transaction may be required to support post-closing covenants - non-competition, non-solicitation, confidentiality - that extend for years after the transaction. The right clause defines a reasonable duration, a reasonable geographic and competitive scope, and a meaningful termination right if the founder is no longer employed by the buyer.

Beyond the three carve-outs, two structural points are worth attention at the financing stage. First, the threshold for triggering the drag - typically a majority of the preferred, often with a separate consent of the institutional lead - should be high enough to ensure that a contested sale requires genuine institutional alignment, not the consent of a single dissatisfied investor. Second, the drag should be drafted with reference to the specific exit forms it is intended to enable; a drag that works cleanly in a stock sale may produce ambiguous results in an asset sale, a merger of equals, or a recapitalization.

Founders who invest the negotiating capital at financing routinely recover it at exit, and the cost of doing so is almost always lower than the alternative.

What we are watching

We will return to this topic across the coming quarter. If you are actively negotiating a transaction where these issues are live, we'd welcome a confidential conversation.

Three takeaways

• The market is settling, but the diligence bar is rising.
• Preparation, not posture, is the source of speed.
• The right structure can move price more than another round of negotiation.