Tag-along rights (TARs) comprise a group of clauses in a contract which together have the effect of allowing the minority shareholder(s) in a corporation to also take part in a sale of shares by the majority shareholder to a third party under the same terms and conditions.[1]
Consider an example: A and B are both shareholders in a company, with A being the majority shareholder and B the minority shareholder. C, a third party, offers to buy A's shares at an attractive price, and A accepts. In this situation, tag-along rights would allow B to also participate in the sale under the same terms and conditions as A.
As with other contractual provisions, tag-along rights originated from the doctrine of freedom of contract and is governed by contract law (in common law countries) or the law of obligations (in civil law countries). As tag-along rights are contractual terms between private parties, they are often found in venture capital and private equity firms but not public companies.[2]
Structure
Generally speaking, tag-along rights comprise three devices: the tag-along clause itself, and a method of enforcement, such as a put option and/or a penalty clause (only applicable in civil law countries as the common law does not uphold penalty clauses).[2]
The tag-along clause itself grants the minority shareholder the right (but not the obligation) to participate in the sale planned by the majority. The majority shareholder must notify all other minority shareholders covered under tag-along provisions and allow them to join in the transaction. If the majority shareholder ignores this obligation, the put option/right to sell provisions engage to enforce the tag-along clause. For instance, if A sells his/her shares to C without including B, the put option would entitle B the right to sell his/her holding to A. A now has a legal obligation to buy B's shares if B so chooses to exercise his/her put option, which disincentivizes A's original opportunistic behaviour. In essence, the gist of this mechanism is quite simply "Either you let me out or you stay in". The possible inclusion of a penalty clause as a premium on top of the put option further disincentivizes opportunistic behaviour because A will now have to buy B's shares in the company at a higher price than when he/she originally sold his/her stake to C, effectively meaning "Either you let me out or you stay in, with a penalty".[2]
Purpose
The main purpose of tag-along rights is to protect minority shareholder interests in any transaction. Majority shareholders are usually big firms with many connections, better negotiating power and stronger capital, and as such are more likely to be able to find a buyer for their shares.[3] Hence, tag-along rights allow the minority shareholder to increase the liquidity of their shares because he or she will be afforded the opportunity to participate in any deal struck by the majority and prevent them from being "left-behind" in a deal.[4] Another reason is that when a majority owner sells his or her stake in a business, this dominant position allows the seller to sell at a price higher than the intrinsic price of the share itself, called a control premium, because the majority holder possesses a higher degree of freedom to make their decisions for the company.[5] Tag-along rights allow minority holders to also join in this premium and be able to sell their shares at this higher price in any sale between a majority and a third party.[4] Because tag-along rights are rights and not obligations, minority shareholders may or may not choose to exercise them. This allows minority shareholders to have a choice in the event of a majority of the
Enforceability
Tag-along rights are a form of contract clause and therefore not enshrined in statutes. As such, they have to be agreed upon by the parties beforehand in a shareholders' agreement.[8] Unlike a company's articles of association, these shareholders’ agreements are not public documents registered to the government, but private dealings between parties. As such, they are not binding on all members of the company, only the participants to the shareholder agreement. This doctrine was made clear in Welton v Saffery [1897] AC 299, where Davey LJ held: "such contracts [...] would create personal obligations, or an exceptio personalis against themselves only, and would not become a regulation of the company, or be binding on the transferees of the parties to it, or upon new or non-assenting shareholders"
In this sense, despite the nomenclature, tag-along rights are found to be enforceable in and operate in the same way as any other contractual term, but not as a right in the ordinary sense of the word (e.g., right to free speech).[8] Building on the holding from Welton, the House of Lords further held in the landmark case of Russell v Northern Bank Development Corp Ltd [1992] 1 WLR 588 that any agreement that restrains a company's statutory rights, even when the company itself voluntarily entered into such an agreement, would be held unenforceable.
As with other contractual terms, the exact wording of the tag-along right would also be examined by courts to determine its enforceability. In Seidensticker v. Gasparilla Inn, Inc., No. 2555-CC, 2007 WL 1930428, the
Usage
Numerous factors shape the use of tag-along rights.
Types of tag-along rights
There are two main types of tag-along provisions. The first ("full" tag-along right) allows the minority shareholder to sell all of their shares in the event of a transaction between the majority shareholder and a third party. The second ("pro-rata" tag-along right) forces the majority holder to reduce the amount of equity it wants to sell and provide the minority an opportunity to also sell their shares on a proportional (pro-rata basis).[9] Full tag-along rights are usually found in firms where there are few investors and each investor has strong rights, as "contractual rights of investors balance each other and a controlling member, if any, has limited maneuvering room for extracting private benefits", while the pro-rata option is "the appropriate measure" for firms with many investors who possess weak minority rights.[9]
Notice periods
The period of notice for the exercise of tag-along provisions is also important. Too short a notice period will make it difficult for other shareholders to make an informed decision about whether to participate in the sale, while a period too long will dissuade potential buyers who do not want to comply with such a cumbersome process.
See also
- Drag-along right, the opposite concept
- Pre-emption right
- Right of first refusal
External links
References
- Evan Weiner, Randall Lee. CONSIDERATIONS For Minority Equity Interest Owners Financial Executive^
- Isabel Sáez Lacave, Nuria Bermejo Gutiérrez. Specific Investments, Opportunism and Corporate Contracts: A Theory of Tag-along and Drag-along Clauses* European Business Organization Law Review, September 2010^