EXIT STRATEGIES FOR SHAREHOLDERS PT 3 - TAG ALONGS AND DRAG ALONGS

What to know before you're forced to sell your shares, or your own sale gets derailed

By Delzad Kutky

What you need to know about balancing majority and minority shareholder power in exits

Drag-along and tag-along rights are set out in Shareholders’ Agreements and can either help balance power or exacerbate the power difference where one shareholder or group of shareholders holds far more shares than another. While tag-along and drag-along clauses are often seen as two sides of the same coin, they are not always both present in a Shareholders’ Agreement and both need careful consideration when negotiating.

Drag-alongs at a glance

A drag-along clause typically allows a majority shareholder or group of shareholders to force a minority shareholder or group of shareholders to sell their shares to a third party on the same terms and conditions as the majority shareholder(s) will be selling their shares to that same third party. In other words, the majority shareholder is dragging the minority shareholder along in their transaction.

Drag-along provisions are attractive to majority shareholders because they open up a larger market of buyers in the even the majority shareholder wants to liquidate their shares in the corporation. While some buyers may be interested in buying a majority stake in a business, others may not feel comfortable buying into a business with minority shareholders they don’t know. The existence of a drag-along clause allows the majority shareholder to force minority shareholders to sell their shares as well if a buyer is only interested in complete ownership of all shares.

From the perspective of a minority shareholder, a drag-along provision adds an element of uncertainty as they may be forced out of the corporation unexpectedly.

Tag-alongs at a glance

A tag-along clause offers a minority shareholder the right to force a third party to buy their shares if the majority shareholder is going to sell their own shares to that same third party. Essentially, the minority shareholder exercises their right to tag-along with the majority shareholder’s sale of shares to a third-party.

Tag-along provisions serve to protect minority shareholders from being left behind when a majority shareholder chooses to sell their shares. Oftentimes a minority shareholder can feel uncomfortable being in business with a new entity they don’t know, especially when the new entity is going to be the majority shareholder. A tag-along mechanism in a Shareholders’ Agreement can give the minority shareholder the option to liquidate at the same time to avoid the risk of being trapped with an unknown business partner.

Conversely, majority shareholders are wary of tag-along rights. Depending on how a tag-along clause is drafted, the mechanism may kill their sale of shares where a third-party buyer who isn’t interested in buying all the shares of a business or it may simply force the third-party buyer to purchase some shares from the majority shareholder and some shares from the minority shareholder, which isn’t the outcome the majority shareholder wanted.

Whether you’re dragging or tagging, you need to be aware of major risks

Drag-along and tag-along clauses are important to negotiate and draft carefully if they will be part of your Shareholders’ Agreement. While the summaries above are a good high-level overview of what they do and how they work, there are key considerations that need to be part of your Shareholders’ Agreement to ensure you don’t run into disputes with your business partners or third-party buyers in the future.

First and foremost, the triggering event for a drag-along or tag-along transaction needs to be clearly defined. This should include any threshold for the percentage of shares being purchased (i.e. all and not less than all of a majority shareholders’ shares, at least 51% of the issued and outstanding shares in the capital of the corporation, or any shares being transferred at all, among other options).

There may also be other conditions that must be satisfied before a tag-along or drag-along sale can be triggered including conditions related to who the third-party buyer is, how many shares the dragged- or tagged-along shareholder will be selling. Additionally, any restrictions on the terms of sale, including price, payment terms, representations and warranties, and indemnities being provided should be considered in the Shareholders’ Agreement.

Concluding Thoughts

Tag-along and drag-along rights can give majority and minority shareholders greater options for liquidity and cause to worry about their ability to sell their shares in a corporation in the manner they choose. It’s very important to consider your bargaining power, financial position, and future plans when deciding to include one or both exit strategy options in your Shareholders’ Agreement.

Furthermore, because they involve a third-party purchaser, a further layer of risk is involved where that purchaser may seek recovery of damages or equitable relief if a tag-along or drag-along procedure is not well-drafted or carefully followed. This, coupled with the fact that a Shareholders’ Agreement is often drafted years before a tag-along or drag-along sale is contemplated, makes the advice of a skilled corporate lawyer invaluable.

Our corporate lawyers at SorbaraLAW are ready to go through your exit strategy options carefully with you to ensure you have a plan and know what to expect when buying shares of an existing business or starting your own business.