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Tag-Along (vs. Drag-Along) Rights Work, With an Example

File Photo: Tag-Along (vs. Drag-Along) Rights Work, With an Example
File Photo: Tag-Along (vs. Drag-Along) Rights Work, With an Example File Photo: Tag-Along (vs. Drag-Along) Rights Work, With an Example

How Do Tag-Along Rights Work?

Tag-along rights, often called “co-sale rights,” are contractual clauses typically included in venture capital deals and intended to safeguard a minority stakeholder. The minority shareholder has the right to participate in the transaction and sell their minority interest in the firm if the majority shareholder sells their investment. Tag-alongs compel the majority shareholder to bring up the minority holder’s shares throughout the negotiating process to exercise the tag-along right.

Recognizing Your Rights as a Tag-Along

A minority stakeholder includes pre-negotiated rights, also called “tag-along rights,” in the first stock issue of a corporation. If a majority shareholder negotiates a stock sale, these rights enable a minority shareholder to sell their share. Tag-along rights are common in startup enterprises and private firms with significant growth potential.

Minority shareholders may profit from a transaction that a more prominent shareholder, often a powerful financial institution, arranges thanks to tag-along rights. Large investors, such as venture capital companies, are often better able to find purchasers and work out payment conditions. Therefore, tag-along rights increase liquidity for minority owners. However, majority owners may often expedite acquisitions and sales on the  secondary market, and private equity shares take much work to sell.

The majority of states’ laws about businesses impose a fiduciary obligation on majority shareholders, which requires them to interact with minority shareholders honestly and sincerely.

Benefits and Drawbacks of Tag-Along Rights

Using tag-along rights has several benefits, chief among them being the provision of financial and legal protection for minority shareholders (which might include staff who have been granted stock ownership) if the firm is being sold. Minority shareholders usually lack the legal expertise and negotiating ability to adequately negotiate for a better deal when a sale is suggested. Minority shareholders win from tag-along rights because they may get the same advantages that majority shareholders negotiate.

On the other hand, tag-along rights deter majority owners from investing in the business. Tag-along rights, after all, compel the company’s big owners and management to make concessions that only serve the interests of the minority shareholders. Put another way, some investors may refuse to invest in a business that imposes unfavorable conditions on them.

A Case of Rights Attached to Tags

Venture capital companies, angel investors, and cofounders rely on tag-along rights. Assume, for example, that three co-founders establish a tech business. The company is operating profitably, and the co-founders think they have sufficiently validated the idea to go large—the co-founder seeks to raise capital from other sources in a seed round. After assessing the company’s worth, a private equity angel investor proposes to buy 60% of it, demanding a sizable amount of stock to offset the risk of investing in a tiny business. The angel investor becomes the company’s biggest shareholder after the co-founders improve the investment.

With an intense concentration on technology, the investor maintains essential connections with some of the bigger, publicly traded technology businesses. The business co-founders own this, so they bargain for tag-along rights in their investment agreement. Over the next three years, the firm expanded steadily, and the angel investors, satisfied with the paper return on their investment, searched for a large tech company to purchase their shares.

The bidder the investor finds is willing to pay $30 a share for the whole 60% interest. The three co-founders included their stock interests in the transaction thanks to the tag-along rights they negotiated. The majority investor’s conditions and price are entitled to the minority investor as well. As a result, the three co-founders sold their shares for $30 each by exercising their legal rights.

FAQs about Tag-Along Rights

What distinguishes drag-along rights from tag-along rights?

Drag-along rights are the reverse of tag-along or co-sale rights. Drag-along rights compel minority owners to accept the terms that the majority shareholders negotiate, in contrast to tag-along rights, which provide minority shareholders the ability to bargain in the case of a sale.

Is it Easier or Harder to Sell Shares in a Company with Tag-Along Rights?

In some cases, tag-along rights may complicate the selling procedure. When a prospective buyer refuses to upsize or modify the conditions of their offer to appease minority shareholders, it becomes more difficult to close the deal.

A Come-Along Clause: What Is It?

When majority owners opt to sell their shares, minority shareholders are forced to sell theirs via a come-along provision, also known as drag-along rights. Tag-along rights are the reverse of a come-along provision.

Conclusion

  • Contractual duties, known as “tag-along rights,” safeguard a minority investment in a startup or business.
  • Tag-along rights are primarily used to make sure that minority investor interests are taken into account when a business is being sold.
  • Minority shareholders may also benefit from increased liquidity via tag-along rights.
  • When the shares are sold, the minority investors are entitled to the same terms and prices as the dominant investor.
  • Sometimes, tag-along rights complicate the closing of a deal.

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