“Drag Along” and “Tag Along” rights are used by investors to facilitate their exit from an investment. They are methods particularly favored by private equity firms
, who almost always do their best to establish a clear exit strategy even before they decide on investing in a company.
A Tag Along is relatively non-controversial: it gives a shareholder the right (but not necessarily the obligation) to exit along with another shareholder when that other shareholder is exiting, usually on the same price and terms. This helps avoid any shareholder involuntarily finding himself or herself with a different co-shareholder to originally expected. Tag Alongs are often requested by minority shareholders, as they allow them to then exit at the same time as majority shareholders, and to share the control premium (e.g. investors are usually prepared to pay a higher price per share when they acquire control of a company).
Drag Along rights are more controversial. A Drag Along right gives the investing shareholder the right to force the other investor(s) to exit should the investing shareholder exit, once again, usually on the same price and terms. For private equity investors, Drag Along rights are usually a sine qua non for any investment. Some private equity investors affectionately refer to their Drag Along rights as their “nuclear option.” On the other hand, for many business owners, a Drag Along right represents a Damocles sword, a threat that they may be forced to sell their business if the investor decides to drag him or her along, usually at a valuation over which he or she has no control.
Unfortunately, perhaps a majority of owners of businesses who seek private equity investment for the first time are not even aware of the existence of Drag Along rights; very often when business owners find out about Drag Along rights being required by an investor, that is the end of the discussion.
Sometimes, that discussion is ended a little prematurely; it is worth spending a little time exploring whether there may be a compromise solution acceptable to all parties, which may mitigate (although not completely eliminate) the risk that business owners are dragged along against their will This will require astute negotiation. A few examples of such compromise solutions might include a combination of the following measures:
A Tag Along is relatively non-controversial: it gives a shareholder the right (but not necessarily the obligation) to exit along with another shareholder when that other shareholder is exiting, usually on the same price and terms. This helps avoid any shareholder involuntarily finding himself or herself with a different co-shareholder to originally expected. Tag Alongs are often requested by minority shareholders, as they allow them to then exit at the same time as majority shareholders, and to share the control premium (e.g. investors are usually prepared to pay a higher price per share when they acquire control of a company).
Drag Along rights are more controversial. A Drag Along right gives the investing shareholder the right to force the other investor(s) to exit should the investing shareholder exit, once again, usually on the same price and terms. For private equity investors, Drag Along rights are usually a sine qua non for any investment. Some private equity investors affectionately refer to their Drag Along rights as their “nuclear option.” On the other hand, for many business owners, a Drag Along right represents a Damocles sword, a threat that they may be forced to sell their business if the investor decides to drag him or her along, usually at a valuation over which he or she has no control.
Unfortunately, perhaps a majority of owners of businesses who seek private equity investment for the first time are not even aware of the existence of Drag Along rights; very often when business owners find out about Drag Along rights being required by an investor, that is the end of the discussion.
Sometimes, that discussion is ended a little prematurely; it is worth spending a little time exploring whether there may be a compromise solution acceptable to all parties, which may mitigate (although not completely eliminate) the risk that business owners are dragged along against their will This will require astute negotiation. A few examples of such compromise solutions might include a combination of the following measures:
- An obligation for investors to seriously attempt one or more methods of selling their interest without dragging along another shareholder;
- The Drag Along may be available only after the expiry of a particular time period (e.g. after four or five years from the date of the investment);
- Exercise of the intent to exercise a Drag Along right may require advance notice to other shareholder(s). Such notice may also be structured to allow the remaining shareholders the right to purchase the shares of the shareholder giving notice according to a particular formula (e.g. EBITDA multiple).
- It might be possible to structure a Drag Along in such a manner that it might be overridden by a right of first refusal (e.g. where one investor negotiates an agreement to sell shares to an outside investor, the existing shareholders would have a defined period within which to step in and buy on the same terms). However, not every investor will accept a right of first refusal, as this may diminish the marketability of the investor’s interest. Also, for a first right of refusal to be of real benefit to a shareholder, it will usually require a cash reserve in order to exercise it.
In a nutshell, the negotiation between an owner and investor with respect to Drag Along rights is a function of the relative bargaining strength of the parties and their negotiating ability. It balances the legitimate desire of an investor to exit from an investment at a time that suits them (minority investments in particular may be extremely difficult to exit without a Drag Along) with the legitimate right of a business owner not to have his or her interest in a business sold against his or her will.