Drag-Along and Tag-Along Rights

It has become increasingly important for private equity firms to include drag-along rights in their standard term sheets and investment documents. Drag-along rights can provide private equity firms with an important exit strategy.

What are drag-along and tag-along rights, and what do they do? Both are clauses included within a shareholder’s agreement (and often in investors term-sheets). A drag-along right (also referred to as drag-along clause or bring-along provision) provides an up-front agreement for all shareholders to participate in a sale of shares to a third party. Say for example a third party offers to buy out a company and the majority shareholders wish to accept the deal. A drag-along right will ensure that minority shareholders accept the buy-out and in essence they are dragged into accepting the deal and at the terms negotiated by the majority shareholder. Often the majority is set at 75%, however companies can set the threshold that suits them.

From a third parties perspective, the drag-along right allows for a clean transaction. Minor shareholders aren’t left to disrupt the plans of the new owner.

Conversely, tag-along rights protect the interest of minor shareholders. In the case of the majority shareholders selling out, the tag-along rights allow the minority shareholder to jump on the back of the buy-out.

I’m fond of the inclusion of both drag-along and tag-along clauses being included within shareholders agreements. Some may argue that as a majority shareholder you don’t want to include a tag-along clause because it could disrupt a sale. I can understand that stand-point. However, I’ve watched the majority shareholders of companies leave their smaller, fellow shareholders behind because they were afraid that the deal would fall over if the issue became clouded involving other shareholders into the acceptance decision. In this situation the result has always been messy leaving the minority shareholder feeling deceived and left out to dry. I believe that in business, as in life, agreements should provide a win-win outcome for not just the buyer and seller, but minority stakeholders as well. Minority shareholders should ultimately benefit from major transactions carried out within the company.

In some situations minority shareholders try to negotiate a minimum sell-out price before signing up as a shareholder. A price that may seem attractive to a majority shareholder may yield a poor outcome for a minority shareholder, hence the request for a minimum sale price. It’s difficult for a minority shareholder to implement such a clause unless they bring substantial value to the company for their seemingly small shareholding.

Here is a sample drag-along and tag-along clause:

“Drag-along” right: In the event that some of the Shareholders accept an offer from an Outsider to purchase a minimum of 75% of the common shares, then all of the Shareholders (including any Shareholder who did not accept the Outsider’s offer to purchase) shall be required to sell all of their common shares to the Outsider on the same terms and conditions, if the Outsider desires to purchase such Shares, and only if the purchase price is at least equal to the Valuation Schedule attached as Schedule B to this agreement.

“Tag-along” right: In the event that each member of a group of Shareholders, which group holds a majority of the common shares, serves a Selling Notice in connection with the same Outside Offer and if after the Outside Offer is served upon the Offerees, one or more of the Offerees decide that s/he or they wish to sell their Shares to the Outsider on the same terms and conditions as contained in the Outside Offer, then the group shall not be entitled to sell, transfer or otherwise dispose of the Offered Shares unless the Outsider purchases at the same time and on the same terms and conditions all of the Shares of the Offerees who so desire to sell their Shares.

I should also qualify that drag-along and tag-along rights generally terminate on a public offering.

Like anything in business, ensure that you are educated on the subject at hand. Understand what clauses like drag-along and tag-along rights mean to you as a shareholder or company founder and as always seek legal advice whenever you are out of your depth.