What are Pre-emptive Rights and Tag-along Rights Defined in Shareholder Agreements?

Shareholder agreements, which are contracts made between shareholders of a company, are often established during Mergers and Acquisitions (M&A), but most commonly at the time of a company’s founding. Particularly at the inception of startup companies, it is common for investor shareholders to limit the transfer of shares by management shareholders in the shareholder agreement, in order to prevent the founders from withdrawing from the company’s operations.

The type of share transfer restrictions set in a shareholder agreement is extremely important. This is because, for investors, it leads to the growth of the company through stable management and ensures opportunities for an ‘Exit’. On the other hand, for management shareholders, it leads to a wide range of fundraising and prevents the outflow of shares to hostile forces.

In this article, we will explain the ‘Right of First Refusal’ and ‘Tag-Along Rights’, which are share transfer restrictions set in shareholder agreements.

What is a Shareholders’ Agreement?

A “Shareholders’ Agreement” is a contract concluded between shareholders of a corporation, which stipulates matters related to the operation of the company and the transfer of shares. In the case of startup companies, the management of the company is often based on the trust relationship between shareholders, and the breakdown of this trust or the change of shareholders can have a significant impact on the management of the company.

Therefore, in startup companies, it is common to include a clause in the shareholders’ agreement that restricts the transfer of shares by the managing shareholders.

The Need to Restrict the Transfer of Shares by Managing Shareholders

At the time of establishment, startup companies often lack assets such as real estate that can serve as collateral, and they also lack sales and creditworthiness. As a result, there are limits to raising funds through bank loans. Therefore, to rapidly expand the scale of the company from its inception, it is essential to raise funds widely from venture capital (VC) and angel investors.

On the other hand, investors who become shareholders often invest with a focus on the human resources and business ideas of the founding members, and they demand that the original managing shareholders continue to hold decision-making power in the company management. If the decision-making power of the managing shareholders is weakened by the transfer of shares, or if the company management is transferred to a third party, the management policy can easily change, leading to instability in the company management.

Benefits of Restricting Share Transfers in a Shareholders’ Agreement

A shareholders’ agreement allows for the establishment of rules that suit the company to a certain extent flexibly, and it can be established solely by the agreement between the parties without the need for a resolution at a general meeting of shareholders.

Some agreements may stipulate that the consent of all or a majority of the investor shareholders is required for the transfer of shares by the managing shareholders. In practice, there is a possibility that share transfers may occur due to unavoidable reasons such as inheritance, so it is often the case that indirect restrictions such as “pre-emptive rights” and “tag-along rights” are imposed.

Right of First Refusal in Shareholder Agreements

The right of first refusal, or “先買権” in Japanese, refers to the right that allows other shareholders to preferentially purchase shares when a certain shareholder intends to transfer their shares to a third party. This is achieved by notifying other shareholders of the transfer details in advance.

In startup companies, the provision of the right of first refusal is primarily established to impose restrictions on the transfer of shares by the management shareholders to the investor shareholders.

However, there are also cases where the management shareholders impose restrictions on the transfer of shares to the investor shareholders. The reason for this is that as a manager, they would prefer to buy the shares themselves rather than have them transferred to an unknown third party.

Specifically, the following clauses are typically stipulated in shareholder agreements:

1. When the management shareholder transfers shares to a third party, they must notify the investor shareholders of the name of the transferee, the number of shares to be transferred, and the transfer price in advance.
2. Upon receiving the notification, the investor shareholder must express their intention to purchase the shares under the same conditions within a certain period.
3. The management shareholder transfers the shares to the investor shareholder who has expressed a desire to purchase them.
4. Only if the investor shareholder does not wish to purchase, the management shareholder can transfer the shares to a third party.
5. If there is no desire to purchase from the investor shareholder and the shares are to be transferred to a third party, the transfer price must be at least the price determined in clause 1.

If there are multiple investor shareholders who wish to transfer, the shares are generally divided according to the shareholding ratio.

In addition to the right of first refusal of the investor shareholders, it is also possible to stipulate in the shareholder agreement that the management shareholders and other investor shareholders can exercise the right of first refusal when the investor shareholders wish to transfer.

The purpose of establishing the right of first refusal clause is as follows:

• To restrict the transfer of shares and prevent the outflow of shares to third parties or hostile forces
• To increase one’s own shareholding ratio by purchasing shares

By granting the investor shareholders the right of first refusal when the management shareholders transfer shares, it is possible to prevent the shares from being transferred to undesirable third parties and to increase the shareholding ratio of the investor shareholders by purchasing shares.

On the other hand, when the investor shareholders achieve an exit through the transfer of shares, there is no risk regardless of who the buyer is, so the right of first refusal may also be granted to the management shareholders.

For management shareholders, having the right of first refusal has the advantage of being able to prevent the outflow of shares to others.

Tag-along Right Clause in Shareholder Agreements

A “tag-along sale right” can be established in a shareholder agreement to restrict the transfer of shares.

The tag-along sale right is a right that allows a shareholder to request that their shares be sold jointly when another shareholder transfers their shares to a third party.

While pre-emptive rights are granted to both investor shareholders and management shareholders, it is common for tag-along rights not to be granted to management shareholders.

Investor shareholders invest in a company with the aim of waiting for the company to grow over a certain period and then realizing profits through the transfer of shares. Therefore, it is necessary to secure opportunities for share transfers for investor shareholders by establishing a tag-along right.

On the other hand, the purpose of management shareholders is not to realize profits, but to grow the company. Therefore, there is no need to grant tag-along rights to management shareholders.

In order to guarantee minority shareholders the opportunity to exit, the following clauses are typically included in shareholder agreements:

• When a major shareholder transfers all or part of their shares to a third party, they must notify minority shareholders of the name of the transferee, the number of shares to be transferred, and the price per share (transfer condition notification).
• Minority shareholders can request the major shareholder to jointly transfer their shares under the conditions stated in the transfer condition notification.
• If a minority shareholder exercises the tag-along right, the major shareholder cannot sell their shares alone.

It is also necessary to specifically state the scope of the shares, who can exercise the right, and who can be requested to make a joint sale.

• The scope of shares that can claim the tag-along right
• Who can exercise the tag-along right
• Who can be requested to make a joint sale

Major shareholders will sell their shares through their own routes when the company has grown to a certain extent, and exit to realize profits. However, minority shareholders who do not have a sale route may be left holding illiquid shares in an unlisted company. When a major shareholder exits and the parent company or management policy of the company changes, minority shareholders will also want to recover their invested capital through the sale of shares.

Establishing a tag-along right clause to secure exit opportunities for minority shareholders can also lead to the benefit of making it easier for various investors to invest in startup companies.

However, if a tag-along right clause is included in a shareholder agreement, the management policy may change easily due to the fluidity of the shareholder composition, and the company’s operation may become unstable. Also, major shareholders may refrain from investing considering the risk of reducing the number of shares they can sell.

Whether or not to establish a tag-along right clause must be carefully considered by comparing the merits and demerits.

Summary: Consult a Lawyer for Shareholder Agreements (Pre-emptive Rights and Tag-along Rights)

The purpose of including “pre-emptive rights” and “tag-along rights” clauses in shareholder agreements is as follows:

• Expand the fundraising possibilities for startup companies
• Prevent the outflow of shares to third parties or hostile forces
• Prevent the management shareholders from distancing themselves from company operations
• Increase the self-share ratio of investor shareholders

The type of share transfer restrictions set in shareholder agreements will likely be a key point in determining whether VCs or angel investors invest in startup companies.

In some cases, investors may hesitate to invest due to concerns about limited opportunities for share transfers.

Specialized knowledge is required to restrict share transfers by including “pre-emptive rights” and “tag-along rights” clauses in shareholder agreements. When drafting a shareholder agreement, it is recommended to seek advice from a legal expert, such as a lawyer.

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Monolith Law Office is a legal office with high expertise in both IT, particularly the Internet, and law. Our firm handles a large number of cases, including M&A involving business transfers, third-party allotment of new shares, issuance of stock options, management buyouts (MBO), establishment of joint ventures (JV), and other stock-related legal affairs, as well as dispute resolution related to these matters.