Term Sheets 101: Drag-Along and Tag-Along Rights

In term sheets and negotiations, two phrases that are useful to be familiar with are “drag-along rights” and “tag-along rights.” 

Drag-Along Rights

Drag-along rights allow majority investors to sell the company without minority stockholders having to sign off on the sale. Minority holders will be paid for their shares but they are unable to block the transaction from happening by refusing to vote in favor of the sale. This protects the majority of investors who want to sell their shares and prevents a situation where small shareholders can derail a sale of the company.

There are still some limitations to drag-along rights. Most importantly, the Board still has to approve any potential sale and the directors are subject to certain fiduciary duties to the company. Once the Board determines that the sale is in the best interest of the company, the stockholders still have to give their sign off, subject to any drag along provisions to which they may have agreed.

Stockholders may also have appraisal rights under which a stockholder can petition a court to determine the value of their shares. These rights are granted under state law and are meant to protect shareholders from being unfairly compensated for their equity. However, in order to preserve appraisal rights, stockholders cannot approve the sale. Drag-along provisions may sometimes include a waiver of appraisal rights so that minority stockholders can no longer exercise those rights.

Tag-Along Rights

Tag-along rights are very different and less common. Tag-along rights allow stockholders to join other holders if some of them are selling their shares to a third party. This gives the excluded shareholders the opportunity to receive consideration for their shares even if they were not involved in negotiating the sale terms.

Tag-along rights can be problematic for majority investors. Any third party who wants to purchase equity from the majority investors could also be forced to buy shares from minority holders. This could make it much more difficult for investors to find a buyer (some buyers may want to buy a controlling stake at a minimal price or may not be financially able to purchase the additional shares from those with tag-along rights). If the majority of investors do find a potential buyer, that buyer could take control of the company by purchasing all of the shares being offered by the tag-along right which could cause significant issues for the Board and management of the company.

Stephanie Fields

Stephanie’s practice focuses on startups and small businesses, from formation to exit events and everything in between.

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