Not only are “drag along” and “tag along” catchy phrases, but they are also important concepts to consider when preparing an Operating Agreement for an LLC or a Shareholder Agreement for a corporation. But, what are they and what do they do?
In layman’s terms, a drag along provision in an Operating Agreement or Shareholder Agreement allows a majority or controlling equity owner (or combination of majority or controlling equity owners) to require minority owners of an LLC or corporation to sell their interests to a third-party buyer upon the same terms and same conditions as those being offered to the majority or controlling owner(s). From the majority/controlling owner perspective, this type of provision prevents minority owners from holding up the sale of a business in an equity sale if, for example, such minority owner is unhappy with the deal terms. The drag along right prevents a minority owner from having a de facto veto on an equity sale transaction. From the minority owner perspective, although such minority owner(s) are “dragged along” in any such sale, they are afforded some level of protection by requiring the buyer to acquire the minority ownership interests upon the same terms as those offered to the majority or controlling owners.
On the other side of the coin, a tag along provision provides the minority owner certain rights to participate in a sale by (typically) the majority equity owners when selling their ownership interest to a third party. A tag along right provides that the majority owner cannot sell a substantial portion of equity to a third party without causing the third-party buyer to acquire a proportionate portion of such minority owner’s ownership interests upon the same terms being offered to the majority or controlling owner. Minority interests in closely held businesses are very difficult to sell, and usually at a material discount to fair market value of the interest. However, a large or controlling interest is much easier to sell and may even carry a premium. A tag along right brings some parity between majority and minority owners. From the minority equity owner perspective, depending on the terms of the deal, this may be a way to protect the minority owner from being “stuck” with an unknown new majority owner. Or, in a more basic sense, it allows the minority owner to monetize a portion of its ownership interests if the majority or controlling owner is attempting to do so.
While these are broad, general categorizations of these terms, suffice it to say that these are important concepts to consider when preparing an Operating Agreement or Shareholder Agreement with passive investors or investors who only hold a small percentage of the overall ownership interests.