Drag-Along & Tag-Along Rights: Why Every Company Needs Them

Dragged to the finish line: why every company needs Drag-Along and Tag-Along rights in their Articles of Association or Shareholders Agreement.

When starting a company, very few founders are aware of the potential issues around shares, share ownership and the implications of that when selling their company.

As the business grows, the expansion of share ownership is inevitable; during the life cycle of the company it is not unusual to see third-party investors, employees with share options, different classes of shareholders all owning a stake in the company and all of whom will need to be aligned on an exit.  However, what happens if some do not want to sell?  What happens if some shareholders think that the price is too low? Or culturally, the buyer isn’t right?  How do we avoid dispute, or a minority shareholding from effectively holding a sale required by the majority to ransom or demanding a disproportionately greater price to see the sale through?

Gold standard to business governance

To prevent potential gridlocks and ensure a smooth transition for all parties involved in an exit, two mechanisms are essential: drag-along rights and tag-along rights.

Drag-along rights

In most business sales, a buyer will look to acquire most, if not all of the total equity of a company, as well as want to avoid the potential legal headache of dealing with minority shareholders. Drag-along rights held within the company’s articles of association, or sometimes a shareholders agreement, allows majority shareholders to compel the remaining minority shareholders to accept an offer to sell 100% of the shares in the company on the same terms and conditions. This prevents a minority of the company’s shareholders from holding out or refusing to sell and blocking an exit.

Including drag-along rights within a company’s articles or shareholders agreement also protects the business in other ways, such as:

• Marketability – it showcases to potential buyers the sale process will be clean, predictable and they will end up with 100% ownership.
• Efficiency – this tends to streamline the closing processes involved with a business purchase, but ensuring all shares of the company are sold, simultaneously and on the same offer terms.
• Valuation – by guaranteeing a 100% sale of the business, the business owners looking to exit can often negotiate a higher premium for the business, benefiting every shareholder in proportion to their shareholdings.

Tag-along rights

Whilst drag-along rights support the majority shareholders, tag-along rights are designed to protect minority shareholders from being left behind in a potential sale.

These grant the minority shareholders the right to be included in the exit, on the same terms as the majority shareholders.

Tag-along rights protect the minority by:

• Equal opportunities – it ensures if a founder/business owner is offered a way out, the minority shareholders get the same opportunity.
• Fairness – it guarantees that minority shareholders receive the same price per share as the founder/business owners, preventing minority shareholder discounting.
• Security – provides a level of security and share liquidity which could be difficult to obtain on the open market.

Why should you include both now?

In essence, both rights effectively create a reciprocal exit mechanism, providing each party with protections in place to avoid any potential issues in future. By including both drag-along and tag-along rights within your shareholders agreement or articles of association early on, you:

• provide certainty to everyone involved including the price and deal structure.
• align interests between both majority and minority shareholders, who are incentivised to work towards a high-value exit benefiting everyone.
• minimise the risk of potential litigation by incorporating clear unambiguous rights to ensure a smooth equity disposal.

Whether you are involved in a family-owned business looking to protect generational wealth (see recent article ‘Keeping it in the family: How Family Investment Companies Work’) , or a startup founder seeking investment, the ‘exit’ stage is the most crucial stage in any company’s lifecycle. Ensuring you have the right protections in place for your company starts at the beginning of any business relationship, especially where everyone is aligned.

Don’t let outdated company articles or shareholders agreement hinder your potential exit from your company. Feel free to reach out today to discuss implementing the right protections for your upcoming investment or exit.

Disclaimer – this article is provided for general information purposes only and does not constitute as legal or other professional advice, as it is not comprehensive, fitting for each circumstance and may not be up to date. Specific advice should always be sought in relation to any legal issue and Clarkslegal LLP does not accept any responsibility for any loss which may arise from reliance on any of the information contained on this site.

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If you would like support with any of the matters outlined above, reach out to our corporate team.