[Startup Must-Know Laws] Structuring for Investment Exit: Call and Drag

Startup Law Essentials by Heecheol Ahn

When a financial investor makes an equity investment, the most important consideration is ultimately the possibility of exit. If the company succeeds in listing through an IPO, the investor can sell their shares in the public market. However, if the IPO fails or is delayed, selling unlisted shares becomes difficult. For this reason, investors seek to include various exit mechanisms such as put options, call options, and drag-along rights in the share subscription agreement or shareholders’ agreement.

The most direct exit mechanism is the put option (right to require sale of shares). If certain events occur—such as failure to achieve a qualified IPO—the investor can require the company or a related party to purchase their shares at a pre-agreed price. From the investor's perspective, this provides the clearest exit possibility. However, if the company is required to repurchase the investor’s shares, the investment may be recognized as a liability rather than equity on the company’s financial statements. This increases the company’s debt ratio and may negatively impact future growth or IPO prospects. Similar accounting burdens can arise if the related party is a legal entity.

Due to these concerns, in practice, a call-and-drag structure is often used instead of a put option. A call option grants the related party the right to purchase the investor’s shares, and a drag-along right allows the investor to require that the shares of major shareholders or related parties be sold together with theirs during an exit. In other words, the call-and-drag structure allows the related party to exercise the call option and buy the investor’s stake in situations where exiting is difficult, such as IPO failure or deteriorating business performance. If the call option is not exercised, the investor can then invoke the drag-along right and force the sale of both their own and controlling shareholders’ stakes to a third party.

However, if the company’s value has declined or the agreed purchase price is deemed too high, the related party may choose not to exercise the call option. In this case, the investor must rely on a third-party sale or the drag-along right, but it is not easy to find a buyer for the shares of a company with low IPO prospects or worsening management. Ultimately, while the call-and-drag structure reduces accounting burdens compared to a put option, it may offer less certainty regarding the actual exit of invested funds.

Therefore, investors must carefully select the exit structure at the time of entering into the investment agreement. While a put option provides a higher likelihood of exit, it can impose debt burdens on the company and related parties. The call-and-drag structure can reduce accounting burdens, but the actual exit possibility is relatively uncertain. The key in an investment agreement is not simply the name of the right, but whether the mechanism can actually function in a crisis situation.

This content was produced with the assistance of AI translation services.