Investor rights in deals with startups

When an investor puts money into a startup, they receive a stake in the company and a set of rights that govern their position as a shareholder. These rights may be set out in a shareholders' agreement (SHA), in the company's articles of association, or in a separate investment memorandum. The purpose of these rights is to strike a balance between the founders’ interests in retaining control of the company and the investors’ interests in protecting their capital and securing an exit at the right time.

Two of the most important rights relating to share purchase agreements are drag-along and tag-along. These rights govern a key scenario: what happens when one or more shareholders wish to sell their stake to a third party? Who may join such a transaction? Who is obliged to sell? On what terms?

Without these mechanisms, the transaction could become a source of conflict, slowing down or even preventing a potentially profitable exit for all parties.

What is a drag-along clause?

It is the right of a majority shareholder or group of shareholders to compel other backers, usually minority owners, to sell their shares alongside them when the company is sold to a third party. In other words, if the owners of a controlling stake decide to sell the company, they can force the other shareholders to participate in the transaction on the same terms regarding price and contract.

This right is typically granted to the company's founders or majority shareholders — individuals who hold more than 50% of the company's shares. However, in some deals, this right may also be granted to a major venture investor if they hold a significant stake or have special rights under the agreement terms.

How does the drag-along right work?

The mechanism behind the drag-along right is simple. Imagine a company has three shareholders: Founder A holds 60%, Investor B holds 25%, and Investor C holds 15%. A buyer offers to purchase 100% of the company for $10 million. Founder A wishes to accept the offer, but Investors B and C either do not wish to sell or are seeking specific terms.

Should the shareholders' agreement include a drag-along right, Founder A may exercise it to compel B and C to sell their shares to the buyer on his terms and at a price commensurate with the value of the entire transaction. Investor B would receive $2.5 million (25% of $10 million) and Investor C would receive $1.5 million (15% of $10 million). If the drag-along clause is included in the agreement, they will no longer be able to withdraw from the deal.

It is important to understand that the drag-along right does not happen automatically. To trigger it, the following is generally required:

• Reaching a certain voting threshold (for example, >50% or >75% of shareholders supporting the sale).
• A notice must be sent to all shareholders within the specified timeframe.
• The principle of equal terms must be complied with — the price and terms must be the same for everyone.
• The buyer must be an independent third party unaffiliated with the sellers.

In what situations does it apply?

The drag-along right is most commonly applied in the following scenarios:

• M&A (mergers and acquisitions) transactions, where a major strategic player or financial investor wishes to acquire the entire company rather than a stake in it. The buyer must obtain 100% control, as the presence of minority shareholders who refuse to sell could jeopardise the deal. A drag-along clause allows the transaction to be completed.

• Exit of the main investor: If a venture capital fund or major investor wishes to sell its stake to a strategic partner, but the buyer insists on acquiring a controlling or full stake, a drag-along clause can be used to bring other shareholders into the deal.

• Liquidation scenarios: In cases where a company is forced to sell due to financial difficulties or an investor's decision, a drag-along clause enables a smooth process.

• Prevention of deal blocking: Minority shareholders may sometimes intentionally or unintentionally block a potentially profitable deal, but a drag-along clause can prevent this.

A drag-along example when selling a startup

A fintech startup raised $3 million in a Series A funding round. Following this, the company's shareholders were as follows: the founders held 55%, a venture capital fund that had invested in the Series A round held 30%, and an earlier investor, a business angel, held 15%. Three years later, a major bank expressed interest in the company, offering $20 million for 100% of the business.

The founders and the venture capital fund were ready to sell, but the business angel refused — he believed the company was worth more and wanted to wait another two years. Without a drag-along clause, the deal would have stalled because the bank wanted full control, and the 15% stake held by the dissatisfied minority shareholder would have made the deal practically impossible.

However, as the shareholders' agreement stipulated a drag-along clause with a 75% threshold, the founders and the fund (together holding 85%) were able to exercise this right. The business angel received $3 million (15% of $20 million), which was a decent return on investment, although not as substantial as he had anticipated. The deal went through on schedule.

What is a tag-along?

A tag-along ('to follow', 'to join') is the right of a minority shareholder to join a share sale initiated by a majority shareholder and sell their stake on the same terms. While a drag-along right allows the majority shareholder to force others to sell, a tag-along right allows the minority shareholder to join in the sale initiated by the majority shareholder.

This right primarily protects minority investors. Without it, a founder or major shareholder could sell their stake at a favourable price, leaving the minority investor with the new majority owner, who has no interest in them.

How does the tag-along right work?

The tag-along mechanism generally works as follows: A majority shareholder (for example, a founder) receives an offer from a buyer to purchase their stake. Before concluding the transaction, the majority shareholder must notify the other owners of the offer's terms and conditions, including the price per share and payment terms. Minority shareholders then have a specified period (usually 15–30 days) to decide whether to exercise their tag-along right and sell their stake to the buyer on similar terms.

If a minority shareholder exercises the tag-along right, the buyer must purchase those shares on the same terms. However, if the buyer does not wish to or cannot acquire more shares (for example, if they only wanted to buy 40% of the company, not 55%), the majority shareholder’s sale may be restricted or even cancelled, depending on the terms of the agreement.

It is important to note that the existence of a tag-along clause can effectively reduce the number of shares that the majority shareholder can sell if the buyer's appetite is limited. Therefore, when structuring transactions, it is essential to clearly stipulate what will happen in such a case.

When can an investor exercise a tag-along right?

This right typically comes into play in several common situations, such as:

• If a founder sells 51% or more of the company’s shares to a new investor or strategic partner, minority shareholders may have reservations about the new owner. The tag-along right allows them to exit with the founder.

• Key shareholders change: If the company’s core team shifts, or the founders sell their shares, this may signal to a minority investor that it is time to exit. A tag-along clause allows them to do so on favourable terms.

• Strategic acquisition of part of the business: If a major player is only interested in acquiring a stake in the company (for example, 60%), but offers a good price, a minority shareholder can exercise the tag-along right and sell their stake at the same price per share.

• Adverse changes within the company. Occasionally, a tag-along clause is used as a fallback option if an investor sees that the company is heading in an undesirable direction and the founder has found a buyer for their stake.

A tag-alone example

The founder of an e-commerce startup decides to sell 40% of their stake to a strategic investor — a major retailer. The deal values the company at $5 million, meaning 40% equals $2 million. A venture investor owns 20% of the company.

In accordance with the terms of the agreement, the founder sends the investor a notification of the deal. The investor analyses the situation and finds that the new strategic partner, the major retailer, is a competitor of one of his portfolio companies. It is not in their interest to remain a minority shareholder in such a company. The investor decides to exercise his tag-along right and sell his 20% stake at the same valuation — $1 million.

The buyer must now decide whether to purchase 40% or 60% of the company. If the buyer is willing, the deal expands. If not, the terms will be renegotiated. In any case, however, the investor is protected: he can either withdraw from the deal or restrict the founder's sale. The tag-along clause has worked.

The difference between drag-along and tag-along rights

Although both rights relate to transactions involving the sale and purchase of shares in a company, they are fundamentally different and serve distinct purposes.

The first and most important difference concerns who is protected and from what. Drag-along protects the interests of majority shareholders (and the buyer), allowing them to complete a transaction without being blocked by minority shareholders. Tag-along, on the other hand, protects the interests of minority shareholders by giving them the right to exit alongside the majority shareholder equally.

The second difference is whether it is mandatory. A drag-along obligation requires minority shareholders to sell if the majority shareholder initiates a transaction and all the terms of the agreement are met. A tag-along is a right, not an obligation. Minority shareholders can decide for themselves whether to exercise it.

The third difference concerns who initiates the process. A drag-along is initiated by the majority shareholder, who 'drags' the minority shareholders. In contrast, a tag-along is initiated by a minority shareholder, who 'tags along' with the majority shareholder's transaction.

The fourth difference concerns the consequences for the transaction. Activating a drag-along clause guarantees that the buyer will acquire 100% of the company (or the desired number of shares) and that the transaction will go ahead. However, activating a tag-along clause may increase the size of the transaction or complicate it if the buyer is not prepared to purchase more shares than originally planned.

In real-world transactions, it is worth noting that drag-along and tag-along clauses often coexist within a single document, complementing each other to form a balanced system of protection for all parties.

Why does an investor need these rights?

Investors, particularly venture capitalists and business angels, are always thinking about an exit strategy. When investing in a startup, they expect to recoup their investment and make a profit within three to seven years. However, implementing this plan can be very difficult without properly structured rights.

Protection of minority investors

A minority shareholder does not control the company, but holds a stake in it. Without specific protection mechanisms, they are effectively at the mercy of the majority shareholder’s decisions. The majority shareholder may sell their stake to a new investor whom the minority shareholder does not approve of, make decisions that reduce the value of the minority shareholder’s stake, or simply disregard the minority shareholder's interests when making strategic decisions.

Tag-along is one of the key mechanisms for protecting minority shareholders. It guarantees that, if the majority shareholder finds a good buyer and sells the company at a favourable price, the minority shareholder will also be able to exit on similar terms. Without a tag-along clause, the majority shareholder could sell 60% of the company at $100 per share, leaving the minority shareholder holding shares in a company with a new majority owner whose plans are unclear.

Furthermore, the presence of a tag-along clause in the agreement acts as a disciplinary measure for the majority shareholder. They know that any transaction involving their stake is automatically open to minority shareholders, which encourages them to seek buyers ready for a full-scale transaction.

The ability to exit an investment

One of the main challenges of venture capital investment is achieving liquidity. A stake in a private, unlisted company is an illiquid asset that cannot simply be sold on a stock exchange. To exit an investment, you need a specific buyer willing to pay a fair price.

This is precisely where the tag-along clause becomes a valuable tool. When a founder or major shareholder finds a buyer for their stake, it creates a window of opportunity for minority shareholders to sell their shares. The tag-along clause enables investors to take advantage of this opportunity and realise their investment. Without this right, they might have to wait years to find a buyer, or they might not find one at all.

It simplifies the sale of the company

Conversely, a drag-along clause simplifies the process for all parties involved, including majority shareholders or those who hold a drag-along right under the agreement. Without this mechanism, selling the company to a strategic buyer seeking 100% control could prove impossible if even one minority shareholder refuses to sell.

When negotiating an exit with a potential buyer, an investor can use a drag-along clause to guarantee that the deal will not be blocked. This is particularly important in venture capital deals, where a company may have 10–20 small shareholders, such as business angels, employees with options and early investors. Securing the consent of each of them can be extremely difficult.

Why does a startup need drag-along and tag-along rights?

Even though they appear to restrict the founders’ freedom, the startup and its founders have an interest in including these mechanisms in the agreement.

Firstly, the inclusion of these rights is standard practice in the market. Any experienced investor — whether a venture capital fund, private investor, or strategic partner — expects to see these rights in the shareholders' agreement. Their absence may raise suspicions and deter potential partners.

Secondly, a drag-along clause protects the founders from exit prevention. For example, imagine you are offered $50 million for your company, but one of your early investors, to whom you once sold a 5% stake at a low price, refuses to sell and demands an exorbitant buy-out fee. Without a drag-along clause, you are powerless.

Thirdly, a tag-along clause protects the founder’s reputation. If a founder sells their stake without notifying minority shareholders or on different terms, this can lead to legal disputes and damaged relationships. The existence of a tag-along clause and its proper enforcement demonstrate that the founder is acting honestly and transparently.

Fourthly, these mechanisms attract higher-quality investors. Venture capital funds and experienced business angels recognise the value of these rights and are willing to pay more or invest on better terms if they are included in the agreement. For a startup, this means a better valuation and better partners.

Finally, these rights simplify company management in the long term. When everyone understands the rules, there are fewer conflicts. Shareholders know that a fair mechanism is in place for everyone, which reduces tension.

How are drag-along and tag-along rights set out in an investment agreement?

What are the key conditions for exercising these rights?

A number of essential criteria must be used to define each of these rights.

• Trigger for activation: what event or condition activates the right? For drag-along, this is usually a shareholders’ decision after they reach a specified quorum to sell the company to a third party. For tag-along rights, it is the receipt of an offer from a third party to purchase a stake.

• Notice periods: How much time do shareholders have to decide? Typically, shareholders are given 15–30 days' notice of the transaction before it's concluded. In the case of a tag-along, a minority shareholder must have 10–20 days to respond to the offer.

• Equality of terms: the price per share must be the same for all shareholders. It is not permitted for a majority shareholder to sell at $100 per share while offering a minority shareholder $70. Drag-along and tag-along rights apply only if the terms are equal for all parties.

• The form of payment typically covers both cash transactions and share swaps. However, the agreement should specify whether they apply to non-cash compensation.

Restrictions and the voting threshold

The voting threshold required to trigger the drag-along right is one of the most notable parameters. This is the percentage of shareholders or shares that must support the sale for the drag-along right to take effect. Typical values:

• 50% + 1 — the lowest threshold, which offers broad opportunities to the majority shareholder but provides little protection for minority shareholders.
• 66.7% (two-thirds) — the standard threshold for most venture capital deals.
• 75% — a higher threshold with better protection for minority shareholders.
• 90%+ is rarely used and very difficult to achieve.

In addition to the threshold, other restrictions are often imposed. There could be a minimum transaction price, for instance, and the drag-along right might be activated only if the company's valuation surpasses a specific threshold (for example, at least twice the investment amount). This protects investors from being forced to sell at a bargain price.

The agreement may also include veto rights, whereby a major investor (Series A or Series B) could block the activation of the drag-along clause if the transaction does not meet their minimum return requirements.

Standard wording

In practice, drag-along clauses are usually worded as follows:

“In the event that shareholders who collectively hold more than 75% of the company's voting shares (hereinafter referred to as the 'Selling Shareholders') resolve to sell all or a majority of their shares to an independent third party (hereinafter referred to as the 'Proposed Transaction'), every other shareholder undertakes, upon the request of the Selling Shareholders, to sell their shares to such purchaser on the same terms as the Proposed Transaction”.

The standard wording for a tag-along clause is as follows:

“In the event that any shareholder (the selling shareholder) receives a bona fide offer from an independent third party to acquire any number of their shares, the selling shareholder must notify every other shareholder at least 20 days prior to concluding such an agreement. Each shareholder to whom such notice has been given shall have the right (but not the obligation) to sell a proportionate share of their shares to such purchaser on the same terms.'

These are basic provisions — in actual agreements, they are significantly more detailed and tailored to the specific transaction. It is therefore advisable to engage a lawyer specialising in venture capital transactions to draft such provisions.

Common mistakes when using drag-along and tag-along rights

In practice, companies and investors often make mistakes that undermine the effectiveness of these mechanisms or even lead to disputes.

• One such mistake is the lack of a clear definition of an ‘independent third party’. Drag-along and tag-along clauses generally only apply when shares are sold to an independent purchaser. However, if the term 'independent' is not defined, disputes can arise. For example, would a company controlled by a relative of the founder be considered 'independent'? Always specify the criteria for independence.

• Vague deadlines and notification procedures. The procedure may be considered broken if the agreement does not specify precise steps and due dates for informing shareholders. Be sure to specify the form of notification (written or electronic), response deadlines, and notification addresses.

• There could be a lack of minimum price protection. If the drag-along right can be triggered at any price, the majority shareholder could, in theory, sell the company for a nominal sum. In that case, minority shareholders would lose their investment. Therefore, always set a minimum valuation threshold for triggering the drag-along right.

• There may be a conflict between the drag-along right and the right of first refusal (ROFR). If the agreement contains ROFR, tag-along and drag-along clauses, how they interact must be clearly defined. For example, is a shareholder entitled to exercise the ROFR clause before the tag-along clause takes effect? If this is not settled, legal uncertainty arises.

• Failure to address representations and warranties. In the case of a drag-along clause, minority shareholders who are compelled to sell are usually required to sign an agreement and provide certain representations and warranties to the buyer. If this is not specified in advance, disputes may arise regarding the warranties that the minority shareholder is obliged to provide. Typically, their liability is limited to warranties regarding ownership of the shares only.

• Jurisdiction is not considered. Understanding which law governs the shareholders' agreement and how local laws impact the drag-along and tag-along mechanisms is crucial, for instance, if the company is registered in Delaware or Cyprus but the shareholders are in Ukraine. In some jurisdictions, there are restrictions on the compulsory sale of shares.

• A dispute resolution mechanism might be missing. If a dispute arises regarding the invocation of a drag-along or tag-along right, how and where will it be resolved? Will it be resolved through ICC or LCIA arbitration? Which court? Which substantive law will apply? These questions must be answered before the agreement is signed, not when the dispute arises.

Conclusions: Why are drag-along and tag-along clauses an important part of an investment agreement?

These clauses are practical tools that define the balance of power between a company’s shareholders, ultimately determining whether an exit will take place and on what terms.

A drag-along clause gives majority shareholders confidence that they can complete a sale of the company without minority shareholders blocking it. This increases the company’s attractiveness to buyers and simplifies an exit strategy.

A tag-along clause guarantees that minority investors will not be excluded from a lucrative deal. They always have the opportunity to exit alongside the majority shareholder on equal terms, and they are not forced to wait years for their buyer.

Together, these two mechanisms form a fair and predictable system for managing an exit from the company. They minimise conflicts and legal uncertainty, while also making the company more attractive to investors and potential buyers.

However, the effectiveness of these mechanisms depends entirely on how well they are drafted in the agreement. Vague wording, a lack of procedures or inconsistencies with other provisions can transform these clauses from protective tools into sources of conflict.

Therefore, before signing any investment agreement — whether you are an investor, founder, or strategic partner — ensure the drag-along and tag-along clauses clearly and fairly consider the interests of all parties. Engage an experienced lawyer who is familiar with the specifics of venture capital. This will save you far more than the fees spent on legal support.