Tag-Along Rights
Tag-along rights are a significant clause for any term sheet because they secure the minority shareholders’ choice to sell or retain their shares in the event of a sale. They are common in venture capital deals, where companies build themselves up with the plan to sell in a limited timeframe. This glossary defines tag-along rights, explains their role in VC, and their benefits for investors.
What are Tag-Along Rights?
Tag-along rights are contractual rights that support minority investors to join the majority shareholders in the event of a share sale due to a liquidation event such as a merger, acquisition, or private sale.
The benefit for minority shareholders with this right is that they can enjoy the same terms, conditions, and prices as the majority shareholders. The right exists to protect and give fair treatment to minority shareholders, to prevent them from receiving unfair terms or exclusion during a liquidity event.
Tag-along rights can easily be confused with drag-along rights, and they are both similar but different. Tag-along rights protect minority investors in sales; drag-along rights allow the majority shareholders to compel the minority shareholders to sell.
These rights are reached via negotiation in shareholder or investment agreements during fundraising rounds, which minority shareholders may not always be involved in, making the rights even more crucial to protecting them.
Purpose of Tag-Along Rights in Venture Capital
Historically, there was a power imbalance between majority and minority shareholders. The majority were usually investors and had more decision influence via board of directors chairs and could decide to sell the company, and minority shareholders who were often the employees at the startup and did the work to build the company.
In the event of startup liquidation, the majority shareholders would get all the benefits, and minority shareholders would not have a choice or reap the benefits of the share prices of the majority shareholders.
A small saving grace is that all minority shareholders don’t need to sell to make a sale, so if you wish to sell the company, it is still possible despite tag-along rights being in place.
Benefits of Tag-Along Rights for Investors
Despite tag-along rights existing to protect minority shareholders, there are some benefits for investors, so it shouldn’t always result in the avoidance of entering investment rounds if tag-along rights are mentioned in negotiations.
The benefits of tag-along rights for investors include:
- Tag-along rights encourage early-stage participation by boosting investor confidence through guaranteed equal exit opportunities.
- They provide investors security, ensuring liquidity events match terms received by larger, controlling shareholders.
- Tag-along rights help balance negotiations, reducing power gaps between majority stakeholders and minority investor groups.
- Smaller investors gain reassurance to commit capital, knowing they will not be excluded from exits.
- Even when unused, tag-along provisions enhance investor protections and strengthen leverage in potential sale negotiations.
It’s crucial for investors to acknowledge these benefits to their own interests so they can make a balanced decision about investing and understand how tag-along rights can impact future sales.
Tag-along rights exist to protect minority shareholders, and while this sounds counterintuitive to investor aims, they can have strategic advantages for investors.
They can build trust between investors and founders and maximize investor confidence in later funding rounds. It’s therefore helpful to investors to negotiate carefully to safeguard their interests as well as minority shareholders.