Mar 20th, 2019
In the context of business and corporate governance documents, drag-along and tag-along provisions can help facilitate exit strategies by requiring investors to act in concert when the time comes to sell the company. These provisions predetermine the rights of both majority and minority equity holders to participate in a sale. As discussed below, drag-along rights benefit members holding a majority of equity in the company while tag-along rights protect those holding a minority interest in the company.
Drag-Along Rights & Obligations
Drag-along provisions (sometimes referred to as squeeze out provisions) allow one or more members holding a majority of interest in the company (majority members) to force the remaining members (minority members) to sell to an unrelated third party. The minority members must sell their interest to the buyer at the same price and on the same terms as the majority.
In many cases, a potential buyer may not be interested in acquiring only part of the company. Even if the buyer can acquire a controlling majority of equity in the company, the buyer may not want to be stuck with a minority group that is uncooperative or hostile. Drag-along rights are intended to facilitate a sale of the company in these circumstances. They allow the majority member to reassure a potential buyer that, once a deal is reached, the buyer will be able to acquire all (and not just a part) of the equity in the company. The minority members get "dragged along" into the deal based on their prior commitment in the operating agreement.
Drag-along provisions may irrevocably appoint one or more agents to transfer the interest of the minority members in the event of a drag-along sale. This can be useful in many contexts, such as when one or more minority members are not available to sign closing documents. This could happen for a number of reasons, including death, disability, or failure to keep the company informed about the member’s whereabouts. In these circumstances, the majority members can still close on the sale of the company.
Tag-Along Rights & Obligations
Tag-along provisions allow members holding less than a majority of equity in the company to participate in a sale at the same time and at the same price as the majority members. Tag-along rights benefit the minority members by allowing them to "tag-along" if the majority members reach a deal with a third party buyer. The majority member is not able to sell its equity in the company if the sale does not give the minority members the right to participate.
Tag-along rights are intended to protect minority members from the vulnerability inherent in a non-controlling interest. They prevent the majority members from “cashing out” without regard to the minority members. Unlike drag-along rights, which typically enhance the marketability of the majority member’s shares, tag-along rights can impair marketability by making an exit sale more difficult.
Effective Use Of Tag-Along & Drag-Along Provisions
Well-drafted drag-along and tag-along provisions are convenient tools for addressing the practical and administrative concerns that occur in the exit context. As with any business planning tool, the effective use of tag-along and drag-along provisions requires a thorough understanding of the members’ respective interests and goals. Once these are determined, tag-along and drag-along provisions are an important tool to help us achieve your goals.
Drag-along provisions should include a mechanism for transferring the interest of any minority members that fail to meet their bligations. This is usually done by irrevocably appointing an agent — typically a manager or other member — to execute any closing documents on behalf of the defaulting minority member. The agreement may allow the company to hold the defaulting minority member's share of the sale proceeds in trust until the member surrenders its original certificates and signs any other required documents.
Tag-along and drag-along provisions can be particularly useful in operating agreements or separate buy/sell agreements to restrict the ability of members to transfer their interests in the company. In this context, tag-along and drag-along rights provide investors assurance that their investment has the potential for liquidity when the time comes to sell the company.
To learn more about how properly-drafted documents can help you when it comes time to exit your business, give us a call today.