VC and angel investors are likely to want ‘customary drag and tag provisions’ in relation to a capital raise for your startup. We’ve explained below what these provisions mean for you.
What are your drag and tag rights?
The drag along clause requires the minor shareholder to sell their shares. The tag along clause requires the minor shareholder to be allowed to join in on a sale. Both clauses are designed to give the minor shareholder the rights to receive the same price, terms and conditions as any other seller.
How do drag along rights work?
Drag along rights enable a majority shareholder to force a minority shareholder to join in a sale of the company. In other words, minority shareholders not involved in the sale are dragged along on the sale.
Drag along rights are designed to protect the majority shareholder and as they enable the sale of the whole company by buying out minority shareholders. Your investors who are likely to be the majority shareholders as your startup progresses will consider these rights to be important.
When to use drag along rights
The rights of a majority shareholder to drag along, can happen in all types of commercial transactions, such as mergers and acquisitions or a company's change of control. The majority shareholder has a stake in the business that is subject to variation based on the company's ownership mix and the shareholders' negotiating power, with an average range of 51% - 75%.
Investors may seek to amend the shareholders agreement to make drag along rights conditional.
Tag along rights
Tag along rights give the minority shareholder the right to sell its stake in the company by joining a majority shareholder selling its stake.
Tag alongs, in effect, oblige the majority shareholder to include minority shareholders in any sale negotiations. This is important for you as the founder since your investor often has better access to potential buyers, and may be able to negotiate better pricing and terms.
When to use tag along rights
Tag along rights are designed to safeguard the minority investor from being left behind if a majority shareholder decides to sell their shares.
When majority shareholders decide to sell, it may put minority shareholders at risk of being forced to sell their shares at a price which is substantially lower or has limited relationship to the actual value of the company. Without tag along rights, minority shareholders may find that they hold unsalable or devalued shares.
Co-sale rights?
Co-sale rights are similar to tag along rights, but applies when a majority shareholder is selling only a proportion of its shares. The sale is made conditional on an offer being made to minority shareholders to sell the same proportion of their shares.
One issue is that the buyer can end up with a large majority interest in the company, which may unsettle the remaining shareholders and may mean a new board of directors is on the way.
Can a minority shareholder block a sale?
With tag and drag along rights, all company shares are saleable if the majority want to do a deal. This can prevent a minority shareholder from blocking a sale and they will be dragged into the sale on the same terms allowing a buy to acquire the full business.
What other rights do minority shareholders have?
Along with drag and tag rights, minority shareholders may also have pre-emptive rights such as a reasonable opportunity to buy shares from other shareholders. This can also protect against having to deal with an unwanted new shareholder.
Do you need advice about your capital raise?