What is Tag-Along Rights?
Tag-Along Rights is an agreement that lays down the terms and conditions in order to protect the minority shareholders from being left out in case the majority shareholder decides to sell its stake and therefore, it enables the minority shareholders to sell their shares along with the majority shareholders at the same valuation
These are most common in the case of private equity or venture capital domains. These organizations raise initial funds from angel investors or private investors for proving the feasibility of their ideas, and once this is established or some other milestone is reached, the owners of the company like to exit from the company by selling it to a bigger company or by going public, etc.
In these cases, the owners may have ample contact in the industry; however, the investors may not, and the owners may understand the industry much better as they are part of the day to day working. Therefore, so that they don’t misuse this edge they have over other investors, they are bound by tag-along rights, in which the investors’ shares are also sold along with the owner’s shares.
These rights are beneficial mostly to the minority shareholders and the investors who don’t participate in the day to day functioning of the company; therefore, they are important from their point of view because of the following reasons:
#1 – Control
These rights give the minority shareholder some degree of control for the management of their holdings because these give them the right but not the obligation. These obligate the majority shareholders to fulfill the contract.
#2 – Protection
These protect the investors in two ways, they don’t let the owners leave the minority shareholders in dire situations and binds them; therefore, it doesn’t allow them to just sell their share and exit from the investment, they have to sell the minority stake also. Further, it is possible that if these rights are not present, the minority shareholders may have to settle for lower prices or may not get the due value of their investment. These rights ensure that such a situation doesn’t arise.
Example of Tag-Along Rights
As per the Shareholder Agreement between North Shore holdings limited and its Shareholders, dated Dec 3, 2015, which can be found in the SEC filings, if any shareholder initiates the transfer of share procedure with any third party purchaser, he is supposed to circulate a notice to all other Tag along shareholders stating the following details:
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- Several shares that are being purchased.
- Details of the Purchaser
- Per-share price agreed upon along with all terms and conditions
- Any agreement that is being prepared or has been prepared for this purpose.
- Date, time, and whereabouts of the transfer
Every Tag along shareholder is given the right to participate in the transfer process. Therefore, it is supposed to send a written notice to the selling shareholder of his intended number of shares to be sold along with the transfer process.
Once the shareholders receive the notice of a transfer being taking place and don’t send the notice of their intent, they are assumed to have waived their rights. Then the selling shareholder can execute the sale without their approval.
The company first bears the fees and expenses up to the set limits. Any amount over the same is to be shared by all the participating shareholders in the ratio of their participation.
The fillings to the SEC are in great detail and can be observed from their website; however, core points are as mentioned above.
Common Mistakes of Tag-Along Rights
It is not always beneficial for the investors or the company to have a tag-along clause. The following are some mistakes that are very frequent:
#1 – Unclear definition of Majority
In certain companies, no single shareholder or a group holds 51% or a clear majority of shares, and therefore, where it is not clear what is considered as the majority, the application of tag-along right may become doubtful. It may not kick in when they should; therefore, it is always advisable to mention the precise definition of the majority. At times having 30% shares may also become a majority. And further, these terms should be continuously monitored in the light of a change in shareholding pattern.
#2 – Non Defining the Nature of Securities Covered
At times only a few types of shares or securities may be covered under the tag-along clause and, therefore, should be clarified to the security holders whether their securities are so covered or not. At times only an umbrella mention of such coverage is made, which doesn’t convey which securities are covered.
Tag along vs. Drag along with Clauses
The main difference is that in the tag-along clause, the minority shareholder has the right and not an obligation to be a part of the sale of shares process. If the minority feels that it can get a better price, they may not be a part of the sale; however, the drag along agreement is the complete opposite. In this, the majority has the right to sell the shares of the minority if it feels so. It becomes problematic when the minority feels that it is not getting sufficient compensation for its share.
There may not always be a consensus in the view of all the shareholders, and therefore, the majority has greater voting right. However, if the investor is getting into such an agreement, they ensure that they pay lower prices at the time of purchase of such a share because it gives them a lesser say. Therefore the price of a share with the tag-along clause will be higher than that with the drag along with clause.
Some of the advantages are as follows:
- Minority Investor Protection and Control: As mentioned in the importance section, these rights help the minority investors by protecting them against the unethical practices of majority shareholders and thus protect them from exploitation.
- Fetches better Price: The minority shareholder may not get a better price on his own due to a lack of marketability of such stock of a private equity company. Therefore as part of a larger deal, they get the same price and, therefore, better value for their share.
- Right and not an Obligation: If a minority shareholder doesn’t desire to participate, he may waive off his right as it is not an obligation to participate but only obligatory for the majority shareholder to request for minority participation.
Some of the disadvantages are as follows:
- Restriction of other Rights: As per convention, some of the other rights of the minority get sacrificed when they get tag-along rights. Therefore it is a trade-off, and investors should think it through before investing in such securities.
- Costly Investment: As Compared to the shares without such rights, the shares are costly when the investors buy because they are supposed to compensate the company for the right they receive.
- Make exits Difficult for the Majority: The pro for minority may become a con for the majority because the time taken to acquire the approval of all the tag along shareholders may dissuade the buyer who may lose interest and also fewer buyers might be interested in a company which has a tag-along clause.
These rights are a common practice and, therefore, very prevalent in the shareholder agreements with the company and the majority shareholder. At times they are known as the ‘co-sale’ agreements also. They aim to protect the minority from unethical practices of the majority and fetch them the best price for their share. Still, at times, they may become problematic and dissuade prospective buyers from entering into a deal.
This article has been a guide to what is tag-along rights and its definition. Here we discuss an example, importance, and common mistakes of the tag-along clause with its advantages and disadvantages. You can learn more about financing from the following articles –