What Are “Drag-Along” and “Tag-Along” Rights?
“Drag-along” and “tag-along” provisions are staples of venture capital and other investment agreements. They are often included in investors’ rights or shareholders’ agreements for corporations or operating agreements for limited liability companies.
The “drag-along” provision, sometimes called a “bring along,” gives a majority owner or owners the right to require the minority owners to participate in a sale of a company to a third party along with the majority. This provides the controlling owners, who typically have more at risk, greater certainty that they will be able to negotiate and approve a sale of the company on favorable terms without minority holders preventing or delaying the sale to negotiate special terms. Standard drag-along provisions provide that the minority owners sell their interests for the same price (or in accordance with the company’s liquidation provisions), and otherwise largely on the same terms and conditions as apply for the controlling owners.
The tag-along right, also known as a co-sale right, is the corollary to the drag-along. It provides that if the majority owners or, in some cases, just the founders, sell their ownership interests directly and not in connection with a sale of the entire company, the minority owners have the right to sell a pro-rata portion of their ownership at the same price and on the same terms and conditions. The purpose of the co-sale right is to protect against the controlling owners or founders cashing out their interests without the minority owners having the same opportunity.
In practice, drag-along and tag-along rights are rarely formally triggered. Rather, they serve as important checks and balances to help assure the owners act fairly and in good faith with each other by providing guard rails.
Because the motivations of each owner and the dynamics and relative bargaining power among the owners vary, investors, founders, and other owners should give careful consideration to the drafting of drag-along and tag-along rights. As with most contract provisions, a little extra preparation upfront can provide the parties with greater certainty in the future when an exit opportunity arises. Below, we highlight just a few of the key elements of drag-along and co-sale provisions.
What Circumstances Can Trigger the Drag-Along Right?
Typically, controlling owners will seek for the drag-along right to be triggered in the event of any transaction resulting in a change in control of the business involving an unaffiliated third party acquirer. Although less common, minority owners may seek to limit the types of transactions that would trigger the drag-along right, require a certain period of time to have passed before the drag-along can be triggered, or require certain valuation thresholds or other company performance benchmarks be met before a drag-along can be triggered.
The drag-along right typically can be triggered if the board and the holders of at least a majority of ownership interests approve the drag-along sale. Depending on the circumstances and negotiating leverage, a percentage ownership greater than a majority may make sense. For example, if two 35% owners are the largest holders, they may agree that they both need to be in favor of the sale to trigger the drag-along, suggesting owners holding at least 70% of the company must approve the sale in order to trigger the drag-along.
When Can Tag-Along Rights be Triggered?
The mechanism for triggering tag-along rights may, like drag-along rights, may vary based on the motivations of the parties. However, tag-along rights commonly can be triggered when the controlling owner(s) or founders key to operating the business have a deal to transfer its or their interests to an unaffiliated third party. Transfers to affiliates and for estate-planning purposes are often carved out.
Who Should Be Able to Participate in a Tag-Along Sale?
Typically, all other owners will have the right to participate in the tag-along sale.
What Type and Amount of Tag-Along Interests may be Sold by Minority Owners?
Tag-along rights apply on a proportionate ownership basis, resulting in the initiating sellers having the amount they planned to sell reduced to accommodate the sale of ownership interests held by the other owners. In situations where there is more than one class of ownership interest, the parties should ensure the formula for determining the amount and class of interests that can be sold by the minority owners in the tag-along sale is appropriate and actually works, such as on an “as converted” basis. Running through real number scenarios can be very helpful in this regard.
Careful consideration in the negotiation and drafting of drag-along and tag-along provisions are important to help ensure that investors, founders, and minority owners in privately-held companies protect their differing interests in anticipation of a future sale of the company.
The attorneys at Linden Lw Partners have extensive specialized experience with drafting and negotiating a broad range of shareholder, limited liability company, and investor agreements in connection with private investments and anticipating the different merger and acquisition scenarios. Please contact us here or call us at (303) 731-0007 to discuss how we can help your company.