In the dynamic realm of corporate governance and shareholder relations, navigating the intricacies of shareholder agreements (hereinafter, “SHA”) is paramount for ensuring clarity, fairness, and accountability. Among the myriad provisions that populate these agreements, tag and drag rights stand out as crucial mechanisms that dictate the dynamics of ownership transfer and decision-making within a company. Tag and drag rights, often included in the SHAs of closely held companies and startups, serve as powerful tools for safeguarding shareholder (including investor) interests, facilitating liquidity events, and preserving harmony among stakeholders. Delving into the nuances of tag and drag rights unveils a complex yet essential aspect of corporate governance, offering insights into their mechanisms, implications, and strategic significance for both majority and minority shareholders.
What are Tag and Drag Along Rights in SHA?
At its core, tag (or tag-along) rights and drag (or drag-along) rights are contractual provisions designed to address the potential scenarios where shareholders seek to sell their ownership stakes in a company. These rights play a pivotal role in determining how ownership transfers occur and the extent to which shareholders can protect their interests in such transactions. In essence, the article focuses on comprehending tag and drag rights in an SHA that goes beyond mere contractual clauses; it embodies a deeper understanding of the intricate interplay between shareholder rights, corporate governance, and transactional dynamics.
Importance of Tag and Drag Rights in a Shareholder’s Agreement
An SHA is a legally binding document that outlines the rights, obligations, and protections of shareholders in a company. It is typically entered into when an investor comes on board and will include all the shareholders, often in conjunction with the transaction documents, the company’s articles of association and other governing documents. SHAs are particularly common in closely-held companies, startups, and private companies where the relationship between shareholders is critical and the ownership structure is more fluid.
Tag and drag rights are often critically negotiated when drafting the SHA; here’s why they are crucial:
- Protection of Minority Shareholders: Tag-along rights empower minority shareholders by allowing them to join in a sale of the company initiated by majority shareholders. This ensures that minority shareholders have the opportunity to participate in the sale on the same terms and conditions as the selling majority shareholders. Without tag-along rights, minority shareholders could risk being left behind in transactions that significantly impact the company’s ownership and control structures or value.
- Facilitating Majority Control: Drag-along rights provide a mechanism for majority shareholders to compel minority shareholders to sell their shares alongside theirs in a sale of the company. This provision is particularly advantageous for majority shareholders seeking to streamline the sale process, overcome potential obstacles posed by dissenting minority shareholders, and maximize the attractiveness of the company to potential buyers. Drag-along rights help ensure that majority shareholders can effectively exercise their control over the company’s ownership.
- Clarity on Transfer of Ownership: By including tag and drag rights in an SHA, the parties establish clear rules and procedures for ownership transfers. This clarity helps minimize disputes and uncertainties among shareholders, providing a framework for orderly and efficient transactions. Shareholders can enter into agreements with confidence, knowing that their rights and obligations are clearly defined and protected.
- Facilitating Liquidity Events: Tag and drag rights are particularly important in the context of liquidity events such as mergers, acquisitions, or sales of the company. These provisions ensure that all shareholders, regardless of their ownership percentage, have the opportunity to participate in and benefit from such transactions. By facilitating liquidity events, tag and drag rights can enhance the attractiveness of the company to potential investors and buyers, ultimately contributing to its growth and success.
Drag-Along Rights
What are drag-along rights?
A drag-along right allows a majority shareholder (i.e., usually a shareholder holding more than 50% of shares in a company that has voting rights attached) of a company to force the remaining minority shareholders (ie usually a shareholder holding less than 50% of shares in a company that has voting rights attached) to accept an offer from a third party to purchase the whole company.
The majority shareholder who is ‘dragging’ the other shareholders must offer the minority shareholders the same price, terms and conditions that the majority shareholder has been offered. For example, a majority shareholder who holds 75% of the shares in the company who agrees to sell their shares in a share sale to a potential buyer, must offer the same price for the shares to the minority shareholders if they want to ‘drag them along’. A drag-along clause will allow the majority shareholder to ‘drag’ the remaining minority shareholders with them and require them to sell their shares to the potential buyer at the same price, in order to allow the buyer to purchase the entire company.
Why are drag-along rights used?
The aim of drag-along rights is to provide liquidity, flexibility and an easy exit route for a majority shareholder. The majority shareholder’s percentage of shares is variable depending on the company’s ownership mix and the negotiating strength of the shareholders but is normally between 51% – 75%. As many buyers of a target company will want 100% control over the business and rarely agree to allow a minority shareholder to retain a minority share, it would be difficult for a majority shareholder to accept an offer if the minority shareholders are uncooperative and block the sale of a company.
Although drag-along rights are heavily favoured towards investors/majority shareholders by preventing them from being ‘locked in’ to the company, these types of clauses also ensure that minority shareholders are treated the same as the majority shareholder.
How are drag-along rights triggered?
The conditions triggering a drag-along right are usually contained in the SHA and can range from sales transactions such as mergers and acquisitions, or a change of control in the company, to events of default such as the company/founders failing to provide the investors with an exit. Drag rights are powerful tools available to investors to protect their investment and consequently, the construct of the drag-along right is often heavily negotiated. The Treelife team recently did a deep dive into a high profile dispute stemming from an investor’s exercise of drag-along rights, check it out here!
Some shareholders, such as venture capital investors or angel investors, may require that drag-along provisions are conditional and limited, or contain certain exceptions.
Tag-Along Rights
What are tag-along rights?
Tag-along rights are also known as ‘co-sale rights’ are the inverse of drag-along rights. When a majority shareholder sells their shares, a tag-along right will entitle the minority shareholder to participate in the sale at the same time for the same price for the shares. The minority shareholder then ‘tags along’ with the majority shareholder’s sale. Tag-along rights are usually worded to state that if the tag-along procedures aren’t followed then any attempt to buy shares in the company is invalid and won’t be registered.
Why are tag-along rights used?
Tag-along clauses are designed to protect the minority shareholders from being left behind when a majority shareholder decides to sell their shares. If a minority shareholder held 10% of the shares in a company, it would be difficult to sell as most buyers will want 100% of a company. This puts minority shareholders at risk of being forced to sell their shares at a price which is substantially much lower or has no relationship to the actual value of the company. Without tag-along rights, minority shareholders may find that they hold unsalable or devalued shares.
Tag-Along vs Drag-Along Rights : Differences
Tag-along rights and drag-along rights are both provisions found in the SHA that deal with the exit strategy of shareholders, but they offer different benefits to minority shareholders.
| Feature | Tag-along Rights | Drag-along Rights |
| Definition | Option for minority shareholders to sell with majority shareholder | Obligation for minority shareholders to sell with majority shareholder |
| Benefit to Minority Shareholder | Same price and terms as majority shareholder | None (may be forced to sell even if not ready) |
| Benefit to Majority Shareholder | None | Ensures clean and complete sale of the company |
| Power Dynamics | Gives minority shareholder some control over exit strategy | Favors majority shareholder, can force sale |
Conclusion
In conclusion, understanding tag and drag rights in an SHA is essential for navigating the complexities of ownership transfers and corporate governance in closely-held companies and startups. These provisions, while seemingly technical in nature, carry significant implications for shareholder rights, company valuation, and transactional dynamics. By empowering minority shareholders with tag-along rights and enabling majority shareholders to streamline ownership transfers through drag-along rights, these provisions strike a delicate balance between protecting minority interests and facilitating majority control.
In addition to their role in protecting shareholder interests, tag and drag rights also contribute to the clarity, certainty, and efficiency of ownership transfers within the company. By establishing clear rules and procedures for transactions, these provisions help minimize disputes, uncertainties, and potential disruptions to the company’s operations. Furthermore, tag and drag rights facilitate liquidity events such as mergers, acquisitions, or sales of the company, enhancing the company’s growth prospects and value proposition for investors and stakeholders.
As companies continue to evolve and grow, the importance of tag and drag rights in SHAs cannot be overstated. By comprehensively understanding these provisions and their implications, shareholders can navigate ownership transfers, preserve shareholder value, and foster a conducive environment for sustainable growth and success within the company. Ultimately, tag and drag rights serve as cornerstones of effective corporate governance, ensuring fairness, transparency, and accountability in shareholder relations.
Frequently Asked Questions (FAQs) on Tag Along and Drag Along Rights
- What are tag-along rights in a shareholder’s agreement?
Tag-along rights allow minority shareholders to join in a sale of the company initiated by majority shareholders, ensuring they can participate in the sale on the same terms and conditions.
- What are drag-along rights and why are they important?
Drag-along rights empower majority shareholders to compel minority shareholders to sell their shares alongside theirs in a sale of the company, streamlining the process and maximizing the company’s attractiveness to potential buyers.
- What role do tag and drag rights play in facilitating liquidity events?
Tag and drag rights facilitate liquidity events such as mergers, acquisitions, or sales of the company, enhancing the company’s growth prospects and value proposition for investors and stakeholders.
- Why are tag and drag rights important for effective corporate governance?
Tag and drag rights serve as cornerstones of effective corporate governance, ensuring fairness, transparency, and accountability in shareholder relations while balancing minority interests with majority control.