If you are the founder of a company, you are likely to come across a term sheet at some point. When terms sheets are drafted, one of the main clauses that are discussed and outlined is the outcome of an exit.
Clauses such as tag along and drag along rights are common ways of protecting the interests of all shareholders involved during an exit. These are the rights of the majority and minority shareholders that are created to represent their competing interests. Shareholder disputes are often thought as David (tag along) and Goliath (drag along), competing against each other with the oppressed minority in the role of David. The best protection for both tag along and drag along rights would be a Shareholders’ Agreement or a well-modified memorandum and articles of association. These contracts govern the shareholders’ rights, obligations and liabilities. Let us detail both drag and tag along rights in more depth.
Drag along rights
Drag along rights let a majority shareholder in a company oblige the remaining minority shareholders in order to take an offer from a third party to purchase the whole company. The clause protects the majority shareholders as the third-party buyers are looking for
complete control of a company. Drag along rights allows for the elimination of minority owners and the sale of 100% of a company to a potential buyer. It aims to provide liquidity, flexibility and an easy exit route for a majority shareholder.
Drag-along rights protect majority shareholders by stopping them from being ‘locked in’ to the company as well as ensuring that the minority shareholders are treated the same as a majority shareholder during an exit.
Let’s assume that Amazon wants to buy your company. You have a shareholder that owns 10%. Amazon doesn’t want to buy 90% of your company. They want to either buy your company or not buy your company, and that 10% can’t become a hold up in your deal. This is why you secure the right to drag investors along, so then you and your other investors will not be held up by a small singular investor on a deal.
An entrepreneur must pay attention to the threshold that determines whether you can drag somebody or not. This is because an investor can use this as a way to block a transaction from going ahead. For example, if the threshold is 75% for drag along rights then you need 75% approval of a deal to drag everybody along. If an individual shareholder owns 30% of the company, then effectively you need their consent to get the deal done. In practise, it is infrequent to see shareholders using their drag-along rights to block a deal but it is common to see them using their drag along rights to secure a good exit for themselves.
Tag along rights
These rights allow minority shareholders to ‘tag along’ with a larger shareholder or a group of shareholders if the majority shareholders (the seller) initiate a sale of shares to a third party. It is designed to protect the minority shareholders in case the majority don’t want to use their drag along rights. This can leave the minority shareholders behind during an exit scenario and it can block liquidity for them. Therefore anyone buying a minority stake — or selling a majority stake –in a private company should have tag along rights.
Minority shareholders can use this clause to take advantage of a favourable deal negotiated between the Seller and a Third Party and to prevent the controlling interest in the company being transferred to a Third Party.
Occasionally, an investor will become tired with the company and they may want liquidation and to sell their stock to somebody. If you as a minority shareholder feel that this might be hostile to your interests, then you can exercise your tag-along rights. In doing so, it makes it harder for individual shareholders who hold substantial ownership to sell their stock. It forces the majority shareholder to work with the other shareholders and with the company to organise the sale in collaboration with other shareholders.
As you can see, there is no ‘one size fits all’ approach when it comes to term sheets and control rights. A clause that fits well for one start-up might not be a good fit for another. VC investment in many scenarios can be a win-win for both entrepreneurs and previous investors. The support of experienced investors enables the start-up to grow and generate a significant financial uplift for all shareholders in an exit scenario. As an entrepreneur, you need to ensure that you know and understand each clause and fight for the clauses that matter instead of allocating disproportionate energy against the terms that don’t matter in the long run.