Having smooth operations and conflict resolution among shareholders is critical. With that being said, how does a company achieve clear, enforceable agreements among shareholders, and how are their interests protected? Unanimous Shareholder Agreements (“USAs”) often include specific clauses to manage the sale of shares and control over the company. Two important clauses are the tag-along (piggyback) and drag-along provisions. These two provisions will be the primary focus of this article; if you want additional information on USAs and what they are used for, check out our other recent articles on USAs at the links below.
Tag-Along (Piggyback) Clause
The tag-along clause, also known as a piggyback clause, protects minority shareholders. When a majority shareholder wishes to sell their shares to a third party, the tag-along clause entitles the minority shareholder to sell their shares for the same price and on the same terms. This ensures that minority shareholders are not left in a disadvantaged position or stuck in a business with an unknown and potentially unfriendly majority owner.
Often, a minority shareholder will have entered into a business arrangement with someone they know, trust, and want to be in business with. When a third party comes in and offers to buy out a majority percentage of the company, the minority shareholder may not want to stay in the business with the new buyer. This tang-along clause gives minority shareholders the ability to sell their shares at the same price as the majority shareholder. Without the USA, minority shareholders could be forced to remain in the company under potentially unfavourable conditions or sell their shares at a less advantageous price. This means they may have to accept less favourable terms from the third-party buyer or remain in the company with new management that they did not choose. It is also possible that the new buyer, who has more bargaining power, could purchase the majority shareholder's shares at a higher price and then try to force the minority shareholder to sell their shares for a lower amount after the initial sale.
The tag-along clause protects a minority shareholder by requiring the majority shareholder to purchase the shares pro-rata if a third party only wants to buy the number of shares the majority shareholder owns. Consider a tech startup where a majority shareholder owns 70% of the shares and a minority shareholder holds the remaining 30%. If a larger tech company wants to buy out the majority shareholder's stake, the minority shareholder can invoke the tag-along clause to sell their shares as well, ensuring they get the same favourable terms. In this case, the tag-along clause means that the purchaser has to purchase all of the minority shareholder’s shares in addition to the shares of the majority shareholder.
Drag-Along Clause
What if the private majority shareholders want to sell their shares of a corporation to a buyer, but certain minority shareholders don’t want to take the deal? In this case, a drag-along clause could be used, which benefits majority shareholders instead of minority shareholders. Without the USA, minority shareholders could block the sale or refuse to sell their shares, potentially preventing the deal from going through and causing significant delays and disputes. With a drag-along clause, the majority shareholders have the power to “drag” the minority shareholders along with them in the event of a liquidation. Drag-along rights are triggered by specific events such as mergers, acquisitions, or sales of the company, commonly referred to as "liquidation events." The majority shareholders must provide notice to minority shareholders detailing the proposed sale, terms, conditions, and timeline, ensuring transparency and preparation time.
Under drag-along rights, the terms of the sale, including the sale price and payment terms, must be uniform for both majority and minority shareholders, protecting the financial interests of all parties involved. The USA should also outline the mechanisms for executing the sale and ensuring compliance with the drag-along provision, including procedures for transferring shares and resolving disputes. The drag-along clause typically specifies a minimum percentage of shares—ranging from 51% to 75%—that must be held by the shareholders invoking the right. This provision ensures that potential buyers can acquire 100% of the company, thus making the transaction more attractive and seamless. As majority shareholders can compel minority shareholders to sell their shares under the same terms, this clause particularly appeals to corporations that intend to be involved in a sale transaction in the future, as potential buyers will likely want complete control over the business and will not want to deal with multiple minority shareholders.
Key Considerations
Negotiating Drag-Along and Tag-Along Rights:
Threshold Levels – Establishing the ownership terms required to trigger drag-along rights can be important.
Consideration Types – Ensuring clarity on whether non-cash consideration is permitted in drag-along provisions is vital.
Notice and Timing – Procedures for notifying minority shareholders about proposed sales and the timeline for exercising tag-along rights should be clearly defined.
Enforcement Mechanisms – Establishing mechanisms for executing and enforcing these rights is essential to ensure compliance and resolve disputes.
Common Pitfalls to Avoid:
Avoiding excessively broad provisions is important to prevent undue coercion and protect minority shareholders' interests.
Ensuring fairness in negotiating provisions is essential for maintaining trust and equity among shareholders.
Understanding the tax implications and legal enforceability of these rights is imperative to avoid unforeseen complications or challenges.
Recognizing that minority shareholders may have limited avenues to block a drag-along sale once the triggering threshold is met is essential for managing expectations and fostering clear communication.
Conclusion
Regular review and updating of the USA, including the tag-along and drag-along provisions, are critical to reflect changes in ownership structure, business strategy, or regulatory environment. They are tools for managing share sales and maintaining a balance between the interests of majority and minority shareholders. By understanding and implementing these clauses, corporations can safeguard their operations and foster a cooperative, conflict-free business environment.
At Outsiders Law, our Business Lawyers are here to help you understand these provisions and navigate future changes to protect your interests in the evolving landscape of corporate ownership.
Disclaimer
The information provided in this article is for educational purposes only. Nothing contained herein should be considered as legal, professional, or tax advice. Please contact us directly if you require legal assistance.
Comments