There is a whole lot of commercial lingo or jargon surrounding investment documentation, and much of it finds its way into legal agreements. Terms like ‘drag’, ‘tag’, ‘liquidation preference’, ‘ROFO / ROFR’, ‘anti-dilution’, ‘put options’ and ‘ratchets’ are extremely common – note that these do not have a strict legal definition, and their implications can vary depending on how you negotiate or draft them. As a business consultant, accountant, lawyer or company secretary, your understanding of these terms plays a significant role in the value you are able to add value to your clients. This understanding can be used while providing legal advice, legal strategy, negotiation or drafting-related assistance.
Before we go any further, let’s give you a background that will help.
Any investor who puts his money into an early stage business does so because he has bought into the vision of the founders (and the traction the business has acquired because of them) – therefore, it is extremely critical for him that the founders stay absolutely dedicated to the business, on a full-time basis.
Further, his shares are not liquid – it is not going to be easy for him to sell shares to a third party. He can’t sell them on a stock exchange. Therefore, he is always looking for lucrative opportunities to make a profit from his investment and exit from the company.
One of the rights any investor will insist on while making the investment, to preserve his freedom to exit, is a tag-along right. A tag-along right kicks-in the moment a founder sells any portion of his shares, and allows the investor to sell his own shares as well. This right is incorporated in the shareholders agreement.
How does a tag-along work?
Investors will not permit the founders to sell any portion of their shares for a significant time (ranging from 4-5 years till the time the company goes to IPO, but the duration is negotiable) after their investment, by inserting lock-in provisions. After expiry of the lock-in, if a founder dilutes his shareholding, investors will want the right to be able sell all of their shares. So, while the founder may only sell 2 percent of his shares, an investor who holds 10 percent of the company’s shares may want the flexibility to sell all of his shareholding. Tag along rights are a bigger problem in the event a company has raised multiple rounds of investment (for example, consider the e-commerce companies). Which investor can tag along and to what extent, in case the founders exit?
Before we get there, let’s analyse this - are tag along rights in the interest of the founders?
Of course not. It becomes much more difficult for founders to find a buyer who is rich enough to buy out the investor’s shares simultaneously, along with the founders’ shares. Even if the founders were lucky enough to find a rich and willing buyer, they wouldn’t want an entirely new investor in the company bearing down their nose just because they sold a measly 2 percent of their shares.
What’s the way out? While you will not see investment agreements which do not feature a tag-along right in favour of the investor, a tag-along can be made more reasonable.
Enter the proportionate tag-along.
Imagine a company where the founders hold 80% shares, and investors hold the balance 20%. Assume that the founders want to dilute (sell) a 20% (one-fifth) of their existing holding in the company. Thus, after selling, their shareholding will be down to 64% (since 20 percent of 80 is 16 percent). In this case, what happens to investor's shares?
Tag along rights allow investors to also sell out at the same price as the founders. In the above example, if the investors had a full tag - they will be free to sell their entire shareholding of 20 percent in the company when the founders dilute even a fraction of their holding (as explained before). If, however, they have a proportionate tag, investors can only sell a proportionate amount (i.e. 20% of 20), which is 4%. In a proportionate tag, the investor shareholding will reduce to 16%.
A proportionate tag is more benevolent for the founders – by limiting the ability of existing investors to dilute (to a proportionate extent), it does not impose the headache of handling an entirely new investor on the founders, and makes it comparatively easier for founders to dilute his shares.
Why will an investor agree to a proportionate tag? How can founders justify a proportionate tag along to an investor?
Dilution of their shareholding by the founders is not necessarily a bad thing. Founders’ shares in their company are the most valuable assets for entrepreneurs and business promoters – even as they continue to remain wedded to their startup in the long term, they may need to liquidate minute fractions of their stake from time to time for raising cash and meeting other personal financing needs.
A sample proportionate tag-along clause reads like this:
If any of the Founders propose to Transfer all or part of the Securities owned by them, such Founder shall first offer the Securities to the Investor, along with the price and other terms and conditions associated with them. If the Investor is not willing to purchase any of the securities, he shall be entitled to offer a proportionate number of Securities (as are being sold by the Founders) to the Recipient, who shall be bound to purchase such Securities on a pro-rata basis, in addition to the Securities proposed to be sold by the Founders.
Comment: This is a simplified version for understanding. Some terms have been capitalized because they will have a specific meaning in investment documentation. In a real transaction, the clause contains further details on timelines, pricing and other conditions pertaining to this. You will notice that it provides investors an opportunity to purchase founder’s shares before they opt to tag along, as this is a typical convention for all investment documentation – this is known as a right of first offer or right of first refusal clause, depending on how it is structured. In case the investor does not want to invoke this option, it can opt to sell out, i.e. tag along.)
Did you find this interesting? Do you want to learn more? This is just the tip of the iceberg – transactional and advisory services around business financing can be a very exciting and lucrative area of practice for lawyers, accountants, company secretaries and business consultants.
Do you want to learn about how liquidation preference clauses, tag-along rights and ratchets work and how to negotiate them from a client’s perspective?
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