Understanding Drag Along Rights
Drag along rights also referred to as “Come along clause”, are special rights granted to majority shareholders of a company. It empowers the majority shareholders to compel minority shareholders to sell their shares of the company to a third party. When majority shareholders decide to sell their shares, this provision obligates the minority shareholders to participate in the share sale, under the same terms and conditions as decided by the majority shareholders. In simpler terms, this provision allows majority shareholders to ‘drag’ the minority shareholders along, to sell their shares along with them.
Drag along rights can be triggered during various corporate transactions such as sale transactions, mergers and acquisitions, change in the ownership of a company or when a shareholder owning more than 50% of the company wants to sell his/her shares. Even though these rights restrict the freedom of minority shareholders to hold on to their shares, it safeguards the minority shareholders as well. Minority shareholders receive a fair and equal opportunity to sell their shares at identical terms of price as majority shareholders, which prevents exploitation and unequal treatment. Moreover, the existence of drag along rights provides a clear framework for future ownership transitions in a company which attracts potential investors.
A Drag along clause acts as a crucial provision in the shareholder agreement, specifically for companies seeking investments. Potential investors are more likely to invest in companies that have incorporated drag along rights, as it provides future protection against obstacles that might arise from minority shareholders during future financing rounds. This right serves as a risk mitigation mechanism, which enhances the company’s attractiveness to potential investors and ensures an easier exit process by reducing minority shareholders’ interference in future strategic decision.
However, in certain investments, it has been observed that if no exit is provided to an investor within a stipulated time as agreed in the transaction documents, the investor gets a unilateral right to sell its securities to any third party and thereby receives the drag along right to proportionately compel all other shareholders of the company to sell some or all of their shares to the third party to enable such an exit at the same price that is being offered to such investor.
Understanding Tag Along Rights
Tag along rights also referred as “co-sale right” are rights granted to minority shareholders and are exact opposite to drag along rights. These rights act as a protective mechanism designed to protect the interest of minority shareholders. Tag along rights allow minority shareholders to take part in a share sale transaction whenever a majority shareholders decides to sell its shares, on the same pricing terms and conditions as the majority shareholder.
These rights protect the minority shareholders against potential exploitation and grants them equal and fair opportunity to ‘tag along’ with the majority shareholders during selling of shares. It prevents them from being left behind in less favourable positions. Without this right, minority shareholders are often vulnerable to receive a lower value for their shares as potential buyers tend to prefer acquiring controlling interests and may offer less prices for separately purchased minority shares.
Tag along rights can be triggered when the company promoters or majority shareholders decide to sell their shares and is beneficial for minority shareholders as they provide them with a smooth and secure exit opportunity and ensure that minority shareholders receive fair valuation for their shares.
Drag-Along vs. Tag-Along: Which Is Better?
The position of a shareholder determines the usage of the two rights in the operations of a company. For majority shareholders, drag along rights are beneficial as they offer more control and flexibility. It makes the sale of company easier since buyers often want 100% ownership in the company without any interference from the remaining shareholders.
However, for minority investors, tag along rights are essential as they provide critical protection, ensuring that they are not left behind in a less favourable position during a sale transaction. This levels the playing field and provides equal exit opportunity to the minority shareholder on the same terms as the majority shareholders.
The ideal structure often involves a mix of both tag along and drag along rights, offering a balanced approach to the shareholding landscape.
Aumirah’s Opinion
As a law firm specialising in corporate governance and company investment transactions, we strongly advocate for the careful implementation of both tag along and drag along rights in the shareholder agreement, with particular attention to balanced protection mechanisms. Investors should be cautious while entering into agreements and should carefully review the trigger conditions for drag along rights. Specific attention should be paid to minimum price thresholds and sale timing restrictions. Minority investors should negotiate and ensure that tag along rights are included with a comprehensive price protection mechanism.
Companies are required to exercise caution in structuring these rights so that they maintain operational flexibility while avoiding potential deadlock situations. Companies should also consider integrating provisions that address potential conflicts of interest and establish clear procedures for handling competing offers.
