Does Your Operating Agreement Address a Situation Where a Buyer Wants to Purchase a Controlling Stake in the Business From Some, but Not All, of the Existing Members?

Welcome, dear readers, to the landmark 20th article in our comprehensive series exploring the intricacies of operating agreements. We appreciate your steadfast companionship on this enlightening journey and are honored by your continued readership. In this final installment, we shift our focus to a crucial yet often overlooked aspect of operating agreements – tag-along rights. These rights offer protection and fairness to minority members when a controlling stake in the business is up for sale. Brace yourself for another deep dive as we unravel how tag-along rights work, their importance, and demonstrate their operation with the help of our familiar characters: A, B, C, D, and newcomer Y.

Understanding Tag-Along Rights

Tag-along rights, often also known as “co-sale rights,” hold a fundamental place in an operating agreement, especially for minority stakeholders. These rights act as a protective cloak for minor members when the majority owners plan to sell their stake. They ensure that if a larger stakeholder sells their share, the minor stakeholders also get the chance to “tag along” and sell their shares on the same terms. This mechanism is a safeguard against scenarios where majority stakeholders might sell their interest to a third party without giving smaller stakeholders the same opportunity.

Why might these rights be included in an operating agreement, you ask? In simple terms, to uphold fairness. Businesses are built on the tenets of fairness and equity, and tag-along rights serve to maintain these values when ownership interests change hands. Particularly for small stakeholders, these rights can be a lifeline, ensuring that they aren’t left in a lurch while the majority holders capitalize on a sale. Without tag-along rights, minority members could find themselves tied to a new majority owner, potentially with different visions for the business, without having had a say in the process. These rights are not just a protection, but an empowerment of minor stakeholders in a business’s journey.

Practical Example of Tag-Along Rights

To fully appreciate the role of tag-along rights, let’s revisit our company made up of four members, “A”, “B”, “C”, and “D”, owning 35, 30, 25, and 10 units respectively, totaling to 100 units. This time, “Y” steps onto the scene, desiring to buy a controlling stake in the company, specifically, units from “A” and “B”, offering $6.5 million. In absence of any protective measures, this would marginalize “C” and “D”, leaving them with little influence in the company’s future. Thankfully, tag-along rights are designed to safeguard such instances, ensuring equitable treatment for all.

In such a scenario, the $6.5 million would be apportioned according to the units each member owns. “A” with 35 units would receive $2.275 million, “B” with 30 units would receive $1.95 million, “C” with 25 units would get $1.625 million, and finally, “D” with his 10 units would receive $650,000. The $6.5 million total is thus fairly distributed among all four members.

The units that remain after the sale, a total of 35 units, would also be proportionally redistributed among “A”, “B”, “C”, and “D”. This implies that “A” will own about 12.25 units, “B” will own about 10.5 units, “C” will own approximately 8.75 units, and “D” will own about 3.5 units. This balanced distribution ensures that the remaining equity in the company is justly assigned, regardless of who initially engaged with the buyer. This example illustrates the power of tag-along rights and their capacity to ensure fairness among members, regardless of the size of their initial stake.

Conclusion

We hope this article has been informative and useful for your business. If you have any questions or comments, please contact us at info@wilkinsonlawllc.com. We plan to answer general questions in an upcoming FAQ series. If you need legal advice specific to your situation, please ask to schedule a consultation with an attorney to discuss your company’s goals.

And with that, we reach the zenith of our 20-part series. We sincerely hope that the insights shared in these articles equip you with the knowledge to navigate the complexities of drafting a robust operating agreement. Remember, a well-crafted operating agreement is not just a legal requirement; it’s a blueprint for success, a tool to facilitate smoother business operations and to foster stronger partnerships. Keep an eye out for future content where we will continue to explore topics that empower you as a business owner or manager.

This article is for informational purposes only and should not be relied upon as tax or legal advice. Please consult professionals for advice tailored to your specific situation. The author and publisher assume no responsibility for any errors or omissions or for any actions taken based on the information presented.