When a startup grows and is in the process of getting funding, the most essential document is the Shareholder’s Agreement (“SHA”).  It governs the shareholders' rights, obligations and liabilities. Provisions commonly found in a SHA can include a compulsory transfer of shares, pre-emption rights, Tag Along Rights (“Tag Along Rights”) and Drag Along Rights (“Drag Along Rights”).

In this blog lets understand the meaning and uses of Tag and Drag Along Rights. But, first let’s understand what the Companies Act, 2013 (“Act”) outlines with respect to transferability of shares. The Act states that the company is run by the directors appointed by the shareholders based on a majority decision. The right to appoint a director gives you the control to decide how the company will be run and provides an assurance to you that there will a director on board who understands your position as a shareholder.

The shareholders in the case of a private limited company are restricted to transfer their shares in order to maintain the shareholding pattern and retain control of majority shareholders. The restriction is applicable on both majority as well as minority shareholders.

Tag and Drag Along Rights are conferred by the Articles of Association (‘AOA’) of the company and theAct to the shareholders. The minority shareholders can hamper a smooth exit of management or an investor from the company in some situations. Therefore, an investor while at the time of investing in a private limited company needs some rights to be included in the SHA to secure his exist and the investment.

A SHA normally prohibits a shareholder from selling their shares without first giving the other shareholders a reasonable opportunity to buy them. The basic idea behind this restriction is to ensure that the existing shareholders is not forced to accept an unwanted new shareholder.

Now let us understand the meaning of Drag Along and Tag Along Rights.

In simple terms, a Drag Along Right allows majority shareholders to force the minority shareholders to join in on a sale of their shares. Whereas, Tag Along Rights can also be termed as called ‘co-sale right’ which allows minor shareholders to ‘tag along’ with a larger shareholder or group of shareholders if they find a buyer of their shares.

Drag Along Rights

A clause in the SHA giving a Drag Along Right allows the majority shareholders a right to require the minority shareholders to sell their shares. The aim of Drag Along Rights is to provide liquidity, flexibility and an easy exit route for a majority shareholder.

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 and wish to stay with the limited ownership in the hope 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 off their shares at a price determined for majority selling 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 of control in 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 are homogenous across the board, 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 are the inverse of Drag Along Rights. When majority shareholders sell their shares, a Tag Along Right will enable the minority shareholders to participate in the sale at the same price and conditions for their shares as the majority shareholders. The minority shareholder then 'tags along' with the majority shareholders in the sale.

Tag Along Rights are usually worded in such a manner in order to ensure that if the tag along process is not followed then an attempt to sell the shares of the company is invalid.

In a well-drafted and well-balanced SHA, when a shareholder wishes to sell its shares, the shareholder is normally required to provide notice to the other shareholders. This requirement is usually contained within a “Right of First Refusal” clause.

Right of First Refusal requires any existing shareholder who wishes to sell their shares and has received an offer from some third party to first offer those shares to other existing shareholders on a pro-rata basis to maintain percentage ownership. Having this right means, a minority shareholder, will be given the opportunity to purchase the shares, before they are released to any individual or entity outside of the company.

Conclusion

In order to summarize why are Tag Along and Drag Along Rights needed we can put forth the following points –

Tag Along Right clause in the SHA:

  • Protects minority shareholders in case the majority do not exercise their drag along rights.
  • Provides liquidity and exit route for minor shareholders.

Drag Along Right in the SHA:

  • Is designed to protect the majority shareholders in case they find a buyer wishing to take over complete control of the company.
  • Drag Along Rights help to eliminate minority owners and sell 100% of a company shares to a potential buyer.

These clauses balance each other out, if you decide to have one, it is advisable to incorporate the other, too.

If you’re a startup founder looking to raise funding or understanding the various nuances of a SHA, please reach out to us. We’ll take you through and answer the questions you may have.

Disclaimer:

The content of this article is for information purpose only and does not constitute advice or a legal opinion and are personal views of the author. It is based upon relevant law and/or facts available at that point in time and prepared with due accuracy & reliability. Readers are requested to check and refer to relevant provisions of the statute, latest judicial pronouncements, circulars, clarifications etc before acting on the basis of the above write up. The possibility of other views on the subject matter cannot be ruled out. By the use of the said information, you agree that the Author / Treelife Consulting is not responsible or liable in any manner for the authenticity, accuracy, completeness, errors or any kind of omissions in this piece of information for any action taken thereof.

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