A shareholders’ agreement is a binding contract between the shareholders which governs their relationship. While it covers shareholders’ rights, obligations, and liabilities, and serves to minimize disputes between them, it should also address situations where one or more parties want to exit the agreement.
As a business owner, you’ll want to be aware of specific provisions your shareholder agreement can include to help with these situations, specifically shotgun, drag-along, and tag-along rights.
We’ve taken a look at each in detail below and provided guidance on when to include them in your shareholder agreements.
A shotgun clause is an exit strategy in a contract that ultimately forces a shareholder to either sell their stake in the business or buy out the other shareholder. A shotgun clause is often seen as a last resort when the shareholder cannot settle a dispute or disagreement.
This clause is ideally suited for business structures where all shareholders are equal owners in the company and is often seen when there are two shareholders. If you’re a minority shareholder, a shotgun clause likely won’t work in your favour as you’ll be forced to either buy out the majority shareholder, which you may not be able to do, or sell your share of the business. In addition, there often isn’t a situation in these cases where a deadlock would arise and need to be resolved with such a clause. So in most cases, in this type of business structure with a minority and majority shareholder, a shotgun clause isn’t really needed.
Also known as a piggyback clause, a tag-along clause exists to protect the minority shareholders in a company. When a majority shareholder wishes to sell its shares of a company to a third party, a tag-along clause entitles the minority shareholder to also sell its shares for the same price and on the same terms.
Often, a minority shareholder will have entered into a shareholder agreement with someone they know, trust, and want to be in business with. When a third party comes in and offers to buy out a majority percentage of the company, the minority shareholder may not want to stay in the business with the new buyer.
This clause gives minority shareholders the ability to sell their shares at the same price as the majority shareholder. Without this clause, the new buyer may be able to buy the majority shareholder’s shares at a higher price (as the majority shareholder has better bargaining power) and then try to squeeze the minority shareholder for a lesser amount after the initial sale.
[Read our blog post: The corporate prenup: Why every corporation needs a shareholders’ agreement]
The tag-along also protects a minority shareholder if a third party only wants to buy the number of shares the majority shareholder owns. Under this clause, they will have to purchase the shares pro-rata.
For example, say a majority shareholder owns 700 shares out of the 1000 shares of the company, and a minority shareholder owns the other 300 shares. If the buyer only wants to buy 700 shares in total (rather than the entire company), the tagalong clause means that the purchaser has to take 70% of those shares from the majority shareholder’s shares and 30% from the minority shareholders’ shares.
A drag-along clause is the inverse of a tag-along clause and benefits the majority shareholder. This right allows a majority shareholder to force the remaining minority shareholders to accept an offer from a third party who wishes to purchase all of the shares of the company.
A prospective buyer will likely want complete control over the business they’re purchasing, and won’t want minority shareholders to retain a minority share. A drag-along clause helps simplify the sale of the business, providing liquidity, flexibility, and a smoother exit route for the majority shareholder. The majority shareholder has the ability to drag along the minority shareholders, so they can all sell their shares together to a third party for the same price, at the same time, and on the same terms.
When to include these clauses in your contract
There is no one-size-fits-all approach when it comes to including these terms in your contracts. It will depend on the structure of the business, how many shareholders there are, their ownership split, and their financial resources.
Often, simple shareholder agreements will have a drag-along and tag-along clause to protect both the majority and minority shareholders. The shotgun clause is used less often and is usually included when two shareholders have equal shareholding.
Is your shareholder’s agreement fit for purpose?
Whether you are incorporating a new corporation with one or more additional shareholders, your organization grows, the structure of your business changes or you bring on new shareholders, you’ll want to review your shareholder agreement to ensure that the relationship among the shareholders is aligned with their expectations.
If you need help reviewing the terms in your shareholder agreement, we can help. Caravel has a team of 85 qualified and experienced lawyers, including those specializing in contract law. Get in touch with our team today to find out more.
The information provided in this article is not intended to be legal advice. Many factors unknown to us may affect the applicability of this content to your particular circumstances.