The importance of deadlock and drag and tag clauses in shareholder agreements

Shareholder agreements – deadlock

You have formed a company and you have carefully considered the worst case scenario of what to do in the event of deadlock. Hopefully your draft shareholders agreement is taking shape. What to do if one party wants to sell and the other(s) do not ? Is that shareholder free to sell if he or she likes regardless of the wishes of the others? Can you be forced into a sale? These eventualities are known generically as drag and tag

Drag and tag are two important provisions often found in agreements between shareholders of a company.

Drag along

“Drag” rights favour the majority shareholder.  They enable the majority shareholder to compel the other shareholder(s) to sell their shares if the majority shareholder has agreed terms for the sale of the company to a buyer.

As the name suggests it allows the majority shareholder to drag the other shareholders along. Buyers rarely agree to permit a minority shareholder to retain a minority share. The minority cannot be compelled to sell unless, not only the price but also the terms upon which the majority shareholder has negotiated the sale, such as payment by instalments or a performance based additional price, must be extended to the minority shareholder otherwise he cannot be compelled to sell.

Drag along protects the majority shareholder from being “locked in” whilst at the same time ensuring that the minority shareholder is treated identically with the majority shareholder. This needs a great deal of thought as you discuss your shareholders agreement with your fellow shareholders. Are you willing to be forced to sell? Can you rely on the judgment of the majority shareholder?  What if he chooses to sell to another company in which he has an interest? Should that be covered in your agreement? You would be well advised to seek the guidance of a specialist company lawyer but at least this article will help you to spot the Drag Along provisions in your draft agreement

Tag along

Not surprisingly the tag clause is designed to protect the minority shareholder from being left behind when a majority, or substantial, shareholder decides to sell. It enables the other shareholder(s) to force the selling shareholder to make it a condition of sale that the buyer must offer to buy the shares of the other shareholder(s) at the same price and on the same terms at the same time.

Protection

Drag and Tag both protect the value of the shares in a company by avoiding the shares being locked in. A 10% stake is difficult to sell and, therefore vulnerable to a buyer forcing a sale at a price which may have little relationship to the value of the company as a whole. It may, therefore be very important in terms of your investment in the company to ensure that your shares can form part of a larger number of shares thus keeping the price up. On the other hand without Tag rights you may find yourself stuck with an unsalable or devalued shareholding. Tag rights provide protection for the shareholders’ share value from being adversely affected due to them not being able to sell them.

Here is a true life example of how drag-along rights can affect shareholders’ interests, A was able to force an unfavorable sale of B Limited to an associated company C Limited, i.e. in effect a sale to itself, leaving the other shareholders behind with a nothing.

One minute the shareholders of B Limited had a profitable business with valuable assets. The next they had no shares and no company. It was open to the shareholders to challenge this abuse of Drag along rights and I will deal with how this might work in a further article. However more careful drafting and better advice would have produced a shareholders’ agreement which would have prevented A from selling, and forcing the other shareholders to sell at a price which was not at arm’s length or at market value. Be aware. It could happen to you!

These rights, properly drafted, of course, are particularly necessary where the intention of the shareholders is to sell at some time in the foreseeable future. They can avoid the ransom threat of a shareholder holding out and killing off the prospect of a valuable exit. So Drag along and Tag Along are important elements of the shareholders’ agreement. Use them well

This is an example of how they can be used in less ethical ways than is the intention of the shareholders when they agree them – all the more reason to be careful who you go into business with and who you instruct to represent you.

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