This article is written by Parth Makarand Ranade, pursuing a Diploma in Advanced Contract Drafting, Negotiation and Dispute Resolution from LawSikho.
The democracy of shareholders largely rests on the rule that the majority shall prevail. However, the power of the majority must be kept within reasonable bounds to prevent the oppression of the interests of the minority.
Thus, the minority shareholders are granted certain rights by the Companies Act, 2013, in order to maintain the balance of power. Further protections may also be afforded to them in the form of the shareholders agreement, thus enticing everyday investors to invest in the company. Such an agreement amongst other things, sets out the rights of the shareholders and ensures that each one is treated fairly.
One of the protections afforded to minority shareholders to protect their interests is the concept of a “tag-along clause”, also known as a co-sale right.
Meaning and Purpose
A tag along rights clause allows minor shareholders to ‘tag along’ with a larger shareholder or group of shareholders if they find a buyer of their shares.
The purpose behind drafting this clause is to make sure that if a major shareholder decides to exit the venture, it would not result in the minor shareholders getting left behind.
To explain the same with an example:
- ‘X’ is a majority shareholder in a company.
- ‘Y’ is a minority shareholder in the same company.
- ‘C’, a third party, makes an offer to ‘X’ to buy his shares at an attractive price.
- ‘X’ accepts this offer, and sells the shares to ‘C’.
- If the shareholders agreement of the company provides for a tag along rights clause, this would give ‘Y’ the right to participate in the sale as well.
- Thus, Y will have the option of selling his shares to C under the same terms and conditions as X did.
As tag-along rights are contractual terms between private parties, they are often found in venture capital and private equity firms but not public companies.
Advantages of a Tag Along Rights Clause
- Being contractual obligations, they protect the interests of minority shareholders. They make sure that their interests are considered in the event of a company sale.
- Minority shareholders are afforded greater liquidity thanks to it.
- The minority shareholders enjoy the same consideration for each of their shares as the majority shareholder did. The terms of this tag are also identical to the sale by the majority investor.
- It allows the minority shareholder to capitalize on an attractive deal put together by the majority shareholder, who have greater negotiation power.
- While sale of private equity shares is heavily regulated, majority investors have the resources and know-how to facilitate the same. The minority shareholders are given the option of using this to their advantage.
Difference from Drag Along Rights Clause
A drag along rights clause is antonymous to a tagalong rights clause. Unlike its counterpart, it is a provision or clause in an agreement that gives the right to a majority shareholder to compel a minority shareholder to join in the sale of a company. The majority owner doing the dragging must give the minority shareholder the same price, terms, and conditions as any other seller.
Thus, using the same example as before:
- ‘X’ is a majority shareholder in a company;
- ‘Y’ is a minority shareholder in the same company;
- ‘C’, a third party, makes an offer to ‘X’ to buy his shares at an attractive price;
- ‘X’ accepts this offer, and sells the shares to ‘C’;
- If the shareholders agreement of the company provides for a drag along rights clause, this would give ‘X’ the right to force Y to participate in the sale as well;
- Thus, Y will be compelled to sell his shares to C under the same terms and conditions as X.
Structure and a typical tag along rights clause
Tag along rights clauses typically work in one of two ways:
- The first kind of structuring provides for every shareholder to partake in the sale proportionately. To give an example:
- X owns 10% shares of the company. The majority shareholder of the company is engaging in a transaction to sell the majority of his shares;
- The shareholders agreement provides for a tag along rights clause;
- Then, X shall be given the opportunity to sell 10% of the total shares that are being sold. The effect of this kind of structuring is that all shareholders will be able to sell some of their shares, but none of them will be able to sell all of their shares.
- The second kind of structuring obstructs a key shareholder from being able to sell their shares, unless and until the entire company is being sold in the transaction. This kind of clause is more restrictive in nature.
A typical tag along rights clause looks like this:
“The Third-Party Buyer shall deliver a written notice to the Minority Shareholder of their offer to the Majority Shareholder. On receiving this notice, the Minority Shareholder shall have the right to compel the Third-Party Buyer to purchase from the Minority Shareholder that portion of the Outstanding Securities that it holds for equivalent consideration and in proportional amounts between the Parties using the ratio of the number of Common Shares that each Party may have on a fully diluted basis.”
Exceptions to the tag along rights clause
Typically, informed investors insist on including tag along obligations in the shareholders agreement to secure their interests. However, key shareholders often negotiate to include exceptions to a tag along rights clause. It is in the interest of the minority shareholders to grant some concessions towards their way, as it keeps the major shareholders committed and motivated.
The advantage of including exceptions to a tag along rights clause allows a majority shareholder are outline below in an example:
- X is a majority shareholder of a company;
- The shareholders agreement provides for a tag along rights clause;
- X negotiates that a small portion of his shares shall be exempted from coming under the scope of the tag along clause;
- If X finds a willing buyer, X can sell off the exempted portion of his shares without giving the minority shareholders the right to tag along in the transaction;
- Thus, X shall be partially rewarded for his contribution. The holding of the company does not get diluted. It is a win-win situation.
An exemption can also be made on the basis of achieving certain milestones, or after the passage of a predetermined amount of time. Depending on the terms negotiated between the parties, such an exemption can be made to apply to the entirety of the holding of a majority shareholder, or only a part of it.
Possible variations for a tag along rights clause
A tag along rights clause is a versatile stipulation that can be moulded to fit the needs of the parties. Some possible variations of drafting it are:
- Deciding how the clause interacts with other clauses such as pre-emptive rights, which govern the sale of shares. To give an example, should the tag along clause be invoked when the majority shareholder is selling his shares to an already existing shareholder of the company?
- The parties can also negotiate the inclusion of a stipulation that the majority shareholder shall be compelled to first offer to sell their shares to existing shareholders, before he can offer them to potential third-party investors.
Thus, the drafting of a tag along rights clause can have several variations. Some factors to keep in mind while drafting such a clause are:
- Does the success of the company rest on the shoulders of specific shareholders? If so, the tag along clause should be negotiated to be in their favour;
- Profitability and maturity of the company;
- Intentions of the shareholders towards formulating an exit mechanism; etc.
Enforceability in India
Section 58 of Companies Act, 2013 indirectly provides for the enforcement of tag along rights clauses. It states that:
“Provided that any contract or arrangement between two or more persons in respect of the transfer of securities shall be enforceable as a contract.”
Thus, it can be said that “tag along” clauses are purely contractual in nature. They arise out of contract only and not from Act. In the case of Vodafone International Holdings BV v. The Union of India Apex court stated that tag along rights are contractual and thus are binding irrespective of whether or not they are expressed in the articles of association of the company. However, care must be taken to ensure that the provisions of the shareholders agreement are not contradictory to anything contained in the articles of association.
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