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What are Tag Along Rights?
What’s important to know about this concept?
In this article, I will break down the meaning of Tag Along Rights so you know all there is to know about it!
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Let me explain to you what Tag Along Rights are and why it matters!
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What Are Tag Along Rights
Tag along rights refer to the right minority shareholders have in a company to join the majority shareholders who are looking to sell their shares to a third party.
In other words, minority shareholders can “tag along” with the majority shareholders in a potential sale of their stake in the company.
For instance, if Mary owns the majority of the shares in a company and John is a minority shareholder, John will have the right to force Mary to include his shares in the negotiations she may be having with a potential buyer.
As such, if Mary decides to sell, she will have the obligation to include John’s shares in the deal.
The main objective of tag along rights is to protect minority shareholders so they have an opportunity to cash out on the same terms and conditions as the majority shareholders.
Very often, tag along rights are negotiated by minority shareholders before the shares are issued to them.
In case a large shareholder decides to sell, the minority shareholders will have the right to force the majority shareholder to include the minority shareholder’s shares in the transaction.
Keep reading as I will further break down the meaning of tag along rights and tell you how it works.
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Why Are Tag Along Rights Important
Tag along rights are important to protect minority shareholders in a company.
Typically, the minority shareholders in startups and companies with significant upside potential will want to negotiate tag along rights before purchasing their shares.
Venture capital firms, private equity firms, and investors having a minority position in a company will generally want to have the right to exit the company if the majority shareholders, typically the founding members and key personnel, decide to sell their stake in the company.
In this context, the minority shareholders that do not want to maintain a minority position in the company can sell their shares on the same terms and conditions as the majority shareholders.
Another reason why tag along rights is important is that it helps minority shareholders potentially get better terms on a potential sale.
This is the case as majority shareholders will generally have more leverage in a transaction than minority shareholders and can dictate better sale terms and conditions.
With tag along rights, minority shareholders have the assurance that they can sell their shares on the same terms and conditions as the majority shareholders.
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Tag Along Rights Drawbacks
Although tag along rights has many benefits for minority shareholders, it’s important to look at the potential drawbacks as well.
In essence, tag along rights are legal protections given to minority shareholders allowing them to join majority shareholders in a sale transaction.
One of the most notable drawbacks is that when companies offer tag along rights to their minority shareholders, the majority shareholders may not have the incentive to invest in the company.
Since the majority shareholders will know that the tag along rights forces them to make concessions that strictly benefit the minority shareholders, they may not be incentivized to further invest in the company.
Another important drawback for majority shareholders is that they may potentially lose a deal if the investor does not have the ability to buy not only the majority shareholder’s stake but also the minority shareholder’s stake.
As a result, since the majority shareholders are forced to include the minority shareholder’s shares in a potential sale transaction, an investor may not be prepared to purchase as many shares or take as much risk.
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Tag Along Rights Example
Let’s look at an example of how the tag along rights can be exercised.
Let’s say that Company A is composed of five groups of shareholders: the co-founders, key employees, regular employees, venture capital firms, and angel investors.
The venture capital firm owns 51% of the company shares whereas all the other three groups own 49% combined.
All of the minority shareholders have negotiated tag along rights giving them the right to sell if the majority shareholder sells.
Now, the venture capital firm considers that the company is in a good financial position and has good revenues justifying a potential sale.
They look around and find a buyer potentially interested in acquiring the venture capital firm’s stake.
However, since all the other shareholders have the right to “tag along” in the sale, they can choose to sell their position along with the majority shareholders.
In our example, the company founders, key personnel, and employees decide to keep their shares but the angel investor chooses to exercise her tag along rights.
This means that the venture capital firm will need to negotiate the sale of its stake and include the shares of the angel investor in the transaction.
Once the transaction is completed, the company shareholders will be composed of the co-founders, key personnel, employees, and the new shareholder.
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Tag Along Rights FAQ
What does tag along rights mean?
Tag along rights are rights given to minority shareholders to participate in the majority shareholder’s sale of equity transactions.
You will generally find tag along right provisions in shareholder agreements and company charters designed to protect minority shareholders.
In essence, if the majority shareholders strike a deal with a third party, the minority shareholders can force the sale to include their shares.
Why are tag along rights used?
There are two main reasons why tag along rights are used.
The first reason is that minority shareholders will want to increase the liquidity of their shares by being able to participate in a deal that the majority shareholders strike for the sale of their equity stake in a company.
Since buyers tend to prefer to acquire a controlling position, the sale of equity giving buyers a dominating position will generally be done at a premium.
Another reason why tag along rights is used is to protect minority shareholders from being left behind in a company when the majority shareholder sells their shares.
What’s important to consider when negotiating tag along rights?
The first element that must be considered is what type of sale will trigger the tag along rights.
Will the tag along rights get triggered when “all” of the majority shareholder’s shares are sold or if “any” shares are sold?
Another aspect to consider is the nature of representations and warranties to be made by minority shareholders in the transaction.
Since the transaction is controlled by the majority shareholders, what can be controversial is whether or not the minority shareholders will be required to give the full suite of representations and warranties as the majority shareholders.
When to avoid tag along rights?
There are some situations where tag along rights should be avoided.
In some cases, tag along rights can make it more difficult for the shareholders to sell to investors or third parties.
If an investor is not prepared to pay more than a certain amount or purchase an interest more than a certain percentage, the tag along rights exercised by minority shareholders may compromise the deal.
Tag along rights can also create friction between the new majority shareholders and the company management.
Since the third-party buyer buys a dominating position in the company, this can lead to management issues and uncertainty for various stakeholders.
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So there you have it folks!
What does tag along rights mean?
In a nutshell, tag along rights refers to legal rights minority shareholders of a company have to take part in a sale of shares by the majority shareholders on the basis of the same terms and conditions.
Tag along rights are often used by venture capital firms, private equity firms, angel investors, and other investors who are minority shareholders in a company.
If they see that the majority shareholders are selling their shares, the investors can join them in the transaction if they consider that staying as a minority shareholder is not beneficial.
The main objective of tag along rights is to protect minority shareholders in a company who can not only benefit from the majority shareholder’s ability to dictate better sale terms but also to avoid being left behind in the company.
Now that you know what tag along rights are and how they work, good luck with your research!
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