A Shareholders' Agreement is an arrangement among a company's shareholders that describes how the company should be operated. It also outlines the rights and obligations of the shareholders, information on the management of the company, and the privileges and protections of the shareholders.
You'll often find clauses such as:
Details of optional versus mandatory buying-back of shares by the company in the event that a shareholder gives his/her shares up or leave the company, or in unable to perform their duties due to either mental incapacity, critical illness, or death,
A right of first refusal clause, detailing how the company has the right to purchase a selling shareholder’s securities prior to them selling to an outside party
Details of a fair price for shares
A potential description of an insurance policy
Among those clauses, you might see clauses called a Drag-along and a Tag-along clause. But what do these mean?
A Drag-along clause (also called a bring-along clause) allows for a majority shareholder of a company (usually over 75% of total shareholding) to compel the minority shareholder to accept an offer from a buyer to purchase the company and include the minority shareholder's shares in the business in the final acquisition deal.
This is a right and not an obligation, so the majority shareholder can choose to not activate this clause.
The name is such because if you were to visualise the action here, it is akin to the majority shareholder "dragging" the minority shareholder along for the ride and into the deal.
Think of it this way - Iqra says to Ryan "I'm going to sell the business to Daisy, and we can get the best price by selling 100%, so I'm including your shares in the deal."
So Iqra as the majority shareholder will look to activate the Drag-along clause and compel Ryan to put their shares up as part of the deal.
The majority shareholder will need to give the minority shareholder the same price, terms and conditions for the sale of their shares as any other seller.
Why is it used?
In general, buyers will want to ultimately purchase the entire company, not just a portion. Buyers may be put off by the idea that they can't acquire 100% control of the company.
So the clause makes the company more attractive to a buyer as they can take more comfort in the knowledge that a majority shareholder could accept the deal without a minority shareholder putting a spanner into the works.
For the majority shareholder of the "Target company" (ie the company that is being acquired), maybe they want to advertise to the buyer that they can enter into a deal for 100% of the company so that, again, the company can be a much more attractive investment to the buyer. Also by doing so, the shareholders can get the full value for the company rather than 75% from only the majority shareholder selling their shares in the company.
For the minority shareholder, they will receive consideration for their shares at the same price per share and under exactly the same terms and conditions that the majority shareholder has agreed with the buyer. Basically, they are in the exact same position per share.
Example:
There are 500 shares in the Target Company. The majority shareholder owns 400 (80%) and the minority shareholder owns 100 (20%).
The consideration per share that the majority shareholder has agreed with the buyer is £100 per share.
The majority shareholder will therefore receive 400 x £100 = £40,000 for their shares. But they want to get more out of the buyer so activates the drag-along clause in the shareholders' agreement.
With the minority shareholder's 100 shares included in the deal, the Target Company will therefore be worth £50,000. The minority shareholder will be compelled to sell under the exact same terms. As a result, the split will be £40,000 for the majority shareholder and £10,000 for the minority shareholder.
Drag-along clauses will need to be drafted with care so that the majority shareholder doesn't experience any issues in activating or enforcing the provision, and so that they don't face a claim from the minority shareholder for unfairly prejudicial conduct.
A Tag-along clause (also called a piggy-back or a take-along clause) allows a minority shareholder to compel the majority shareholder to include the shareholdings of the minority shareholder in the negotiations.
Again, this is a right and not an obligation so the minority shareholder can choose whether they want to activate it or not.
It gets the name because you can get the visual representation of someone "tagging along" with someone else going somewhere, or by one person "taking along" another person on a journey.
Think of it this way. Iqra says to Ryan "I'm selling my shares in the business to Daisy, I'm outta here, see ya!" but Ryan says "hang on, I want to go with you!" Ryan as the minority shareholder can activate the Tag-along clause which would give them the right to join the transaction and sell their stake in the company.
The minority shareholder is entitled to the same price and terms and conditions as the majority shareholder when activating the clause and compelling the majority shareholder to include their shares in the deal.
Why would a minority shareholder do this?
It makes sense for a minority shareholder to have the opportunity to sell their shares and realise the value of the investment at the same time as other shareholders, so this clause provides for that.
Perhaps the minority shareholder doesn't want to work with the new incoming shareholder, so the clause allows for an easy exit whilst getting the same value for their shares as the majority shareholder.
Perhaps the minority shareholder has just had enough and wants to sell their shares at the same time as the majority shareholder and simply have done with it. They may be retiring, they may be moving on to other investments or ventures, or they simply don't want to be a shareholder anymore and saw the acquisition as a good opportunity to exit.
Perhaps the success of the company is down to the majority shareholder's efforts, so the minority shareholder might want the opportunity to "sell out" when the majority shareholder sells and exits the company.
It gives the minority shareholder the chance to capitalise on a deal the majority shareholder has a part in. Maybe the majority shareholder has access to more buyers who could offer a higher price for the business when the day comes to sell. So this clause, when written well, gives the minority shareholder a greater chance of getting a good price for their shares.
Should you even include these?
Having these clauses in the shareholders' agreement offers the most flexibility for all involved and for if any of the above actually transpire. And again, the activation is a right, not an obligation, on the shareholder that it refers to.
It is also useful should there be any change of the business or their relationship in the future. There could be a personal falling out and they don't want to work together any more, so a sale of the company could provide the perfect excuse for an exit.
Or there could be a decision to take the company in a different direction, such as a car manufacturer becoming a supermarket, and one party doesn't agree and wants an exit.
Essentially, this is very much a case of "have it and not need it, than need it and not have it".
If you want to learn more, check out these further resources:
Credit: Cover image photo by Emily Morter on Unsplash