In the previous article, we got acquainted with the concept of “bring-along” (or “drag-along”) rights, and also found out that there is another way to protect shareholders – the so-called “tag-along” right. Now we’ll talk in detail about that concept, what it means and how it can be implemented in the shareholders’ agreement.
As you remember, the “bring-along” right is an obligation of minority shareholders to sell their shares in the event of a sale of shares by a majority of shareholders (or a percentage higher than a simple majority) at the same price and on the same conditions.
Basically, the “tag-along” right is the opposite – it may be defined not as an obligation to sell the stake, but as a RIGHT for the minority shareholders to join a transaction, if the majority share is being sold.
So, the “tag-along” right (also called a “co-sale” or even a “piggyback” right) is a contractual provision that is used to ensure that the interests of the minority shareholders are taken into account in the sale of the company.
And it may also guarantee the liquidity of the minority stake, which means that the “co-sale” requires the investor to purchase the minority shares even if he did not intend to do so, and had no interest in that deal. And of course, just as in the case with the “bring-along” rights, the transaction for this purchase has to be made on the same terms and conditions as the majority stake purchase. This is an additional protection guarantee for the minority shareholders, because buying the majority shares is usually more valuable to new investors, so they tend to pay more for them.
So how does the “tag-along” right work in the real world?
For example, assume there is a growing start-up with three co-founders. They want to expand and attract an investor, and for that purpose they sign the investment agreement and sell 70% of the shares of the company, in exchange for raising additional funds. In such situation they will then remain with a minority stake of 30% in their own company.
Then assume the business grows, and the investor holding a majority stake in the company is thinking about selling his stake to make a profit. That investor starts looking for a new buyer to purchase his shares for a good price. Usually, majority shareholders, such as big firms or other financial institutions, tend to be in a better position to find buyers and negotiate good payment conditions.
Suppose that an offer of a new investor is so attractive that the minority shareholders want to sell their stake on the same terms. If these shareholders didn’t include the “co-sale” provision into their agreement with that majority shareholder, their stake of 30% may not be as interesting to the new investor (because the 70% stake already gives the buyer majority control over the company).
But if the “tag-along” right was negotiated by the minority shareholders at the time of their initial investment transaction, they can now join the deal and make a profit too. So this provides an excellent opportunity to sell the minority stake on very good terms, regardless of its size, and no matter how attractive it was to the potential investor at first. A standard “tag-along” right would dictate that the minority shareholders are entitled to sell their pro-rata share, based on the percentage being sold by the majority shareholder, and that the number of shares the majority shareholder desires to sell would be reduced to allow the minority shareholders to participate, unless the purchaser decides to acquire all of the shares.
Taking into account all of the above, we can conclude that the “tag-along” clause is a good way to provide financial and legal protection for minority shareholders, including for example founders or employees who received small shares in accordance with an employment contract, but also investors joining a company and owning less than a majority. But it must be assumed that not all the investors are interested in including this clause in an investment agreement. Why?
In some cases, “co-sale” rights can complicate the process of selling a share in the business. It can become more difficult for the majority shareholder to complete a sale of shares when the potential investor has no intention to increase or change the conditions of his initial offer just to protect the rights of the minority shareholders. In other words, this provision may sometimes jeopardize the entire share purchase transaction if the investor refuses to buy the minority shares along with the main stake.
So if this clause is important to the minority shareholders, it must be negotiated by the parties at the beginning and implemented in the written contract (shareholders’ or investment agreement). Otherwise, the rights of the minority stakeholders will not be protected with this provision, as usually in most jurisdictions it is not provided by legislation.
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THIS ARTICLE IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DO NOT CONSTITUTE LEGAL ADVICE. THIS ARTICLE IS PROVIDED WITHOUT ANY WARRANTY, EXPRESS OR IMPLIED, INCLUDING AS TO ITS LEGAL EFFECT AND COMPLETENESS. THE INFORMATION SHOULD BE USED AS A GUIDE AND MODIFIED TO MEET YOUR OWN INDIVIDUAL NEEDS AND THE LAWS OF YOUR STATE, BY INDEPENDENT COUNSEL YOU RETAIN. YOUR USE OF ANY INFORMATION CONTAINED IN THIS ARTICLE, IS AT YOUR OWN RISK. WE, OUR EMPLOYEES, CONTRACTORS, OR ATTORNEYS WHO PARTICIPATED IN PROVIDING THE INFORMATION CONTAINED HEREIN, EXPRESSLY DISCLAIM ANY WARRANTY, AND BY DOWNLOADING OR USING OR RELYING ON THIS ARTICLE; NO ATTORNEY-CLIENT RELATIONSHIPS ARE CREATED. DO NOT USE THIS ARTICLE WITHOUT AN INDEPENDENT LAWYER YOU HAVE SPECIFICALLY RETAINED FOR SUCH PURPOSE.
© 2022 Yair Ud