If you’ve ever read a good Shareholders’ Agreement or Company Constitution, you may have come across strange things called ‘tag-along’ and ‘drag-along’ rights.
I first came across these beasts when I was working in London for a private equity law firm in the City.
When you first read these clauses it isn’t always clear what they are trying to achieve, and why you would include them in your Shareholders’ Agreement (or Constitution). Let’s find out why.
Starting with ‘tag-along’ rights
A ‘tag-along’ right is triggered when a majority of shareholders (the Majority) choose to sell their shares in the company. By exercising this right, the holder of a small parcel of shares (the Minority) can require the Majority selling out to get the Minority the same deal on their shares.
Why would a Minority want this right? Because of something called a ‘control premium’ and a ‘minority discount’.
Sometimes a purchaser does not want to own all of a company’s assets – it merely wants to be able to ‘control’ the assets, and the purchaser will want to get control of the company’s assets for the lowest possible price.
Because ‘control’ generally requires more than 50% of the shares (or 75% for some issues), the purchaser may offer people holding between 50% and 75% of the shares a ‘premium’ above the fair market value of each share. The purchaser can afford to pay the Majority this premium because they will not be paying anything to the Minority – so overall the price of gaining control of the company’s assets is minimised.
If this transaction is able to go through, the Minority will be left holding a small parcel of shares in a company that has effectively been ‘parked’. In fact, the value of the Minority’s shares are then likely to incur a significant ‘minority discount’ because no one in their right mind would purchase them.
To put this in context, the Minority stake may be worth less than half its normal value. For this reason, a tag-along right is often referred to as a ‘minority protection’.
The bottom line is, before you buy a minority stake in a company – make sure you have a tag-along right! We often see people pay full fair value for a small stake in a company, only to find out that the stake is actually only worth half that value.
Moving on to ‘drag-along rights’
A drag-along right can be triggered when a Majority wishes to sell the whole of the company to a third-party. When this right is exercised, a Minority shareholder must go along with the deal, i.e. sell out at the same time and on the same basis as the Majority.
Why would a Majority need this right? Because of something called ‘greenmailing’.
Often a purchaser will not be willing to purchase a company unless it is able to acquire no less than 75% or 100% of the shares. For example, a purchaser may not want a Minority holding a ‘blocking-stake’ that prevents a special resolution from being passed (i.e. 75%). A purchaser may also require no less than 100% to consolidate the company into their group for tax purposes. A further reason may be to avoid having to take into account the interests of a Minority, i.e. potentially engaging in oppressive conduct.
Knowing this, a Minority may hold-out on participating in a sale transaction until they get something extra, i.e. the Minority may require more than their fair share of the total sale price. You may have heard of ‘corporate raiders’ who buy a blocking stake and then extract a nice profit when they finally agree to sell out. This is what we are talking about.
So before letting someone buy a minority stake in your company, make sure that you have in place a drag-along right so they can’t hold you ransom when the time comes to sell out.