Term Sheets: What is the co-sale right (aka. tag along right)?
This week we continue our series on key VC financing deal terms.
This week’s question: What do I need to know about co-sale rights (aka. tag along right)?
Our answer: Co-sale rights give certain investors the right to “tag along” and sell a portion of their shares on the same terms as a key holder (e.g., founder or key employee) in a proposed sale to a third party. These rights are usually exercised after the company and major investors decline to fully exercise their right of first refusal (ROFR). Co-sale rights give investors a fair opportunity to exit under the same terms as key holders. Our recommendation is to limit the scope of co-sale rights to major investors, apply them only to transfers by common stock key holders, carefully and clearly define the extent to which investors can participate pro rata, and include standard exemptions to avoid an overly broad grant of rights.
Key Considerations
1. Scope and Liquidity. Be careful about co-sale right language that could broadly restrict your ability as a key holder to sell shares. Co-sale rights should be limited to (i) major investors (ie. a defined set of investors, typically who hold a minimum threshold of shares) rather than all preferred stockholders and (ii) to the common stock held by key holders.
2. Pro Rata Participation. Investors who exercise their co-sale rights can sell a portion of their shares based on their ownership stake relative to the shares that co-selling investors and key holder(s) own. The formula matters because, for instance, you can push to reduce investor participation by including all key holder shares in the calculation and not just the shares being sold. This is a negotiable term that founders should understand clearly to avoid unexpected limitations later.
3. Exempt Transfers. Similar to ROFR exemptions, negotiate co-sale exemptions to preserve flexibility without undermining investor protections. Common carve-outs include (i) transfers to affiliates or personal entities, (ii) estate or tax planning transfers to trusts or family, (iii) de minimis transfers (e.g., under 5%), and (iv) transfers approved by a set threshold of investors or the board. These carve-outs help preserve flexibility without undermining the investor protection intent.
Why It Matters
Co-sale rights are a standard tool allowing investors to participate in exit opportunities and have control over their investment and the cap table. For founders, including these rights signals alignment with investors which can support fundraising efforts, but if done carelessly co-sale rights can overly restrict your ability to achieve liquidity. While granting co-sale rights can help you negotiate in financings, be mindful of the scope and potential constraints they may impose on future liquidity for your founder or employee stock.
