The Drag along and Tag along rights

DRAG ALONG AND TAG ALONG RIGHTS UNDER SHAREHOLDERS’ AGREEMENT:-

As we know in private limited and closely held public limited companies, there are restrictions on transfer of shares. When an entrepreneur starts a venture or business with new ideas or new invention, he needs finance. Finance will be provided by Banks, Financial Institutions, Government sponsored institutions and Venture Capital Funds. The Venture Capitals invest in start up ventures by acquiring share capital of the entity. Every investor, who is investing in a start up venture, before investing seeks the way to exist from the venture after earning profits. They enter a Shareholding Agreement with the promoters of the company before investing in the company.

The shareholders in the case of a private limited company are restricted to transfer their shares to maintain the shareholding patter under control of majority shareholders. The restriction is applicable on both majority as well as minority shareholders.

These rights are conferred by the Articles of Association of the company and the Companies Act, 2013 to the shareholders of private limited company. The minority shareholders restrict the exits of management or an investor from the company by enforcing these rights.

So an investor while at the time of investing in  a private limited company needs some rights to be included in the Shareholding Agreement to secure his/its exist and the investment.

TAG ALONG RIGHTS:

Generally in case of private limited companies, many rights are available to shareholders through its Articles of Association. There are some restrictions on sale of shares subject to Right of first refusal. If shareholders want to sale his shares, he must first offer these share to the existing shareholders for their purchase.  

This right is given to the minority shareholder to exist along with majority shareholders when they exist, on the same price and terms. This Tag-along right is generally demanded by the minority shareholders, as it allows them to exist with the controlling shareholders on the same price and terms (in cases investors are paying higher prices for the shares, they acquiring in a start-up).

Since minority shareholders are restricted to transfer their shares, but they are generally given right to participate or “Tag Along” in sales of shares by other controlling shareholders, who are not restricted to sale their shares.

Tag-along mechanics are complicated by the existence of multiple classes of shares desperately held between controlling shareholders and the minority shareholders.

Note: Suppose in a company XYZ Pvt. Ltd., Mr. X, Mr. Y and Mr. Z are the three shareholders holding 40%, 30% and 30% Shares respectively. Mr. X and Mr. Y wants to sell controlling interest i.e. 40% of the shares in the company to Mr. S, then Mr. Z can enforce through Tag-along right sale of his shares also on the same price and terms and conditions on which Mr. X and Mr. Y is selling their shares to Mr. S.

DRAG-ALONG RIGHT; - is an important concept under Corporate Law. This provides a right to majority shareholders, if they sell the stake, the minority shareholders are forced to join the deal on the same price and terms as the majority shareholder. It right protects the majority shareholder.   

It gives a right to investing investor to force other investor(s) to exist, should the investing investor exist, on the same price and terms as agreed. The investing parties generally forced the controlling shareholders as well as minority shareholders to exist, while he is existing. This right is generally not favoured by the promoters or controlling shareholders in a company, since this force them to sell their controlling interest in the company on the basis of valuation on which they have no control.

The minority shareholders are forced to participate in the sale through this right waiving appraisal rights.

This is a right that allow majority shareholders in a company to enforce minority shareholders to accept an agreement. This concept is well define as when a majority or controlling shareholders want to sell the company the remaining shareholders must consent or not raise objections.

Note: Suppose in a company XYZ Pvt. Ltd., Mr. X, Mr. Y and Mr. Z are the three shareholders holding 40%, 30% and 30% Shares respectively. Mr. X and Mr. Y wants to sell the company to Mr. S, and Mr. S wants to acquire 100% shares of the company and Mr. Z has not given his consent to this deal. In this case if there is a Drag-Along clause in Shareholders Agreement among Mr. X Mr. Y and Mr. Z. Then through this right Mr. X and Mr. Y enforce Mr. Z to sell his share in the company or consent to the agreement to sell the company with Mr. S.

It is beneficial to Majority as well as Minority Shareholders also, since Minority Shareholders will get best prices for their shares than expected.