What are drag-along and tag-along rights?

When selling a company, the priorities of both majority and minority stakeholders must be taken into account. Drag-along and tag-along rights exist to protect the interests of each of these parties respectively. This article explains what drag-along and tag-along rights are, and what needs to be considered when negotiating them in a sale.

What are drag-along rights?

A drag-along right enables a majority shareholder to force minority shareholders to consent to the sale of a company.

Suppose X company has 4 shareholders including Jack who owns 51% of the issued shares, making him the majority shareholder. Peter comes along who wants to buy X company.

Jack likes the deal and agrees to sell his shares. Having drag-along rights enables Jack to “drag along” X company’s minority shareholders, requiring them to sell their shares to Peter to complete the purchase.

In this way, drag-along rights serve to protect a majority interest in a company. They prevent minority shareholders from holding up a promising deal.

However, they also must ensure that minority shareholders can sell their shares with the same rights and on the same terms and conditions as the majority shareholders.

Some buyers want complete control of a company. Drag-along rights empower them to eliminate minority shareholdings, while tag-along rights protect the minority’s interests (more on this next).

The key advantage for majority shareholders is to increase the marketability of the business by delivering the company with no minority shareholders. Having drag-along rights in place can potentially secure a higher premium for controlling all interest when valuing the company.

Key considerations when negotiating drag-along rights

Price of shares

If minority shareholders are in a strong position, they may insist on a minimum price for their shares to avoid being forced to sell at a low price, for example, in circumstances where a majority shareholder becomes insolvent and wants to dispose of its assets quickly.

In addition, minority shareholders might wish to include rights as part of the drag-along process to ensure that the price provided for their shares has been fairly valued.

Representations and warranties

Minority shareholders are generally not expected to give warranties and representations other than as to capacity and title, because they have no control over the warranty package agreed by the majority shareholder.

Form of consideration

Generally, a majority shareholder’s right to “drag-along” minority shareholders only applies where the consideration for the shares is in cash. Minority shareholders are likely to object to any drag-along rights which would apply to the sale of their shares other than for cash, for example, a share for share exchange, as they may be left with a minority stake in another company with limited rights and no exit route.

What are tag-along rights?

Tag-along rights, sometimes referred to as ‘co-sale rights’, are a form of protection for minority shareholders. With tag-along rights in place, should a majority shareholder decide to sell their shares in a company, minority shareholders will then be able to join the transaction on the same terms (i.e., selling their shares at the same price).

For minority shareholders, such rights offer a viable exit strategy. For example, without  tag-along rights, minority shareholders will be vulnerable to being left behind should the majority shareholder decide to sell its shares to a third party investor.

Similarly, by giving a potential purchaser the opportunity to acquire a controlling holding, tag-along rights may allow a higher valuation of the shares.

In the context of share transfers, tag-along rights will frequently provide minority shareholders with more security than pre-emption rights, especially when minority shareholders lack the financial means to buy out a majority shareholder.

One point to consider in the context of tag-along rights is whether such rights will be triggered if the majority shareholder decides to sell some, but not all, of its shares.

Key considerations when negotiating tag-along rights

Part sales

One point to consider in the context of tag-along rights is whether such rights will be triggered if the majority shareholder decides to sell some, but not all, of its shares.

Representations and warranties

Whether minority shareholders who trigger their tag-along rights should be required to give the same representations and warranties as the majority shareholders is usually a matter for negotiation.

Since the majority shareholders control the sale process, minority shareholders will want to limit any contractual assurances they give. On the other hand, because the minority shareholders will be entitled to the same price per share on exit as majority shareholders, arguably, they should be required to give the same representations and warranties.

A possible solution to this impasse may be to consider obtaining warranty and indemnity insurance.

Where to include drag-along and tag-along rights?

Drag-along and tag-along rights are usually included in a shareholders’ agreement or articles of association of a company.

Summary

Drag-along and tag-along rights are contractual obligations which operate to protect both minority and majority shareholders in a company. The inclusion of such rights as provisions in a well drafted shareholders’ agreement are often important as a means of addressing investor concerns and protecting shareholders’ interests; tag-along rights operate to benefit minority shareholders, drag-along rights, majority shareholders.

For further information on drag-along and tag-along rights, or more general corporate related issues in Egypt, UAE, and the UK, please contact Ehab Elsayed.