With the rise of successful startups, Mergers and Acquisitions (M&A) are becoming more important. M&A refers to companies like venture capital firms buying, combining, or selling companies for a profit. The two main types of shareholders are minority shareholders, who typically hold less than 50% of the company’s stock, and majority shareholders, who generally own more than 50% of the company’s stock.
Majority shareholders have more power in deals, but tag-along rights can help even the playing field for minority shareholders. This shareholders agreement gives a minority shareholder the right to join the transaction and sell his or her minority stake. This is provided that the majority shareholder sells his or her stake, and this post will go into detail regarding this concept.
What are tag-along rights?
Tag-along rights are also nicknamed “co-sale” rights and are used to protect a minority shareholder during venture capital deals. It allows them to join the transaction and sell their shares if the majority of shareholders do. This clause is usually pre-negotiated prior to the venture capital deal and is very common in the startup/tech industry. It’s also common in any industry that has a substantial risk but high upside potential.
Tag-along rights basically give minority shareholders more liquidity and flexibility when investing. Liquidity either refers to how easily an asset can be converted to cash or sold without losing its value. Some investments, like publically traded ETFs, are very liquid because they can be easily bought or sold quickly without losing much value. On the other hand, assets like real estate, as well as shares of private companies, are illiquid because it’s harder to find buyers, and each investment can’t be sold in a day.
The majority of shareholders own a larger percentage of the company, with venture capital firms being a common example. Venture capital firms have greater abilities to attract buyers, negotiate payment terms, and even sell private shares on secondary markets.
Another common example of a majority shareholder is a person called an angel investor. Angel investors are well-connected businesspeople with high net worths who invest in startups for significant upside. Angel investors usually fund a startup in exchange for significant equity or ownership in the company to compensate for the risk. Mark Cuban is a famous angel investor and is part of the famous show Shark Tank, which involves entrepreneurs pitching investors for funding.
Important tag-along rights definitions
There are many subsets of finance, with private equity having the most unique language. It can be tough to understand this industry without understanding some basic terms like:
Venture Capital
Refers to investor groups, investment banks, or financial institutions providing financing to high-growth potential start-ups. These investments can be very risky, and some investors require equity in the company. This financing method can be great for companies that have been around for less than 2 years and don’t have the means to sell public shares. Venture Capital can be seen as a subset of private equity.
Private Equity
An encompassing term that includes venture capital and other non-public investments. Private equity firms can directly invest in private startups like venture capital, but they can also make public companies private. This practice is called a leveraged buyout as private equity firms use debt (i.e. leverage) to buy a public company that is usually struggling, which delists their shares. Once the firm is private, private equity firms work to improve the company’s financials and have the goal to either sell their interests to a buyer at a profit or have another IPO.
Drag-Along Rights
These are usually triggered during a company’s merger or acquisition and mainly benefit the majority shareholder. The majority shareholder can use these rights to force minority shareholders to sell their interests at the same rate and terms as the majority shareholders. Drag-along rights eliminate any minority owner and allow 100% of the company to be sold to the new buyer.
Check out our guide on the Drag-Along Rights
Angel Investors
These are usually affluent individuals who are accredited investors. Like venture capital, they invest in smaller companies in exchange for equity and other compensation. However, they don’t invest large amounts in each company as they don’t have the resources larger firms do. In fact, one company would typically be 10% or less of an angel investor’s portfolio. Angel investors also invest in companies during the early stages and can act in an advisory role.
Preemptive Right
This is also referred to as a subscription right, and it gives an investor the right to maintain his or her equity percentage by buying a proportionate number of shares in the future. It also helps investors find deals that outside parties can’t since they can buy shares before anyone else. This preemptive right can be found when buying options investment securities and during mergers. It also prevents dilution, which occurs when equity owners have a diminishing equity percentage.
For example, investor A has 30 shares in company A, which has 100 total outstanding shares. Investor A has a 30% stake in the company and would have a lower percentage if company A issued an additional 20 shares. Therefore, investor A could have a preemptive right that would allow him or her to purchase 10 more shares to maintain the 30% equity stake.
A hypothetical example of tag-along rights
Two co-founders launch a tech startup, which is going well, and they seek outside investments via a seed round. They work to attract outside investors like venture capital, private equity firms, and angel investors. Eventually, the co-founders find a venture capital firm that is pleased by their firm’s growth and wants to invest hundreds of thousands of dollars with them in exchange for a 70% equity position. This equity position might seem large, but it’s common in the startup world as it compensates for high risk. Per small business trends, 90% of new startups fail.
Fortunately, the co-founders’ business thrives, and the venture capital firm is satisfied with its investment. The venture capital firm has seen a significant return on investment but wants to sell in order to invest in other businesses. This firm finds a buyer for its 70% equity share and sells it for $40 per share. The co-founders pre-negotiated tag-along rights with the venture capital firm, which allows them to sell their ownership at $40 each.
When to use
Tag-along rights can be a great way to protect smaller investors and employees. In the past, it wasn’t as common for employees to become shareholders in the company. This has changed since many companies are recognizing the power of equity awards. This clause gives employees the ability to get a deal as good as larger investors like private equity firms and ensures that they won’t be shortchanged. These rights are generally used with private firms that are growing rapidly and whose shares are illiquid.
Therefore, tag-along rights make it easier for smaller investors to buy undervalued shares during a company’s liquidation.
When not to use
These rights aren’t ideal for the company’s management team along with other majority shareholders. Also, these deals can make it harder to negotiate for better prices during liquidation events. Investors might offer different terms if they are forced to purchase minority shares in addition to their desired investment.
Tag-along rights could help majority shareholders control a substantial part of the firm if they purchase the minority shareholders‘ stock. This action could cause strife among the management team and increase the shareholders’ uncertainty.
A good alternative to tag-along rights is preemptive rights, which allow investors to buy shares before other outside parties can. These rights also help investors maintain the same equity position in the company by buying shares on a pro-rata basis.
Common mistakes
Tag-along rights can add complexity to an area of finance that is already tricky enough. Some common mistakes to avoid with tag-along rights include:
Not precisely defining the terms
Companies need to precisely decide what a majority shareholder is. Generally, the majority of shareholders own at least 50% of the company, but that is open to negotiation. They also need to define which types of shares are subject to tag-along rights. There are many different types of stock, but the main two are class A and class B shares.
Class A shares have significantly higher voting rights than class B shares and are valued accordingly. For example, famous investor Warren Buffett offers Class A and Class B shares in his company, Berkshire Hathway. However, each Class A share trades for roughly $300,000, while a Class B share trades for around $200.
This extreme example demonstrates how concentrated voting power can really influence stock prices. Despite the difference in voting power, each shareholder has the same equal right to equity in the company. It’s also important to realize those common shareholders would be paid last after creditors, bondholders, and preferred stock investors.
Not considering the company’s structure and impact on dilution
Each company can have a different structure, which could be an LP, LLP, LLC, S corporation, or C corporation. LLCs and LLPs are two structures that provide limited liability, meaning that the business owners’ personal assets are protected from creditors. If the company fails, creditors can’t seize a business owner’s assets, like his or her home, to pay off debts. Limited liability also protects shareholders as the maximum loss they could have is their initial investment.
Limited liability companies can have complex ownership schedules, making it smart to determine crossclass tag-along rights as well. These increase shareholder dependency and will mitigate the risk of one sale disadvantage to the remaining investors.
Not factoring in the right of first refusal
As these rights are subject to negotiation, majority shareholders can restrict the minority shareholders’ ability to object to a sale or agreement. Related to this, tag-along rights can trigger a right of first refusal or ROFR. This provision allows a person or company the option to start a business transaction before anyone else. For example, an ROFR could prompt the first opportunity to buy stocks or other assets at the same price and terms as a different offer. If the investor that has the ROFR declines, the owner can sell it to anyone they desire.
ROFRs can be used by venture capitalists to get the best price on investments as it can help them time the market. Outside of investing, ROFRs exist in child custody agreements. One common use is that a ROFR demands that one parent offer the other parent the opportunity to watch the kids before using an outside third party or relative.
Bottom line
- Tag-along rights are really influencing the financial markets and are helping grow the venture capital industry. This situation has sparked many new transactions, which fall under the mergers and acquisitions (M&A) category.
- Majority shareholders own a higher percentage of the company than minority shareholders and have greater power in the transaction.
- Tag-along rights give minority shareholders more power when and if a majority shareholder sells his or her stock.
- Tag-along rights are used in a variety of cases and have been relevant to many industries, but it’s imperative to avoid common mistakes like not clarifying the specific terms per contract.
FAQs
Are drag-along rights and tag-along rights one and the same?
No. Tag-along rights protect minority shareholders and give them the right to participate in major deals like majority investors. Conversely, drag-along rights benefit the majority stakeholder’s investment by preventing the liquidation of their shares, and these terms enable majority shareholders to coerce minority shareholders to sell their stock on the same terms as the majority shareholders.
Are tag along rights always included in all shareholder agreements?
No, they aren’t, as this clause is subject to negotiation. Some agreements have it, and others don’t.
Who sees the most gain out of using tag-along rights?
Usually, minority shareholders see the largest benefit from these provisions since they can sell their shares at the same price as the majority shareholders. These rights give the minority stakeholders liquidity and can help them realize significant gains.
Do tag-along rights make it easier to sell company shares?
Sometimes they do, and other times they don’t. If buyers know that the shareholder agreement contains tag along rights clauses, they could be prompted to buy more shares than desired in the company.