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When a startup expands and raises funds, the Shareholder’s Agreement (SHA) becomes the most critical document. It governs the rights, obligations, and liabilities of the shareholders. Essential provisions of an SHA may include pre-emption rights, Tag Along Rights and Drag Along Rights.
In private limited companies, minority shareholders face restrictions on share transfer to maintain the shareholding pattern and the majority shareholder control. The majority shareholder has the right to include Tag Along and Drag Along Rights in the SHA to maintain liquidity, flexibility, and facilitate their exit.
Tag and Drag Along Rights are conferred by the Articles of Association (“AOA”) of the company to the shareholders. The minority shareholders can hamper the management or an investor from the company in some situations. Therefore, an investor, at the time of investing in a private limited company, needs some rights to be included in the SHA to secure their exit and the value of their investment.
In simple terms, a Drag Along Right allows majority shareholders to compel the minority shareholders to join in on a sale of their shares. Whereas, Tag Along Rights can also be termed as ‘co-sale right’ which allows minor shareholders to ‘tag along’ with a larger shareholder or group of shareholders if they find a buyer to their shares.
Drag Along Rights
The Drag Along Right, also known as the “Come-along clause,” confers the majority shareholder the ability to require the minority shareholder to sell their shares at the same price, terms, and conditions. In case a potential buyer wants to control the company and the majority shareholders agree to sell their shares, the Drag Along Rights protect the majority shareholder from the minority shareholder blocking the sale.
As many buyers of a target company will want 100% control over the business and the minority shareholders may not wish to sell their shares hoping that share prices may rise it, becomes difficult for the majority shareholders to get an easy exit from the company.
Majority shareholders, therefore, include the Drag Along Rights provision in the SHA that gives them the power to compel the minority shareholders to sell their shares at a price determined for majority shareholders and on the same terms and conditions.
In an instance where there is a bid for buying the entire company, and the majority shareholders holding more than 50% of the company agree to sell their shares, the majority shareholders shall have the right to “drag along” the remaining minority shareholders and require the minority shareholders to sell their shares so that the bidder is able to purchase the entire company.
This provision prevents a situation where a minority shareholder has the ability to block the sale of a company that was going to give an exit to the majority shareholder or a collective majority of existing shareholders.
Drag Along Rights are triggered in all types of sales transactions such as mergers and acquisitions, or a change in control of the company. Another notable point is that even though Drag Along Rights are meant to protect the majority shareholder of a company, they are also beneficial for minority shareholders.
Since this type of provision requires that the price, terms and conditions to be homogenous across all the sellers, minority shareholders can realize favorable sales terms that may be otherwise unattainable.
Tag Along Rights
Tag Along Rights are also known as ‘co-sale rights’, and they balance the Drag Along Rights. In the event of majority shareholders selling their shares, Tag Along Rights enable the minority shareholders to participate in the sale at the same terms and conditions as the majority shareholders. This clause creates a contractual obligation on the company to protect the stake of minority shareholders.
Conclusion
Including these provisions in an SHA ensures minority shareholders are protected by receiving the same sale terms as majority shareholders. Additionally, it prevents the majority shareholder from being forced to accept an unwanted new shareholder.
In conclusion, both Tag Along Rights and Drag Along Rights play crucial roles in maintaining the liquidity and flexibility of a company. Including these in the SHA creates contractual obligations, protects minority shareholders, and ensures that the majority shareholder control is maintained.
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