The Tag Along right is the right to “tag-along” on a share sale of an individual shareholder. In a startup fund raise, Investors usually get Tag Along rights to significant share sales of Founders. That means they can sell a pro-rata part of their shares when a Founder wants to sell shares. The idea is: Investors want to protect themselves from being invested in a company where the founder suddenly leaves.
Lets put this into perspective. Especially in the early days, Founders matter a whole lot. Additionally, startup shares are highly illiquid and the Investor might not even have the right to sell shares without consent. So one or all of the Founders leaving could be very detrimental to the company and hence to investors. Just think of a young founder with little cash to their name. Imagine her being offered a couple hundred thousand dollars for their controlling stake. She might just take it, even if its below market value. In absolute terms its still life changing money as founders own a large percentage of stock. Hence the tag-along that at least allows the investors to partially exit on similar terms.
Mechanics of a Typical Startup Tag-Along
So how does the Tag Along actually work? Typically, it will allow an investor to replace part of the founder’s to-be-sold shares with her own. The amount the investor can sell is usually dependent on her share holding in proportion to the total shareholding. The terms of the sale will typically be identical to the founder’s terms. That means the investor gets the same price and doesn’t need to find their own buyer.
Additionally there is usually a threshold that allows a founder to sell a small amount of shares without triggering the Tag Along. This provides useful flexibility if the company gets very valuable. The founder might want to buy let’s say an apartment but has never earned a significant salary. Without having a carve out, she would have to go through substantial approval procedures to sell a relatively small part of her shares wasting everybody’s time. Besides that, a specific carve out can be predetermined. Think of a likely upcoming cash need that is anticipated already or to prepare for tax payments.
Administratively, if a shareholder, who is bound by Tag Along rights, wants to sell an amount of shares that will trigger the Tag Along clause, she will need to make an announcement to the shareholders that have such a right. This is called a Tag Along notice. The detailed shareholder agreements will specify all of this. The exact timings during when a shareholder will have the right to execute such a right and how to give notice.
Example of a Tag-Along
Lets think of an example Tag Along clause how it could be written in a Termsheet. Please note the full tag along in a Shareholders Agreement or in the Memorandum and Articles of Association (M&A) would be more detailed, specifying also the full mechanics and deadlines to be uphold.
"In the event that a Founder wants to dispose of, sell and/or transfer any Shares (excluding new shares to be issued, subject to a carve out for the Founders’ reasonable tax planning which does not impact control of the Company), which result in a change of control the Company shall grant an option (and/or procure the buyer/transferee to grant an option) to the Investor Group to sell pro-rata, at Investor Group’s discretion, all or part of Investor Group’s shares at terms no worse than those offered to Founders. If the Founders lose control as a result any such transfer, then the Investor Group has the option to sell all their shares to the buyer before the Founders."
Lets assume this company has issued 700 ordinary shares (owned by 2 founders) and 300 preferred shares (owned equally by 3 Investors). This clause then translates into the following if the founders want to sell 500 or more of their shares:
- The Tag Along triggers and investors are allowed to participates pro rata
- The Founders are required to issue a Tag Along notice
- If one investor wants to participate, that investor gets to participate pro rata based on their shareholding in relation to total shareholding: 100/1,000 x 500 = 50 shares
- The Founders then can sell only 450 shares
- If more Investors want to participate, the Founder can sell even less shares
As always, Tag-Along rights have been established in Startup fund raises as best practice habits because they make sense. There are however no fixed rules to their nature in most jurisdictions. Hence founders and investors can cook up whatever esoteric variation they can think of.
For example founders could argue to want a Tag-Along right on investor share sales. Or both sides could eliminate any sort of threshold and make “any” share sale to require a Tag-Along notice. Reversely, if there are multiple founders, Investors could define a Tag-Along to only apply if all or only one specific founder tries to sell their shares. Likewise the percentage of shares to be sold that require a Tag-Along notice is also up for discussion. Is it share majority of all ordinary share equivalents? Or half of all the founder shares?
The options are endless but should probably be kept to something common. Sometimes founders and investors use esoteric rules to create “trouble” in one area of a Termsheet negotiation to trade for something else that they really want in another clause. Use that approach with caution though! If the rights are to far off, the next round’s investors will likely reverse them to something more standard anyways. Also, if you negotiate on this level with new investor, you should probably run for the exit.
Downsides to Tag-Alongs
While investors justifiably should be protected from a Founder suddenly leaving the company, the Tag-Along is not a perfect tool for that. Just like in the example above, the Investor will always keep a portion of their shares. And that company is now still void of their original founder.
One might say, well, the benefit is more to get an additional form of liquidity before a real exit. Here the counter argument would be, is this potential liquidity really so meaningful in comparison to all the administrative hurdles it creates for such share sales?
Alternatives and Additions to Tag-Alongs
The pure protective function of having a Founder depart too early, could be governed by Investor Vetos or Board Approvals on (majority) share sales. The benefit of such safe guards is that the Founder really can’t leave.
Think of the consequences of a triggered Tag-Along that required change of control (or even just sale of the majority of the Founder shares). It means the shareholding has now changed dramatically and the Founder has departed. This is such a significant change that it could deserve an investor or board veto in the first place. If a buyer would be willing to buy a majority stake in the company, why not try to sell 100%. The counter lever for Founders to make such safe guards not insurmountable is to adjust the voting powers among directors and investors. Founders will likely control the majority of board seats and there will always be Investors that side with the Founders. So Vetos that require 100% investor consent are of course much harder to manage than 75% or 51% consent Vetos.
One can also combine Investor and Board Vetos with Tag-Alongs. E.g. create Vetos that are not too difficult to overcome and in return build in the Tag Along to offer that additional exit potential. This allows Founders a route to sell a majority, when there is no buyer for the whole company. And Investors can be sure to participate in such partial exits.
The common Tag-Along allows Investors to sell some of their shares when a Founder wants to sell a majority of their shares. It protects Investors from being stuck in a company where the Founder wants to leave. And it is a way of participating in such a sale. That said, the simple protection function can be obtained through regular share sale Vetos by Investors or the Board of Directors.
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