How Tag-Along (vs. Drag-Along) Rights Work, With an Example

What Are Tag-Along Rights?

Tag-along rights also referred to as "co-sale rights," are contractual obligations used to protect a minority shareholder, usually in a venture capital deal. If a majority shareholder sells his stake, it gives the minority shareholder the right to join the transaction and sell their minority stake in the company. Tag-alongs effectively oblige the majority shareholder to include the holdings of the minority holder in the negotiations so that the tag-along right is exercised.

Key Takeaways

  • Tag-along rights are contractual obligations to protect a minority investor in a startup or company.
  • Tag-along rights are mainly used to ensure that the stake of minority stakeholders is considered during a company sale.
  • Tag-along rights also provide greater liquidity to minority shareholders.
  • The minority investors are entitled to the same price and conditions as the majority investor when the shares are sold.
  • Tag-along rights can sometimes make it more difficult for a sale to be completed.

Understanding Tag-Along Rights

Tag-along rights are pre-negotiated rights that a minority shareholder includes in their initial issuance of a company's stock. These rights allow a minority shareholder to sell their share if a majority shareholder is negotiating a sale for their stake. Tag-along rights are prevalent in startup companies and other private firms with considerable upside potential.

Tag-along rights give minority shareholders the ability to capitalize on a deal that a larger shareholder — often a financial institution with considerable pull — puts together. Large shareholders, such as venture capital firms, often have a greater ability to source buyers and negotiate payment terms. Tag-along rights, therefore, provide minority shareholders with greater liquidity. Private equity shares are incredibly hard to sell, but majority shareholders can often facilitate purchases and sales on the secondary market.

Under most states' laws regarding corporations, majority shareholders owe a fiduciary duty to minority shareholders, meaning they must deal with minority shareholders honestly and in good faith.

Advantages and Disadvantages of Tag-Along Rights

One of the most basic advantages of using tag-along rights is that it gives the business' minority shareholders (including, sometimes, employees given stock ownership) financial and legal protection when the company is being sold. When a sale is proposed, minority shareholders typically don't possess enough bargaining power and legal knowledge to properly negotiate for a better deal. Tag-along rights benefit minority shareholders because they're able to receive the same benefits the majority shareholders bargain for.

The flip side of this coin is that tag-along rights may discourage majority shareholders from investing in the company. After all, tag-along rights force the company's management and large shareholders to make concessions that will only benefit the minority shareholders. In other words, some investors will simply not select a company that makes less-than-favorable obligations of them.

Example of Tag-Along Rights

Co-founders, angel investors, and venture capital firms often rely on tag-along rights. For example, let's assume that three co-founders launch a tech company. The business is going well, and the co-founders believe that they have proved the concept enough to scale. The co-founders then seek outside investment in the form of a seed round. A private equity angel investor sees the value of the company and offers to purchase 60% of it, requiring a large amount of equity to compensate for the risk of investing in the small company. The co-founders accept the investment, making the angel investor the largest shareholder.

The investor is tech-focused and has significant relationships with some of the larger, public technology companies. The startup co-founders know this and, therefore, negotiate tag-along rights in their investment agreement. The business grows consistently over the next three years, and the angel investor, happy with their investment return on paper, looks for a buyer of their equity among the major tech companies.

The investor finds a buyer who wants to purchase the entire 60% stake for $30 a share. The tag-along rights negotiated by the three co-founders give them the ability to include their equity shares in the sale. The minority investors are entitled to the same price and terms as the majority investor. Thus, the three co-founders, using their rights, effectively sell their shares for $30 each.

Tag-Along Rights FAQs

What Is the Difference Between Tag-Along Rights and Drag-Along Rights?

Tag-along or co-sale rights are essentially the opposite of drag-along rights. Whereas tag-along rights give minority shareholders negotiating rights in the event of a sale, drag-along rights force the minority shareholders to accept whatever deal is negotiated by majority shareholders.

Do Tag-Along Rights Make it Easier or Harder to Sell Shares in a Company?

In some instances, tag-along rights can make the selling process more difficult. It becomes harder to complete the sale when the potential buyer doesn't want to increase or change the terms of their offer in order to please minority shareholders.

What Is a Come-Along Clause?

A come-along clause, also referred to as drag-along rights, force minority shareholders to sell their shares when majority shareholders decide to sell theirs. A come-along clause is essentially the opposite of tag-along rights.

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