- ALTERNATIVE INVESTMENTS
- PRIVATE EQUITY and VC
Googlawi / Jake Shi
Tag-along rights, also known as co-sale rights, act as a protective shield for minority shareholders. They allow these smaller stakeholders to join—or "tag along"—when a majority shareholder sells their stake, ensuring they can exit on the same terms. On the flip side, drag-along rights empower majority shareholders to force—or "drag"—minority shareholders into a sale, potentially against their wishes.
KEY TAKEAWAYS
- Tag-along rights are contractual obligations to protect a minority investor in a startup or company.
- They are used mainly to ensure that the stake of minority stakeholders is considered during a company sale.
- Tag-along rights also provide greater liquidity to minority shareholders.
- The minority investors are entitled to the same price and conditions as the majority investor when the shares are sold.
- Tag-along rights can sometimes make it more difficult for a sale to be completed.
Understanding Tag-Along Rights
Tag-along rights are prenegotiated rights that a minority shareholder has in a company's stock. These rights allow a minority shareholder to sell their share if a majority shareholder is negotiating a sale for their stake. Tag-along rights are prevalent in startup companies and other private firms and have upside potential.
Tag-along rights give minority shareholders the ability to capitalize on a deal that a larger shareholder—often a financial institution with substantial pull—puts together. Large shareholders, such as venture capital firms, are usually more able to find buyers and negotiate payment terms. Tag-along rights, therefore, offer minority shareholders greater liquidity. Private equity shares are hard to sell, but majority shareholders can often ease purchases and sales on the secondary market.
Under most states' laws for corporations, majority shareholders owe a fiduciary duty to minority shareholders, meaning they must deal with minority shareholders honestly and in good faith.
Advantages and Disadvantages of Tag-Along Rights
One of the most basic advantages of using tag-along rights is that it gives the business' minority shareholders (including, sometimes, employees given stock ownership) financial and legal protection when the company is being sold. When a sale is proposed, minority shareholders typically don't possess enough bargaining power to properly negotiate for a better deal. Tag-along rights benefit minority shareholders because they're able to receive the same benefits the majority shareholders bargain for.
The flip side of this coin is that tag-along rights could discourage majority shareholders from investing in the company. After all, tag-along rights force the company's management and large shareholders to make concessions that will only benefit the minority shareholders. In other words, some investors will simply not select a company that makes less-than-favorable obligations of them.