Transfer of Share Rights | Tag Along and Drag Along

In the previous blogs we spoke about ROFO/ROFR as well as Promoter Lock-In and Founder Vesting of shares. In this blog let’s talk about the last set of Transfer of Share Rights: Tag Along Rights and Drag Along Rights.

Both Tag Along and Drag along are certain rights which are relevant in the context of transfer of shares by shareholders. It governs how the right holder can either participate in a transfer (tag) or force a transfer (drag). Let me elaborate this further in the blog one by one.

Tag Along Rights

Tag Along Right, as the name indicates, is a right typically with a minority shareholder (generally an investor) to participate in a round where a majority shareholder (or the shareholders as mentioned in the definitive document/SHA) is selling shares to a buyer.

The right holder has a right to join the round with the same transaction terms applicable. The selling shareholder is obligated to include the minority shareholder’s shares as part of the transaction.

This right is aimed to protect minority shareholder’s interest in the event of a sale by the majority shareholders (typically the promoters) which might lead to a change in control.

Typically, the minority shareholder can join the round with number of shares in proportion of their shareholding in the company (pro-rata tag). This is however based on how the definitive agreement is drafted. For example: I have seen cases where the investor has sought for a full tag (vs. a pro-rata tag) giving the investor a right to sell all of their shares before the promoters can sell to the buyer.

Drag Along Rights

While Tag Along rights protect the minority shareholder, Drag Along rights are intended to favor the majority shareholder in the event of an exit opportunity.

Drag Along Rights are rights that typically majority shareholder possess that enable them to ‘drag’ the minority shareholders (or as defined in the SHA) to sell their shares to the buyer who wishes to acquire a particular target stake in the company.

While typically given to majority shareholders, in the context of early-stage startup investments, these rights are also awarded to minority investors in the event of trigger of ‘exit’ or ‘accelerated exit’ clauses as per the SHA which enables the investor to go into the market and find suitable buyers as the promoters haven’t been able to secure an exit for the investor in the specified timeframe as per the SHA.

The clause basically gives an advantage to the investors to force a full acquisition or significant stake sale to a third-party buyer by dragging the minority shareholder’s shares in the interest of closing the transaction.

Why do investors insist for Tag and Drag rights?

Most definitive agreements will have tag and drag rights in the favor of the investor. Reasons are straightforward given what these rights entail:

Tag Rights

In the event of promoters selling their shares, investors definitely don’t want to be left behind as a minority shareholder (atleast they want to retain that option).

Drag Rights

This is when an investor is forcing an exit (either on trigger of ‘exit’ clause or ‘accelerated exit’ clause). In such a case, if they find a strategic buyer who intends to either acquire the entire company or acquire a significant stake, investors do not wish that the promoters put a spanner in the deal. This right thus ensures that the promoters are forced to sell their shares as well to the extent the buyer wishes to acquire stake in the company.

Note that in most cases, if the investor triggers the drag clauses, the promoters do get an option to buy shares from the investor on the same terms first failing which they will have to participate in the transaction as per the drag clause.

Mind the La(w)nguage

Tag Along Rights are typically worded as below

In the event that the Investor is unwilling to purchase the Right of First Offer Shares, the Investor shall have the right, but not the obligation, to participate in such proposed Transfer of Shares by the Promoter by requiring the Third Party Purchaser purchases from the Investor, at the sole discretion of the Investor, a maximum of such number of Shares then held by the Investor at the same price and upon the same terms and conditions on which the Promoter proposes to transfer its Shares to the Third Party Purchaser.

Drag Along Rights are typically worded as below

In the event that the Company and the Founders fail to provide the Investor an exit before the Exit Period, the Investor, has the right to require the Dragged Shareholders to sell all or any of the Securities held by them (“Drag Along Shares”) to any Person identified by the Investor (“Buyer”).

Founders should watch out for:

Full Tag vs. Pro-Rata Tag

• Investors might insist for a full-tag option which enables them to sell all of their shares to the buyer first before the promoter (or other shareholders) sell any of their shares to the buyer.
• This might be not desirable in cases where promoters are seeking a partial exit of a minority stake to ensure some liquidity for themselves, and investors might insist for an exit for themselves first.
• In such cases promoters can offer a pro-rata tag — which means investors can liquidate to the extent of their proportional shareholding.
• If unacceptable to the investors, promoters can further offer a full tag only in case of change of control in the company, i.e., the promoters are selling shares to the extent that they are giving away a controlling stake to a third party. This is a fair expectation from an investor point of view as they ought to have an option to exit before promoters in case, they are selling a controlling stake to a third person.

In conclusion, tag and drag clauses are the third hurdle in this steeplechase of promoters aiming to liquidate their shares in the company along with Promoter Lock-in and ROFO/ROFR.

Most SHA documents will definitely have these rights which are considered quite standard. Founders need to be careful that they don’t sign-up to something that is out of the usual which might hamper their independence and flexibility in engaging in such future transactions.