The constitution of a company is governed by its Articles of Association, along with any Shareholders’ or Investment Agreement. These documents also define the rights and responsibilities of all shareholders, to protect the interests of all parties concerned (including the company). Drag along and tag along rights are common clauses found in Shareholders’ Agreements and/or Articles, along with provisions relating to the compulsory transfer of shares and pre-emption rights.
Drag along and tag along rights protect majority and minority shareholders respectively in the event of a sale of the company, to ensure that all shareholders get a fair deal for their shares.
What are drag along rights?
In the event where a majority of the shareholders wish to sell their shares in the company, a drag along clause would give them the right to force minority shareholders to sell their shares too. This enables the majority shareholders to negotiate the sale of the entire company with a potential buyer. The “drag along threshold” can be set at any level, but would typically be somewhere between 50% and 75%. This means that in order to exercise the drag rights, dragging shareholders would need to hold the requisite number of shares (whether individually or between them as a group).
The minority shareholders are then “dragged along” in the deal, and forced to sell their shares whether they had intended to or not. Whilst they have no right to refuse to sell their shares, they are guaranteed the same price and conditions for their shares as the majority shareholder has secured for themselves. This therefore provides a level of protection for the minority shareholders.
Some minority shareholders – particularly venture capital or private equity investors – may demand specific terms for the drag along rights. These could stipulate a minimum share price or return on their investment, for example. Care should always be taken to consider how the drag along rights interact with pre-emption rights and other veto rights that institutional investors may have over the sale of the business to ensure that these provisions interact in the intended manner.
What is the purpose of drag along rights?
Drag along rights protect the interests of majority shareholders by granting them flexibility and enabling them to secure an exit on their own terms. During an acquisition, many buyers will wish to buy 100% of the company in order to secure full control over its operations. Without a guarantee of the purchase of all shares, the buyer will typically either walk away or lower their offer. Drag along rights allow the majority shareholder to therefore offer the sale of the entire company, including the shares belonging to minority shareholders, when they find a buyer.
The interests of the minority shareholders are still protected because they will receive the same deal terms for their shares as the majority shareholders. Since minority shareholders hold only a small percentage of the company, their shares are not very liquid and they would struggle to make a better deal on their own (indeed we often see hefty ‘minority discounts’ on share valuations) so it is often in their interest to participate in a full sale.
This leads us neatly on to tag along rights.
What are tag along rights?
Unlike drag along rights, which benefit the majority shareholders, tag along rights protect the minority shareholders. With tag along rights the minority shareholders are automatically entitled to participate in any sale that majority shareholders have agreed, and secure the same price for their shares. The buyer is obliged to extend the same deal terms offered to majority shareholders to all shareholders in the company.
What is the purpose of tag along rights?
In the event that a majority shareholder secures a sale for their shares in the company – for example 75% of the company – the minority shareholders may not wish to be left behind, as the company is effectively taken over by new management. Since most buyers will want to buy 100% of a company, selling just 10% worth of shares on their own is unlikely to secure a good offer. A majority shareholder is in a far stronger position for securing a good deal for their shares since they can offer greater control over the company through their proportion of shares. Minority shareholders are therefore more likely to get a better price for their shares if they form part of a larger sale.
When are drag along and tag along rights triggered?
Both drag along and tag along rights are triggered in the event of any company merger, acquisition or change of control. Each Shareholders’ Agreement and set of Articles will have their own specific terms as agreed between the shareholders and the company, but typically if a number of shareholders forming a majority of the shares agree on a sale, they could then drag along the remaining shareholders.
In some Shareholders Agreements there are preference shares or other classes of share which carry greater rights than ordinary shares. In this case, a majority vote by these shareholders may then trigger the drag along of the ordinary shareholders.
The contents of this article do not constitute legal advice and are provided for general information purposes only.
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