Tag Along and Drag Along Rights in Shareholders Agreement

Tag-Along Rights

Minority shareholders of a closely held entity are often restricted from selling their investments to a third party without the consent of management and/or a large contingency of other shareholders. In the event that a shareholder is permitted to sell its interest to a third party, governing agreements that contain tag-along provisions enable the other shareholders of a company to participate in the sale of such an interest, and such rights can generally be exercised at the discretion of each individual shareholder.

A typical tag-along provisions in a shareholder agreement are found in following language:

Prior to the consummation of any transfer to a third party purchaser, each other shareholder may give notice to the initiating shareholder stating that he/she wishes to participate in the proposed transfer. Each shareholder shall state the percentage interest that he/she wishes to transfer, and each shareholder shall be entitled to receive its pro rata share of the aggregate consideration paid by the third party purchaser to all of the other shareholders participating in such proposed transfer.

 

Several considerations should be evaluated when analyzing tag-along provisions. An analyst first needs to consider whether the interest being valued is a minority interest or a majority interest. For a majority interest holder, tag-along provisions are likely to be perceived negatively in terms of marketability, as these provisions could (i) restrict the ability of a majority interest holder to fully exit its investment in a single transaction; and (ii) change the majority shareholder’s interest to a minority investment.

To illustrate this concept with an example, let us assume there is a company with three shareholders; one shareholder (Owner A) owns a 60 percent majority interest and the other two shareholders (Owner B and Owner C) each own a 20 percent interest. Next, let us assume that the majority interest holder wishes to fully exit its investment and finds an investor (New Owner) willing to pay fair market value for a 60 percent interest. If both minority interest holders elect to exercise their tag-along rights, the current majority interest holder may only be able to liquidate a portion of its interest instead of fully exiting the position. An illustration of the transaction is shown below:

After the transaction, the New Owner will hold a 60 percent interest, the former majority shareholder (Owner A) will own a 24 percent minority interest and the other former 20 percent interest holders (Owner B and Owner C) will each own an 8 percent minority interest in the company. Thus, the tag-along provisions denied a full exit for Owner A. Further, because of the tag-along provisions, Owner A was converted from a majority interest owner (with control) to a minority shareholder (without control) whose investment is now restricted by the terms of the governing agreement and/or state laws.

Drag-Along Rights

A drag along provision allows the majority shareholder(s) to require the minority shareholder(s) to sell their shares. This is usually triggered in a takeover offer.

For example, when there is a bidder who would like to buy the entire company, and the majority shareholder(s) holding more than 50% of the company agree to sell their shares, the majority shareholder(s) can “drag along” the remaining minority shareholder(s) and require the minority shareholder(s) to sell their shares so the bidder is able to purchase the entire company.

To protect the minority shareholders, the drag along provision will usually require the majority shareholder(s) to ensure that the minority shareholder(s) is able to sell the shares on the same terms and conditions.

A typical drag-along provision may resemble the following language:

In the event that the Majority Shareholder agrees to sell his/her share in the company, the Majority Shareholder shall have the right (but not the obligation) to initiate a sale of the company and to require each other shareholder to participate in a sale of the company on the same terms and conditions as the Majority Shareholder, except that each other shareholder would be entitled to be paid its pro rata share of the aggregate consideration paid to all of the shareholders in such sale of the company.

Drag-along provisions can prevent a situation where minority shareholders have the ability to block a sale of the company that was otherwise initiated by the controlling shareholder or a majority of the other shareholders. As previously mentioned, an owner of a non-controlling interest is typically unable to control the business and affairs of a company; however, governing agreements sometimes contain provisions that prevent a liquidation or a sale of substantially all of the assets of a company without the unanimous consent of the shareholders. These types of provisions give minority shareholders some aspect of defensive control and ensure minority shareholders that they will not be forced to sell their interest at a price that is less than what they would prefer. A drag-along provision structured along the lines of the above example would nullify this defensive control and, therefore, negatively impacts the control aspects of such interest.

However, we also note that drag-along rights could positively impact minority shareholders. Similar to tag-along rights, under the assumption that a company receives a bona fide offer from a third party to purchase 100 percent of the company at a price equal to fair market value, then minority shareholders could potentially liquidate their interests at a price greater than fair market value.

 

Source : Major Portion of above write up has been taken from well known law portal Law360.

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