23 February 2023
When a startup expands and is in the process of raising funds, the most essential document is the Shareholder’s Agreement (“SHA”). It governs the shareholders' rights, obligations and liabilities. The provisions commonly found in an SHA may include a compulsory transfer of shares, pre-emption rights, Tag Along Rights (“Tag Along Rights'') and Drag Along Rights (“Drag Along Rights”).
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 the Act to the shareholders. The minority shareholders can hamper the 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 exit and the investment.
An 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 are 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 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 of their shares.
Drag Along Rights
The right to drag along is specifically provided to the majority shareholder. It is also known as the “Come-along clause” in the SHA. It 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 to facilitate an easy exit for the 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 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 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. It is aimed to provide benefits to the minority shareholders. Hence, 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.
The clause of Tag Along Right is usually articulated in a manner to ensure that if the tag along process is not followed then an attempt to sell the shares of the company is invalid.
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:
Drag Along Right in the SHA:
These clauses balance each other out, if you decide to have one, it is advisable to incorporate the other, too.
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