Majority and minority shareholder protection: Drag along and Tag along rights

Many start-ups and joint ventures with a limited number of shareholders are often set up with the ultimate goal to sell the company to a third-party buyer in the future. This goal is achieved when the entire issued share capital (all shares) of the company is transferred to a new owner. But what happens when the shareholders cannot agree on the sale price or approve the sale altogether? How do you avoid seeing a good deal fall apart while offering adequate protection to minority and majority shareholders? This is where the drag along and tag along provisions in your shareholders’ agreement will play a central role. The provisions are widely used  in venture capital and private equity transactions and  aim to protect the rights of minority and majority shareholders in the event of an acquisition or a change of control.

 

Drag along rights allow majority shareholders to compel minority shareholders to participate in an acquisition (drag along) typically on the same terms as the selling majority shareholder.

Tag along rights allow minority shareholders to choose to participate in an acquisition (tag along) typically on the same terms as the selling majority shareholder.

 

Drag-along rights

A drag along provision – typically set out in the shareholders’ agreement – reflects the agreement between the minority and the majority shareholders that in the event of a transfer of more than a certain number of shares in the capital of the company to a third-party buyer, the majority shareholders have the right to compel the minority shareholders to sell their shares on the same or broadly the same terms.

 

Including a drag along provision in your shareholders’ agreement protects the majority shareholder against time-consuming negotiations with each shareholder individually – thus compromising the overall success of a deal. It equally protects the minority shareholders by offering them fair treatment and (usually) equal sale terms. Finally, a drag along clause also boosts a company’s marketability because potential buyers will not have any cause to be concerned about the likelihood of disagreement with the minority shareholders. All of those factors are likely to have a positive effect on share valuation and a higher premium for control. 

 

Tag-along rights

Tag along rights prevent majority shareholders from being able to complete the sale of their shares to a third-party buyer unless the minority shareholders have been offered to sell their shares on equal terms. Tag along may be triggered when the majority shareholders decide to sell their stake to a third-party buyer and the minority have not exercised their pre-emption rights. For example, they may not have sufficient funds to purchase the majority shareholders’ shares or they may not wish to take up a higher percentage in a company for a different reason.

 

In the absence of tag along rights, the minority shareholders might end up in a business venture with an unknown or unwanted business partner. Having an unhappy minority following the acquisition may also reduce a potential buyer’s appetite to acquire the company (or negatively influence the company’ valuation). Incorporating these rights into your agreements will reassure the minority shareholders that their investment is safeguarded because they have the option to tag along with the majority shareholders’ deal to sell their shares at a favourable price. Such rights are particularly useful if the majority shareholders choose not to exercise their drag along rights. 

 

Key considerations

• Not all drag along or tag along rights are created equal. If the company has more than one shareholder, you probably have – or are considering putting in place – a shareholders’ agreement. Make sure to avoid generic drag-along and tag-along clauses and to set out key drag along and tag along terms in sufficient detail, including minimum price, valuation method, triggering thresholds and conditions, amongst other considerations.

 

• Triggering threshold. It is common for the tag along rights to be triggered when the majority shareholder or shareholders that together hold more than 50% of the shares in the company, propose to sell their shares and such a sale would result in a change of control. The percentage that triggers the exercise of drag along rights is also often negotiated. If the minority shareholders are in a strong position (for example, a much-needed investor), then they may insist on a higher percentage (typically more than 75%), so as to avoid being forced to sell by a basic majority.

 

• Liquidation preferences. When the company has several classes of shares, including preferred shares, the drag along can be structured in such a way that all sale proceeds end up with preferred shareholders (in accordance with the liquidation preference waterfall). You may agree that these rules do not apply or are altered so that ordinary shareholders do not end up with nothing.

 

• Valuation methods. Compared to public companies traded on a recognised stock exchange, establishing value of shares in private companies inevitably presents a challenge. Valuation methods include those based on nominal value of shares to earnings-based valuations to the discounted cash flow methodology and beyond. If you agree to offer a minimum price level to the minority, it is important to agree which valuation method would be used.

 

• Compensation. Make sure to think about how the minority shareholders may be compensated as both cash and non-cash considerations may be offered, such as, liquid securities or shares in another private company.

 

Carefully drafting your drag along and tag along clauses is important, especially because selling to a third-party buyer is the most preferred – and likely – exit strategy for both founders and investors. We are frequently asked to assist with this task and would be happy to discuss how to safeguard your position as a majority or minority shareholder and how to minimise the risk of future disputes.

 

Our insights, articles and guides do not, and are not intended to, constitute legal advice or be an exhaustive review of all legal developments. Although every effort is made to ensure that the information provided in this article is accurate as of the publication date, please be aware that this is area of law may be subject to change. Please seek legal advice before applying the information provided to any specific circumstances, transactions or legal issues.