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17 April 2017
Tag-along and drag-along provisions
Shareholders' excitement over a new joint venture can be overshadowed when issues concerning the available options for exit from the investment arise for discussion. It is prudent for shareholders to address the full spectrum of their investment as early as possible, including the start-up stage and the operation of and exit from the investment. Company law and practice provide tools to create the boundaries necessary to protect shareholders' business relationships from third parties and each other.
Pre-emption clauses place valid restrictions on shareholders' freedom to transfer shares in a private company. The model articles in Table A of the Companies Law (Cap 113) contain standard restrictions on the transfer of shares, pursuant to which all existing company shareholders have the right to be offered shares which one shareholder intends to transfer to another. Also known as rights of first refusal, pre-emption rights are attached to shares held in a company and are enforceable against individual shareholders by the company. When two or more shareholders decide to join forces in developing a new corporate vehicle intended for growth and profit and are willing to devote time and money to the vehicle they should – and the law and practice allow them to – have first say in who is allowed to become part of this vehicle in future.
Basic pre-emption rights on the transfer of shares are often complimented by more sophisticated mechanisms aimed at enabling a smooth exit from the company in certain circumstances. Shareholders have the benefit of adhering to rights and options, such as the tag-along and drag-along options outlined in the shareholders' agreement and transposed in the company's applicable articles of association, which ensure that existing shareholders have the opportunity to express their agreement or opposition to the entry of a third party into the company.
A tag-along provision entitles a shareholder (usually the minority shareholder) to participate in a sale by another shareholder (usually the majority shareholder) at the same time to receive the same price for each share. Accordingly, the minority shareholder tags along with the majority shareholder's sale. The advantage of a tag-along provision is that it grants the minority shareholder the right to have their shares sold when the majority decides to exit the investment at the same time and on the same terms.
A drag-along provision allows a company shareholder (usually the majority shareholder) to force the remaining shareholders to accept an offer from a third party to purchase all of the company's share capital where the majority shareholder has accepted an offer made on the same terms. The minority shareholders are thus dragged along and forced to sell their shares at the same time as the majority shareholder and for the same price per share. The aim of the drag-along provisions is to offer liquidity and an exit route to the majority shareholder. The benefit of negotiating such a clause is to ensure that the joint venture remains an attractive investment where a third party can purchase all of the share capital without the risk of entering into an investment with a group of uncooperative minority shareholders.
The difference between the tag-along and drag-along provisions is that the former grants a right to minority shareholders to choose whether to participate in a sale by protecting its own interests. A drag-along provision creates an obligation on the minority shareholders to sell, which is why it is usually a provision negotiated into a shareholders' agreement by the majority shareholders. In both cases, the terms and timing of sale are the same, which maintains balance and equality among shareholders.
The Cyprus courts recognise and uphold pre-emption clauses as well as tag-along and drag-along provisions contained in shareholders' agreements where a dispute arises for resolution. In the course of an interim order application, the court upheld a company's decision to call a meeting to amend the articles of association to include a drag-along provision with a view to creating a balanced exit from the company where the other shareholders contested such action.
While it is impossible to foresee the outcome of a specific transaction and foretell the exact time of exit from an investment, shareholders have the power to have these issues addressed in advance by receiving advice from their lawyers on how to best structure their exit from the investment.
For further information on this topic please contact Stella Koukounis at S Koukounis & Partners LLC - Solsidus Law by telephone (+357 99 415 708) or email (firstname.lastname@example.org). The S Koukounis & Partners LLC - Solsidus Law website can be accessed at www.solsiduslaw.com.
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