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Drag-Along and Tag-Along Rights

Updated: Dec 8, 2023

When venture capitalists invest in a startup, the terms of the shareholder agreement become crucial in safeguarding their interests. Two provisions that play a pivotal role in such agreements are Drag-Along and Tag-Along Rights.

What is Drag-Along Rights:

Drag-along rights provide majority shareholders especially Institutional Investors / Venture capitalists with the authority to ensure that minority shareholders have to compulsorily join in the sale of the shares if majority shareholders are selling their shares or are doing a deal of selling whole of the company. In essence, if a substantial offer is on the table, majority shareholders can "drag along" minority shareholders to ensure a unified sale.


This provision is particularly beneficial for majority shareholders who seek to sell the entire company or a substantial portion of it to a strategic acquirer. By obliging minority shareholders to participate in the sale, drag-along rights facilitate a seamless transfer of ownership and enable the acquirer to gain complete control of the company.


Scenarios Where Drag-Along Rights Come into Play


Drag-along rights typically come into effect in the following scenarios:


1. Strategic Acquisition: When a majority shareholder receives an attractive offer from a strategic acquirer who desires full ownership of the company.


2. Company Exit Strategy: When majority shareholders decide to exit their investment in the company and seek a buyer for their entire stake.


3. Merger or Consolidation: In the event of a merger or consolidation involving the company, where minority shareholders' shares may be exchanged for shares in the resulting entity.


Example:

Imagine a scenario where a tech giant expresses interest in acquiring the entire startup. If the majority shareholder, often a venture capitalist, possesses Drag-Along Rights, they can enforce the sale of all shares of theirs as well as of minority shareholders and promoters , ensuring a comprehensive acquisition.


Understanding Tag-Along Rights:

Tag-along rights are rights given to a group of shareholders, venture capitalists or institutional investors to sell their shares in the event any other group of shareholders, venture capitalist or institutional investors are selling their shares.

For Example in a Company if a cap table consist Angel Investors, Promoters, Investor A , Investor B , Investor C. Investors A , B and C holds Tag-along rights . Than in the event Investor A is selling its stake to any other Existing or New Investors say Investor D than Investor B and Investor C also have Tag-along Rights to sell their shares to Investor D at same terms and conditions and considerations at which Investor D is purchasing shares from Investor A . Investor D is obliged to compulsorily purchase shares from Investor B and C or else he won’t be allowed to purchase shares from Investor A also . Tag-along rights of B and C Investor is an option to exercise or not and not compulsion to sale shares to Investor D.


In case Investor A holds a Drag Along rights than in that circumstance it can drag Investor B and Investor C to sale shares to Investor D at same terms and conditions.


Scenarios Where Tag-Along Rights Come into Play


Tag-along rights typically come into effect in the following scenarios:


Partial Sale by Majority Shareholders: When a majority shareholder decides to sell a portion of their shares, providing minority shareholders with the option to sell their shares as well.


Minority Shareholder Liquidity: Minority shareholders can exercise tag-along rights to exit their investment if they find the sale terms favorable.

Example:

Consider a startup where a venture capitalist owns 60% of the shares, and an angel investor holds 40%. If a large corporation offers to acquire the VC's stake, the angel investor can exercise Tag-Along Rights to sell their shares to the same buyer under the same terms.


Benefits of Drag-Along Rights for VC Investors

VC investors, often holding minority stakes in portfolio companies, benefit from drag-along rights in several ways:


● Enhanced Exit Liquidity: Drag-along rights provide VC investors with an exit strategy when the majority shareholders decide to sell the company.


● Fair Valuation: VC investors can expect to receive the same price per share as the majority shareholders, ensuring fair treatment.


●Reduced Negotiation Friction: Minority shareholders are not left to negotiate individually with the acquirer, streamlining the exit process.


Benefits of Tag-Along Rights for VC Investors:

VC investors, often holding minority stakes in portfolio companies, benefit from tag-along rights in several ways:


● Control Transfer: In cases where there is a change in control of the company, Tag-Along Rights can be triggered, allowing minority shareholders to participate in the sale.


● Negotiation Leverage: Tag-along rights give VC investors more bargaining power in negotiating the terms of their exit, ensuring fair compensation.


● Attracting VC Investments: Tag-along rights can make a company more attractive to VC investors by providing them with clear exit options.


Why Do VC Investors Need Both Drag-Along and Tag-Along Rights?


While drag-along rights provide VC investors with a guaranteed exit when the majority shareholders decide to sell the company, tag-along rights offer flexibility in case the majority shareholders only want to sell a portion of their stake. Having both provisions in place ensures that VC investors have the best possible exit options, regardless of the majority shareholders' intentions.


Conclusion


Drag-along and tag-along rights serve as essential mechanisms for safeguarding the interests of both majority and minority shareholders in venture capital-backed companies. By providing clear exit strategies and ensuring fair treatment, these provisions foster a harmonious environment for all investors, facilitating successful exits and enhancing the overall attractiveness of VC investments.


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