A shareholders agreement is a common legally binding contract between shareholders and a company. The terms ‘tag along’ and ‘drag along’ exist in provisions under these agreements, which work to balance the rights of majority shareholders and minority shareholders. This Legal Kitz blog will explain what a shareholder agreement is, what tag along and drag along mean, and how they vary to balance shareholders’ rights.
What is a shareholder agreement?
A shareholders agreement governs the shareholders, business relationships and other arrangements. It should clearly set out the shareholder’s rights, responsibilities, liabilities and obligations. These agreements will also work to ensure that each shareholder is treated fairly.
One of the common functions of a shareholders agreement is to prohibit a shareholder from selling their shares without giving other shareholders a reasonable opportunity to purchase them. This is a ‘pre-emptive’ right. The notion behind this, is that existing shareholders will not be forced to accept a new shareholder that is unwanted or undesirable for this business. While shareholders do not make important decisions on trades or management that a director would, they hold a powerful role in checking and ensuring a business is being run responsibly. This is why existing shareholders have the right to buy exiting shareholder’s shares either through their tag along or drag along rights.
What are tag along rights?
Tag along rights, as suggested in the name, give a shareholder the right to join and tag along with another shareholder if they find a buyer for their shares. This means that a key shareholder, or group of key shareholders, cannot sell their shares without giving other shareholders a right to participate in the sale.
How do tag along rights work?
Tag along clauses are generally structured in two ways. The most common type of tag along provision will give all shareholders the right to participate in a sale proportionally. This is an opportunity to sell your percentage of shares in the parcel of shares being sold. It will usually cause some shareholders to sell, but it will also include some barriers which do not allow everyone to sell all of their shares. Another type of tag along provision is a more protective one that prevents a key shareholder from selling their shares, unless the entire company is sold.
This right is specifically important for an investor or a minority shareholder. This is because normally, a shareholder would want the opportunity to sell their shares and realise the value of their investment at the same time as other shareholders. Not to mention, if the success of the business is dependent on the involvement of that key shareholder, another shareholder may want the opportunity to sell down or out if that person ceases their role as a key shareholder.
What are drag along rights?
Drag along rights, as suggested in the name, allows a shareholder who finds a buyer for the company to ‘drag’ the other shareholders into the sale. This means that a shareholder can initiate a sale of an entire company, regardless of whether the other shareholders agree. They are also commonly referred to as a ‘come along’ clause.
How do drag along rights work?
Drag along rights can be structured in different ways. In any circumstance, it is important to consider the minimum proportion of shareholders numbers required to agree to a sale before a drag along right is active, and whether there should be a pre-emptive round before a drag along right is active. In each consideration, it is very important to consider who holds the drag along rights and the likelihood of other shareholders being willing to be dragged along. Having a critical mass against this clause can cause serious issues for future business.
This right is specifically important for a company’s founding or controlling shareholders. This is because a drag along clause acknowledges that minor shareholdings are not readily liquid in private companies. Because of this, it will often be easier to find a buyer for the entire company, rather than just for a particular stake. It protects the company as a whole and works to maximise opportunities for the company in the share market, rather than allow plans to be derailed by a minority shareholder.
Drag along rights are not usually found to be oppressive to minority shareholders, since there is the protection of statutory provisions. The most relevant is section 232 of the Corporations Act 2001 (Cth).
Legal advice
Often, both clauses allow shareholders to find a buyer willing to purchase the entire company. This causes both terms to commonly be mixed up, but it is important that shareholders recognise how these clauses protect different shareholder groups. A tag along right gives optional opportunities to minority shareholders and a drag along protects the plans of key shareholders. They are both designed to serve completely different purposes, whilst having a similar outcome of finding a buyer for the entire company. If you are having trouble understanding or drafting a shareholder agreement with a tag along or drag along clause, Legal Kitz is here to help. We offer FREE 30-minute consultations to assist you with any queries or concerns. Book here now for your free consult.