As a startup consultant, I have reviewed various types of term sheets for startup funding. The most common clause that I have found in Term Sheets is the clause that deals with the Tag-along and the Drag-along rights of the investor. However, there is quite a bit of confusion and seldom does the parties to the agreements understand the nuances attached to this clause. In fact, once we make them understand the impact of this clause we have found more often than not the promoters go back to the negotiation table to discuss this clause.

What is Tag-along Rights?

Tag-along right is the right of the investor to tag themselves while the promoters sell their shares to a 3rd party. In other words, it means the right of the investor to co-sale their stake on a proportionate basis when the promoters sell off their portion in the organization. So say, if I am a shareholder holding 90,000 shares along with an investor in the company  who holds 10,000 shares and I wish to sell 9,000 shares or 10% of the company to a 3rd Party, then I have to convince the 3rd Party to give an offer of purchase to the investor on a proportionate basis with the same Terms that he has offered me.

Example of Tag-along Clause

In the event of a bona fide third party investor identified by any of the Promoter, agrees to invest in Share Capital of the Company, and if one or more of the Promoters propose to Transfer any Equity Shares to such third party investor, then subject to the Investors Consent the promoters will have to arrange by which the Investors can also sell their shares to the third Party at the same terms and condition as it was offered to the Promoters on a pro-rata basis.

What is Drag-along Rights?

As per this clause if the investors wish to sell the shares to a third party, then he can force the promoter to sell off their shares on a pro-rata basis to the 3rd Party. In other words, the Investor can drag the promoters in its sale deal with the 3rd Party. Going by the previous example, if I am a shareholder holding 90,000 shares along with an investor in the company  who holds 10,000 shares and he wishes to sell a portion of his stake to a 3rd Party, then he can drag me in the deal where I have to sell the shares on a proportionate basis to the concerned buyer.

Example of Drag-along Clause

In the event of a bonafide third party investor identified by the Investors, agrees to invest in the Share Capital of the Company and the Investors propose to Transfer any Equity Shares held by them (“Offered Securities”) to such third party investor (“Proposed Transferee”), the Investors shall have the right to require the Promoters to sell / Transfer, such number of shares, to the 3rd Party on proportionate basis. 

Needless to say, this is one of the most critical clauses of the Term- Sheet Agreement and hence utmost care to be taken to draft this properly. If you wish to further understand the clause please refer my video- “What does Tag-along and Drag-along rights mean in Term Sheet Agreement?” which I have done with my colleague Niladree.

We at Taxmantra.com help startups and VCs in drafting and reviewing their term sheets so that their rights are properly protected. If you have any query regarding this feel free to drop a line at info@taxmantra.com.