Tag-Along Rights Clause
(Operating Agreement) (LLC)

Summary

This is a template for a tag-along rights clause (operating agreement) (LLC) that may be incorporated into in the operating agreement of a limited liability company (LLC). This template includes practical guidance and drafting notes. Tag-along rights (like drag-along rights) are typically seen in the venture capital and private equity contexts for business entities—generally private companies—in which investors' equity interests are certificated in the form of capital stock. LLCs usually do not issue equity interest certificates. Accordingly, bootstrapping corporate capital stock language into the LLC context, where "membership interests" apply, can be particularly tricky. This issue is further syntactically compounded because—unlike shareholders, who can own more than one share—each member of an LLC has one (and only one) membership interest, albeit the percentage of each member's membership interest can, and usually does, vary with respect to the other members. Generally speaking, the holder of a non-controlling membership interest (i.e., borrowing conceptually from the corporate stock world, the "minority" owner) may be restricted, under the terms of the LLC operating agreement, from initiating a transfer, unlike the founding member (i.e., essentially the "majority" owner) with respect to his, her, its or their controlling membership interest. However, at the time of the LLC's formation the ostensible minority members may have optimal bargaining power in relation to the controlling, founding member, who is likely to be hungry for capital to start the business and therefore may be more inclined to agree to the inclusion of a tag-along rights provision in the operating agreement. Tag-along rights prevent the controlling member from excluding the non-controlling, minority interest holders from the benefit of the sale by the controlling, majority member (which is the usual paradigm of a tag-along rights provision). Moreover, tag-along rights give the minority members the opportunity to share in any control premium offered to the controlling member by the prospective purchaser. However, tag-along rights can also be drafted to apply to a sale of any membership interest instituted by any member—even the minority interest holder(s). Therefore, much like drag-along rights, tag-along rights can ultimately result in the sale of the entire company—albeit, at the discretion of the purchaser—even if this was not envisioned by the initial selling member. However, because a tag-along right provides an option (but not an obligation) to those possessed of the right to participate in the sale of the controlling member's membership interest (whether all or a portion) on a pro rata basis, it can have unwelcome consequences for the unwary. Consider the situation where a 70% membership interest in an LLC is owned by Seller A and a 15% membership interest is owned by each of two other members, Sellers B and C, who enjoy tag-along rights. If Seller A intends to exit from the LLC by offering to sell his or her entire 70% stake to a potential purchaser, unfortunately for Seller A the-tag along rights of Sellers B and C will defeat Seller A's goal. This is because the potential acquirer (if intending to purchase just a 70% stake in the LLC—and no more), will have to purchase the 70% stake pro rata from the majority and the minority holders together—and on identical terms. As a result, Seller A will retain a 21% membership interest position (.70 x .70 = .49; .70 - .49 = .21) and each of Sellers B and C—having tagged-along on A's attempted sale of his or her entire 70% stake—will still retain a 4.5% interest (.70 x .15 = .105; .15 - .105 = .045). In other words, the prospective purchaser will still acquire the desired 70% ownership stake, but in portions from each of Sellers A (49%), B (10.5%) and C (10.5%). Accordingly, the purchaser will be the new majority (70%) interest holder, but Seller A will be transformed into a minority interest holder (21%) instead of entirely exiting from the company as hoped, and Sellers B and C will remain as minority interest holders (10.5% each), but now each with even less ability to impact the company's direction and control. In their usual application, tag-along rights are generally more protective of minority investors (because they too can receive the benefit of the controlling member's bargain) while drag along rights are generally more protective of majority investors because the intended sale of their interest—and potentially all equity interests in the company—cannot be blocked by minority investors. Drag-along rights must also be coordinated with any right of first refusal (ROFR) and/or right of first offer (ROFO). If members have a ROFR, then upon the planned sale by the ostensible selling member (regardless of whether the ROFR provision applies only to a selling majority member or also to selling minority members) of his, her, its or their membership interest to a third party (which is always requirement for a ROFR), the other (i.e., the non-initiating) members will have a the first priority right to purchase the selling member's membership interest. In the case of a ROFO, the selling member intending to sell his, her, its or their membership interest (again, regardless of whether the ROFO provision applies only to a selling majority member or also to selling minority members) does not have to first obtain a bona fide offer from a third party. Rather, once the divesting member informs the other members of the planned divestment, it's up to the other members to produce a colorable "first offer" acceptable to the divesting member. For both ROFR and ROFO, if the non-selling members do not purchase the selling member's membership interest under those rubrics, they nevertheless can still participate (as sellers themselves) in the sale of the selling-member's interest in accordance with their tag-along rights. For a full listing of key content for in-house counsel and corporate secretaries when performing corporate functions, see In-House Corporate Secretary Resource Kit. For more information, see Limited Liability Companies. For sample operating agreements, see Operating Agreement (Real Estate) (Member-Managed, Single Member), Operating Agreement (Member-Managed, Multiple Member) (LLC), Operating Agreement (Manager-Managed, Single Member) (LLC), and Operating Agreement (Manager-Managed, Multiple Member) (LLC).