RIGHT TO DRAG ALONG
Shareholders are typically categorized as majority or minority based on their ownership stake, with majority shareholders controlling over 50% of company shares and minority shareholders holding less than 50%. The drag-along right, also referred to as the ‘come-along clause,’ is a provision primarily benefiting majority shareholders. This right empowers majority shareholders to not only sell their own shares but also compel minority shareholders to sell their stakes under identical terms and conditions to a third-party buyer. Essentially, majority shareholders ‘drag’ minority shareholders along in a sale transaction, enhancing liquidity and flexibility for controlling interests.
This provision is particularly attractive to potential acquirers seeking full control of a company, as it mitigates the risk of minority shareholders impeding the transaction. By facilitating the elimination of minority interests, drag-along rights increase a company’s marketability and streamline the acquisition process. While primarily serving majority shareholders’ interests, these rights also ensure that minority shareholders receive equitable treatment in terms of price and conditions during a sale.
Sometimes, buyers wanted to have full control over the company but due to minority shareholders they are unable to. So, this right provides buyers to eliminate minority shareholders and to have full control over the company. Drag along helps to increase the marketability buy removing all the minority shareholders and delivering company with all rights. Drag-along rights are put in place to protect the interests of majority shareholders in a company by preventing minority shareholders from blocking beneficial deals. Though Drag along does not focuses more on rights of minority but it also makes sure that their shares are traded in favourable rates and conditions.
Key consideration of Drag along
- Given the variability in shareholder structures across companies, it is crucial to precisely define ‘majority’ and ‘minority’ shareholders within the drag-along clause.
- In the absence of a single majority shareholder, provisions may allow for multiple shareholders collectively owning over 50% to initiate a drag-along sale.
- Under certain circumstances, such as majority shareholder insolvency, minority shareholders may gain leverage. In these scenarios, minority interests may negotiate for safeguards against undervaluation or exploitation, including minimum price thresholds and fair valuation mechanisms.
- Minority shareholders may seek to incorporate specific rights into the drag-along process to ensure that the valuation of their shares is fair and transparent.
THE RIGHT OF TAG ALONG
The tag-along right, also referred to as co-sale rights, is a provision designed to safeguard the interests of minority shareholders. This mechanism allows minority shareholders to participate in a sale transaction initiated by the majority shareholder, under the same terms and conditions. When exercising this right, the majority shareholder determines the price and conditions for the share sale, with the minority shareholder having the option to join the transaction.
This offers minority shareholders an exit opportunity and protects them from being left behind in potentially unfavourable circumstances. The tag-along right is particularly beneficial for minority shareholders because the pricing determined by the majority shareholder is less likely to be exploitative. In the absence of this right, minority shareholders might be compelled to negotiate prices independently, potentially resulting in financial losses. Consequently, the inclusion of tag-along rights is considered a crucial protective measure in shareholder agreements.
Tag-along rights are commonly found in startups and private companies, offering minority shareholders the opportunity to participate in transactions arranged by larger shareholders, typically influential financial institutions. This provision serves multiple purposes: it facilitates an easier exit for minority stakeholders, enhances liquidity, and often results in higher valuations for their shares. However, potential buyers may be deterred by companies with tag-along clauses, as these primarily benefit minority shareholders. Venture capital firms and other large shareholders generally possess superior capabilities in identifying buyers and negotiating favourable terms. By allowing minority shareholders to join these deals, tag-along rights significantly ease the process of selling their shares. This is particularly valuable in the context of private equity, where shares are typically difficult to sell independently, but majority shareholders can leverage their position to facilitate transactions in the secondary market.
Key Consideration of Tag along
- Tag-along rights are triggered when a majority shareholder sells all or a significant portion of their shares. They allow minority shareholders to participate in the sale proportionally to their ownership, providing an opportunity to exit or partially exit their investment.
- These rights protect minority shareholders from being left behind in potentially unfavourable situations, ensuring they can benefit from the same terms and conditions as the majority shareholder in a sale transaction.
- Tag-along provisions can be activated even if the majority shareholder retains some ownership after the sale, allowing for partial exits by minority shareholders.
- There’s ongoing discussion about whether minority shareholders exercising tag-along rights should receive the same guarantees and advantages as the majority shareholder, given the voluntary nature of these rights.
- Some argue that minority shareholders should have a say in the sale process and potentially provide fewer guarantees, considering they’re receiving the same price per share but aren’t leading the sale process.
DRAG ALONG VS. TAG ALONG
Tag-along and drag-along rights are contrasting provisions in shareholder agreements, each serving different purposes and beneficiaries. Tag-along rights are specifically designed to protect minority shareholders, allowing them to join in on sales initiated by majority shareholders. This provision ensures that minority shareholders can sell their shares at the same price and terms as the majority, preventing them from being left behind or forced to accept unfavourable conditions. Conversely, drag-along rights primarily benefit majority shareholders. These rights enable majority shareholders to compel minority shareholders to sell their shares to the same buyer when the majority decides to sell. This mechanism allows the majority shareholder to offer 100% of the company’s shares to potential buyers, potentially increasing the company’s attractiveness and overall sale value. In essence, while tag-along rights protect minority shareholders from exclusion or unfair treatment in exit scenarios, drag-along rights empower majority shareholders to facilitate complete company sales. These opposing rights aim to balance the interests of both minority and majority shareholders in various sale situations, each providing specific protections and advantages to their respective beneficiaries.
The main points of distinction are –
- Purpose
Right of drag-along and tag-along are distinct provisions in shareholder agreements, each designed to protect the interests of different groups. Drag-along rights primarily safeguard majority shareholders’ interests, allowing them to compel minority shareholders to sell their shares when a buyer for the entire company is found. This gives minority shareholders no choice but to participate in the sale. However, this forced sale doesn’t necessarily disadvantage minority shareholders, as they typically receive the same favourable valuation for their shares as the majority. Conversely, tag-along rights protect minority shareholders by giving them the option to join the majority shareholder in selling their shares to a buyer. This provision isn’t compulsory; rather, it offers minority shareholders a voluntary opportunity to exit the company alongside the majority.
- Effect
Tag-along rights allow minority shareholders to sell their shares under the same terms as majority shareholders during a sale. This protects minority shareholders by ensuring they receive fair value and aren’t excluded from the transaction. On the other hand, drag-along rights require minority shareholders to sell their shares alongside majority shareholders at the same price and conditions. This primarily benefits the buyer by enabling a complete acquisition of the company. For minority shareholders, drag-along rights mean they must sell their shares regardless of their preferences when a sale is initiated by the majority.
- Trigger
when majority shareholders aim to sell their entire stake to a buyer, but minority shareholders are reluctant. Using these rights, the majority can compel the minority to sell their shares under identical terms and conditions. This mechanism is particularly effective when a significant number of shareholders are interested in selling, as it enhances the sale process and allows the buyer to potentially acquire the entire company, thereby simplifying the transaction.
- Impact
Tag-along rights ensure minority shareholders can participate in sales initiated by majority shareholders, guaranteeing equitable terms and fair pricing. This mechanism safeguards minority interests, preventing exploitation and fostering a positive environment where minority shareholders feel included and valued in significant transactions. In contrast, drag-along rights enable majority shareholders to compel minority shareholders to sell their shares under identical terms and conditions. This impacts the sale process by allowing the buyer to acquire 100% of the company, facilitating a comprehensive and streamlined transaction. While this ensures a complete sale, it does require minority shareholders to participate regardless of their individual preferences.
- Negotiation Points
Tag-along rights require majority shareholders to notify minority shareholders when planning to sell shares, providing full transaction details. This allows minorities to join the sale under equal terms, ensuring fair value for their shares. Drag-along rights, conversely, typically involve negotiated terms like a threshold percentage to activate the right, pre-emptive rights for minorities, and specific notice periods before mandatory sale participation. These provisions enable majority shareholders to execute a complete sale effectively while involving all shareholders. The negotiated terms balance the majority’s ability to facilitate a full company sale with protections for minority interests, ensuring a comprehensive transaction process that considers all parties involved.
CONCLUSION
Tag-along and drag-along rights are essential mechanisms for maintaining equilibrium between majority and minority shareholder interests during company sales. Tag-along rights offer protection to minority shareholders by enabling their participation in majority-initiated sales, ensuring fair treatment and compensation. This safeguards against potential mistreatment and promotes transparency in transactions.
Conversely, drag-along rights enable majority shareholders to expedite sales by requiring minority shareholders to sell their shares under identical terms. This facilitates comprehensive transactions, allowing buyers to acquire full company ownership smoothly. Both rights contribute to fairness and efficiency in corporate deals, highlighting the importance of protecting shareholder interests while enabling seamless ownership transfers. These rights are underpinned by clear provisions for notification, timing, and consideration, providing all parties involved in share sales with legal clarity and certainty.
Authors:
Mohit Porwal (VP- Legal & Finance)
Awertika Shrivastava (Trademark Trainee)
