Should you include a tag along clause in your shareholder agreement?
More and more founders are insisting on including tag along clauses in their shareholder agreements. The following is a quick explanation of what one is, and why you might use one.
What are tag along rights?
A tag along provision gives a shareholder the right to force a buyer to buy his or her shares on the same terms and in addition to any other shares.
The inclusion of this clause gives a shareholder comfort that if any other owners decide to sell, he or she can also exit from the company at the same time.
The reason why this might be advantageous is usually because any new owner is likely to want to change the direction of the company in some way. The existing owner, especially if he is a founder, might not agree with the new objectives, but might not otherwise be in a position to veto those changes. A tag along provision gives the existing owner a way of getting out of the business while the going is good (in his or her eyes).
When is a tag along provision used?
Most founders don’t include a tag along clause at the outset of their relationship. It is usually only inserted into a shareholder agreement when an institutional investor such as a business angel or venture capital firm invests.
Professional investors usually want to build a company and sell it on within a short time frame. That strategy might suit the founders well. But the next buyer might want to do something else with the business. Since any professional investor is likely to buy a majority stake, the founders might not have much say over who the second buyer is, or which direction the business takes after the second sale.
So the founders might agree with the institutional investor to include a tag along provision in their shareholder agreement. The clause does not affect their relationship in any way – it just gives the founders a means of exit next time round.
Are there any disadvantages to including one?
A tag along clause is beneficial for founders – especially for those with minority interests. Professional investors are likely to have much wider sales networks and thus should be able to find an attractive price for the shares. Plus, those investors will sell reasonably soon. The clause benefits minority owners by allowing them to piggy-back on the deal the professional makes (importantly, if they want to). That means they can continue with running the business rather than finding buyers or negotiating terms.
A professional investor also benefits. Not only will the next buyer be more likely to want to buy the whole business (and not have to worry about minority shareholders disrupting their plans for change), but a tag along clause gives minorities a sense that they are being treated fairly, and thus less resistant to changes in business direction or sale. Including such a term can align the interests of the founders and the professional investor towards rapid growth followed by near term sale.