Drag-Along vs Tag-Along: Know the Exit Rules

Among the many crucial clauses of a term sheet, “Exit Rights,” specifically “Drag Along” and “Tag Along” provisions, are important. These clauses dictate how and when shareholders can sell their stakes in the company, significantly impacting a founder’s control and potential returns. This guide breaks down these concepts, highlighting their importance, common variations, and key considerations for founders.

Definition

Exit rights are provisions in a company’s shareholder agreement or term sheet that govern the sale of shares, particularly in the event of a company acquisition or a major shareholder selling their stake. They ensure a structured process for all shareholders to participate in or be compelled to participate in such transactions.

Drag Along Rights (“Bring Along” or “Come Along” Rights):

Imagine a group of friends planning a trip, and the majority wants to go to a specific destination. “Drag along” means the majority can force the minority to come along on that trip, even if they initially preferred another destination. In a company, this means that if a specified majority of shareholders (usually investors) agree to sell the company, they can force the remaining minority shareholders (often including founders) to sell their shares on the same terms and conditions.

  • These provisions enable a majority shareholder (or a group holding a certain percentage of shares) to compel minority shareholders to participate in a company sale, typically to ensure a buyer can acquire 100% of the company’s equity.
  • Think of it as a train where the majority of passengers decide the destination, and everyone else on that train has to go along.

Tag Along Rights (“Co-Sale” or “Piggyback” Rights):

Using the trip analogy, if a friend decides to sell their ticket for a trip, “tag along” means you, as a minority, have the right to sell your ticket alongside them, on the same terms. In a company, if a majority shareholder sells their shares to a third party, “Tag Along” rights give minority shareholders the option to join the sale and sell a proportionate amount of their shares on the same terms and conditions.

  • These rights protect minority shareholders by allowing them to participate proportionally in a sale initiated by a majority shareholder, ensuring they are not left behind or forced to sell at a lower price later.
  • This is like carpooling. If the driver is going somewhere, you have the option to ride along.

Why it Matters?

These clauses are critical because they dictate control and liquidity:

  • For Investors: Investors typically include drag-along rights to ensure a clear and unhindered exit path for their investment. Acquiring companies usually want 100% ownership, and drag-along rights prevent a small group of shareholders from blocking a beneficial sale. They facilitate easier exits and ensure the company can be sold efficiently, even if some minority shareholders are reluctant.
  • For Founders: While drag-along rights might seem investor-friendly, they are crucial for founders to understand because they can significantly impact their control over the company’s destiny. Founders need to be aware that they could be compelled to sell their shares even if they disagree with the timing or terms of the sale. Conversely, tag-along rights are a vital protection for founders (as minority shareholders post-investment), ensuring they aren’t left holding unsalable or devalued shares if larger investors exit. They provide an opportunity for founders to achieve liquidity alongside major investors.

Common Variations

The exact wording and thresholds of these clauses can vary significantly, and these variations are often key negotiation points:

  • Trigger Thresholds for Drag Along:
    • Typical: Often set at a “supermajority” (e.g., 75%, 80%, or even 90%) of voting shares or preferred shares.
    • Founder Watch Out: A lower threshold (e.g., a simple majority of 50% or 60%) can give investors significant power to force a sale without broad consensus, potentially even without founder approval. Founders should aim for a higher threshold that requires wider shareholder agreement. Some clauses might require approval from both preferred and common shareholders.
  • Parties Who Can Trigger Drag Along:
    • Typical: Primarily the majority investors.
    • Founder Watch Out: In some agreements, founders might also be able to trigger drag-along rights if they constitute a majority or if a specific board approval is required. Founders should negotiate to ensure their involvement in the decision-making process.
  • Conditions for Triggering:
    • Typical: A bona fide (genuine) third-party offer for the entire company, or a “deemed liquidation event” (e.g., merger, acquisition, sale of substantially all assets).
    • Founder Watch Out: Ensure the definition of a “deemed liquidation event” is clear and doesn’t inadvertently trigger the drag-along in situations not intended for a full company sale (e.g., sale of a minor asset).
  • Consideration:
    • Typical: The sale is usually for cash consideration.
    • Founder Watch Out: The clause should explicitly state whether non-cash consideration (e.g., shares in the acquiring company) is permitted, and how such consideration will be valued and distributed equally among all selling shareholders.
  • Proportionality in Tag Along:
    • Typical: Minority shareholders sell their shares proportionally to the selling majority shareholders.
    • Founder Watch Out: Ensure the tag-along right allows for participation on exactly the same terms and price as the majority, preventing any discriminatory treatment. Some tag-along rights might allow for a “full tag” where the minority can sell all their shares, especially in specific scenarios like a change in control.
  • Exemptions:
    • Typical: Transfers to affiliates or family members are often exempt from these provisions.
    • Founder Watch Out: Ensure there are clear carve-outs for specific situations where drag-along might not apply, such as if the company is close to achieving a major milestone that would significantly increase its valuation.
  • Sunset Clauses/Expiry:
    • Typical: Drag-along rights may expire upon an IPO.
    • Founder Watch Out: Check if these rights are perpetual or have an expiry date or event (like an IPO) after which they no longer apply.

It could be understood with the help of simple examples:

  • Drag Along: A startup has Investor A with 70% ownership, Founder B with 20%, and Founder C with 10%. A large tech company offers to acquire 100% of the startup. Investor A, using their drag-along rights (assuming the threshold is met), can force Founder B and Founder C to sell their shares to the acquirer on the same terms and price, even if B and C were hesitant to sell. This ensures the buyer gets the full company.
  • Tag Along: In the same company, if Investor A decides to sell 30% of their shares to a new private equity firm. Founders B and C, exercising their tag-along rights, can choose to sell a proportionate amount of their shares (e.g., 30% of their holdings) to the same private equity firm, on the same terms and price as Investor A. This allows them to realize some liquidity.

Evolv’s Recommendations

  • Understand the “Who” and “When”:
    • Who can trigger? Ideally, negotiate for the drag-along to require approval from a broad group, including a significant portion of common shareholders (founders). Avoid clauses where a single investor or a small group can unilaterally force a sale.
    • When can it be triggered? Be mindful of the conditions that trigger drag-along rights. Ensure they align with a genuine company sale and not minor asset disposals.
  • Negotiate the Thresholds: Push for a higher drag-along threshold (e.g., 75% or 80%) to maintain more control and ensure that a larger consensus is required for a company sale.
  • Equal Treatment is Key: For both drag-along and tag-along rights, ensure that all shareholders, regardless of their class (preferred or common), receive the exact same price, terms, and conditions for their shares in a sale. Watch out for any provisions that could lead to discriminatory treatment or different consideration for different shareholder classes, beyond liquidation preferences.
  • Liquidation Preference Impact: Be aware that even with equal terms, if the sale price is below the total liquidation preference payout, common shareholders (including founders) might receive little or nothing from the sale, even if dragged along. Understand how liquidation preferences interact with drag-along rights.
  • Define “Bona Fide Offer”: Ensure the drag-along clause specifies that the sale must be to a “bona fide” (legitimate, arm’s length) third-party purchaser and not to an affiliate of the majority investor on potentially less favourable terms.
  • Consider Carve-Outs: Explore negotiating specific scenarios where the drag-along might not apply, for instance, if the company is close to a major milestone that could significantly increase its valuation in the near future.
  • Notice Periods and Process: Ensure the clause clearly outlines the notice period for exercising these rights and the process for execution (e.g., details to be included in the notice, required shareholder actions). This provides transparency and time to react.
  • Legal Review is Non-Negotiable: Always have a qualified startup lawyer review your term sheet. They can identify subtle nuances and potential pitfalls in these clauses that could have significant long-term implications for your ownership and control. Do not rely solely on your own interpretation.
  • Align with Company Stage: The “natural” balance of these rights can evolve with the startup’s stage. Early-stage companies might have more founder-friendly terms, while later-stage deals might see investors requiring stronger drag-along provisions. Understand what is typical for your stage and negotiate accordingly.
  • Don’t Fear Negotiation: These clauses are negotiable. Don’t assume they are set in stone. Be prepared to discuss and push for terms that protect your interests as a founder while still providing a viable exit path for investors.

By carefully understanding and negotiating these critical exit rights, founders can better protect their interests and navigate the complexities of venture capital term sheets.