Tag-along and drag-along clauses: These are the start-up terms

Whether it’s sooner or later: At some point founders are always confronted with investors who want to get out. In order for things to go smoothly in these situations, it is important to know what a tag-along and a drag-along clause is and how it works.

Start-ups, start-up founders and investors enter into a tight relationship with time in the event of equity participation. Exactly how this relationship is structured is regularly regulated in participation agreements and sometimes directly in the articles of association.

But as future business development is not always clear, many investors are looking for ways to respond to the development of the startup with exit scenarios – the so-called exit variants.

And also the shareholders holding shares of less than 50 percent in the company have certain interests with regard to the change of control of the company if the investor withdraws from the company by selling his share.

Ways to shape these situations are so-called drag-along and tag-along clauses. Since the effect of these clauses is not always clear, let’s take a look at them.

The drag-along clause

The drag-along clause regulates a duty to co-sell shares if the investor willing to sell is a majority shareholder. What is the idea behind it and what exactly happens in this situation?

First of all, one has to imagine that the investor will eventually have an interest in selling his share. He usually only wants to participate in society for a certain period of time.

It is exciting for him, if he is a majority shareholder, but not a sole shareholder. So he holds, for example, 60 percent, but not 100 percent of the shares. If he wants to sell his share, the buyer has to deal with a question. How do I deal with the remaining partners?

It will be optimal for him if he gets the shares of the minority shareholders at the same time. Exactly this effect has the drag-along clause. For the latter obliges the other shareholders to sell their shares together with the majority shareholder.

The shares of the minority shareholder are thus “pulled along” – translated “to drag” translated means nothing else than pulling along. As a rule, the same terms regarding the price and date of transfer as for the portion sold by the investor apply to the sale of the shares “taken along”.

The drag-along clause from the perspective of the buyer and the founder

The advantage of this rule for the seller, who is the majority shareholder, becomes clear when one puts himself in the buyer’s position. You have read correctly: We now look at the buyer and not at the seller.

An acquirer of a company is often only interested in acquiring a 100 percent interest. He wants to acquire all shares of the company, including those of the minority shareholders, in order to become sole ruler.

If he did not acquire all the shares immediately, he would eventually have to deal with the other shareholders. Although they do not have a majority in the company, they can exercise certain minimum rights.

For example, they have to be summoned to shareholder meetings, and care must be taken to ensure that the votes are correct because they are otherwise vulnerable. This causes additional expenses, which the acquirer regularly does not want to have.

Of course, it must be seen that this rule has the disadvantage for the minority shareholder not to have any influence on the time of sale or on the selling price of his shares. He has to accept the negotiated conditions.

The fact that the same conditions apply to the co-selling minority shareholder as to the investor holding the majority of the shares may, for example, be of material and disadvantageous importance in the agreement of a non-competition clause.

Minority shareholders – for example, the founders of the start-up – should therefore be particularly careful when formulating the drag-along clause.

For example, you should allow for separate rules. This may include, but is not limited to, the agreement of a certain minimum price, a right of first refusal for the minimum shareholder or a blocking of sales until a certain date.

The tag-along clause

The tag-along clause, on the other hand, does not regulate a duty but a right: namely the right of co-sale of one or more minority shareholders.

This situation is as follows. If the majority shareholder sells his shareholding, the minority shareholder has the right to sell his share on the same terms.

To understand this situation, one has to briefly imagine the situation of a minority shareholder. He has probably teamed up with the majority shareholder in the company, fully aware of the circumstances.

If the majority shareholder sells his stake, the minority shareholder is faced with two questions. On the one hand, he regularly does not know exactly how the buyer deals with the company and with it as a minority shareholder.

The minority shareholder, on the other hand, has no opportunity to exercise control over the company through his small holding.

By selling his shares, he ensures at least a stake in the negotiating success of the usually economically stronger majority shareholder in the course of the sales negotiations.

Conclusion to the drag-along and tag-along clause

It does not matter whether the start-up is about the situation of the investor or the founders and also independent of holding a majority or minority stake: at some point, it’s always about the issue of leaving the company.

Once the participants have thought about it, the drag-along and the tag-along clauses quickly come into play, because these clauses can elegantly create certain situations in the event of an exit.

For the investor, the drag-along clause is interesting because it allows it to hold 100 percent of the shares – all shares can be given to a buyer. The other shareholders are obliged to sell their shares.

For the founders, the tag-along clause can be interesting because they can ensure that an investor can not get out of the company alone, but always their shares must be sold.

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