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by Jonathan Reuther
11 November 2021

Tag-and-Drag-Queens all along

Rules on the sale of shares: Sailing along or being pushed?

It is not uncommon for company founders to bring venture capitalists on board during the start-up phase. The founders often do not contemplate a later exit from “their company”. They want to build up the company in the long term. But this is different with venture capital investors. When they acquire shares, they are thinking about a successful exit later on.

Already when acquiring shares to the company, a later conflict of interest between founders and investors therefore becomes apparent. It is usually reflected in the rules for the sale of shares: One rule serves the existing shareholders (tag-along), the other the investor and his successors (drag-along).

Tag-Along

Every change of shareholders entails risks for the remaining shareholders. This is why shareholder agreements normally stipulate restrictions: shareholders may only sell their shares with the consent (of a majority) of the remaining shareholders. However, such a restriction typically does not apply to investors. They want to freely dispose of their shares at the right time.

By using the tag-along right, the existing shareholders may sell their shares as well (at the same economic conditions). This makes sense, because a new shareholder, who has not been chosen by the existing shareholders, may significantly influence the company’s business. This can lead to unpleasant surprises for the existing shareholders, for example when it comes to appointing managing directors. In addition, with a tag-along right, the existing shareholders will participate in the value gain that has been made possible by the investor.

What happens, however, if the acquirer does not want to take over the additional shares of the existing shareholders? Then either the deal has to be called off or the investor has its way and only its shares are sold. A mediating solution is to allow all shareholders to sell at the same proportionate amount in relation to their existing shares. Another idea is to impose an obligation on the investor to acquire the shares of the existing shareholders.

Drag-Along

In contrast, a drag-along clause is rather unpleasant for the existing shareholders. It imposes an obligation to sell. Buyers usually want to acquire certain majorities in the company which allow them to determine the company’s policy. In order to sell to such buyers, the investor will want to oblige the existing shareholders to (partially) sell their shares as well. This is a serious encroachment on the rights of the existing shareholders, who lose their position as shareholders against their will. If drag-along clauses are too aggressive, they may be invalid under applicable law.

But existing shareholders can also protect themselves. They may require that a certain percentage of the existing shareholders need to consent before the co-sale obligation is triggered. They can also shield themselves from low prices for their shares by using company valuation methods as a lower limit. Guarantees and warranties can be limited to the extent customary for the type of transaction. The investor can be made liable for a sale on unfavourable terms. Involving a representative of the existing shareholders in the sales negotiations can ensure transparency and participation.

Summary

From the point of view of existing shareholders who accept an “external” investor, a tag-along provision makes sense. The negative effects for investors of such a right of sale can be limited, which however weakens the rights of the existing shareholders.

The drag-along provision is important for investors. It is often a condition for the investment. Since an obligation to sell interferes with shareholders’ rights, existing shareholders should make sure that it is kept within certain bounds.

 
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