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Private Equity Planning Your Exit
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An inherent part of any private equity investment is the route by which the investee ultimately disposes of their equity stake in the company (an Exit). The anticipated exit route attracts detailed planning from a tax and legal point of view to fully protect the investor.
Typically, investors look for a return between 3 and 5 years after the original investment, although, investors will need to keep in mind that an exit from the outset can not be absolutely guaranteed as there are too many uncertainties that may arise. However, parties can try to put themselves in the best position to take advantage of the opportunities which arise by a comprehensive investment agreement and careful tax planning. It is important to consider the following:-
- The range of Exit methods commonly used and their advantages and disadvantages.
- Who decides the timing of the Exit.
- Provisions (either in the company’s Articles or investment agreement) that can be put in place to influence the outcome.
Exit Methods
The main exit routes for an investor include:-
- Public floatation
- Trade Sale
- Secondary Buyout (a sale to co-investors or other private equity providers)
- Break up and Distribution of proceeds (restructured and sold in parts)
- Redemption of shares (redeemable preference shares are redeemed)
- Portfolio sale (private investor seeking to sell a number of investments)
- Management buyout.
Key aspects of the Investment Agreement/Articles of Association
It is important to set the parameters for the exit from the outset of the investment, to minimise the potential for later tensions or disagreements on this subject between the investor and managers of the investee company. To clarify the exit terms and to protect the investor’s position legal advice should be sought at the outset. It is important that the investment agreement includes the following provisions:
- Exit control covenants detailing intentions of the investor and placing obligations on the management to use reasonable endeavours to arrange an exit before a certain date.
In practice this clause may be difficult to enforce due to the ambiguous meaning of ‘reasonable endeavours’. However, an exit covenant will at least help the parties focus on their intentions and the overriding objective of the investment.
- Exit Control triggers detail the following:-
- who has the right to enforce an exit, for example, a certain percentage of the shareholders;
- the method of establishing the sale price;
- who is allowed to sell their shares and when.
- Drag Along Rights enable the investor to require the sale of the entire issued share capital even if some shareholders disagree. This is important as the ability to sell the entire issued share capital of the company is critical in achieving maximum valuation.
- Tag Along Rights enable the investor to require their shares to be sold if a certain percentage of other shares are sold. These rights are important so the investor does not get left behind.
- Management Covenants seek to ensure that the management of the company adhere to proper business conduct and standards, for example, by placing an obligation on the management to produce regular management and financial information. This will maintain the value of the business and also allow the investor to monitor the progress of the business.
- Prohibition on sales: it is likely and advisable to prohibit the management selling shares without the investor consent. In addition, it is likely that the company’s articles of association will contain pre-emption provisions applicable to all transfers of shares save for certain exemptions.
- No warranty protection: as the investor does not have day to day involvement in the company, the investment agreement should state that no warranties will be given by the investor on an exit other than that it actually owns its shares.
- Limiting contingent liabilities: the exit sale agreement must be carefully drafted to ensure that the investor is not directly liable for any future liabilities of the company and that no obligations have been inadvertently accepted by the use of the words ‘jointly and severally’ in relation to the selling shareholders.
- Ratchet clauses will enable the managers to a higher percentage of the sale proceeds based on the target rate of return and timing of the Exit.
These clauses are intended to provide a framework for an exit transaction, to ensure that the investor’s expectations and requirements are documented and to ensure a constant focus on the exit through out the investor’s relationship with the company. The preferred exit routes documented in the investment agreement will depend on a number of factors including the business of the target company, time constraints, the target company’s business plans and tax planning.
Role of Legal Adviser
It is important to seek legal advice early to be armed with the correct information before any negotiations are held regarding the investment terms. Experienced legal advisors can identify and deal with the issues in a proposed investment and detail the best Exit routes for an investor in a concise and pragmatic way.
If you would like to discuss any of this information further please contact:
Matthew Crosse
E: matthew.crosse@tollers.co.uk
T: 01604 258100
2 Castilian Street
Northampton
Northants
NN1 1JX
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Closing the Deal
Chris Rees, a partner at Nelsons Solicitors, explains how to manage the completion process, following an offer of business investment.
So, after much pitching and selling to prospective investors and painful hours of honing your business plan and forecasts, you’ve done it. You have an offer of investment and are looking to close the deal. Hard work done? Unfortunately not.
UNDERSTAND THE DEAL TERMS AND STRUCTURE
It is important to fully understand the key terms and the basic deal structure. Is there one or multiple investors? Are all the investors angels, or funds, or a mix? Is there a lead investor? Will the investment be all equity, all debt, or a mix? Will the investment all go in on day one or will it be staged? Are tax considerations fundamental to the deal? And so on. It is sensible to set those terms out in a ‘terms sheet’ or ‘heads of agreement’ (Heads). This is generally a non binding document setting out the intention of the parties, albeit it will often contain some binding obligations such as who picks up the costs if the deal aborts, exclusivity and confidentiality. If you have not managed to get the investors to sign up to a formal confidentiality agreement or non disclosure agreement (a two way confidentiality agreement), then try to do so at this stage.
INSTRUCTING THE RIGHT ADVISERS
You are entitled to take advice and should do so. If the investors and their advisers prepare the first drafts of the main documents, remember these will possible. It is highly likely that you will have to pick up the tab for the advisers’ costs, including the investors’ advisers, so this
needs to be built into your costings. For all advisers, it is advisable to try to agree the scope of the work they will undertake and a price upfront.
DUE DILIGENCE
The investors will raise enquiries bout the business, the assets, the company, the management team etc. It is essential that you and your advisers deal with this efficiently, in writing, and in full and clear detail. If your house is
in order, this process should be relatively painless. You will also need to keep your business plan and forecasts up to date.
THE KEY DOCUMENTS:
INVESTMENT AGREEMENT (OR SHAREHOLDERS’ AGREEMENT) – this will contain, for example, warranties about the business to be given by you; control issues, namely things which cannot be done without the investors’ consent; board meeting ormalitifes and structure; restrictive covenants; access to information provisions; and exit related provisions.
NEW ARTICLES FOR YOUR COMPANY – this deals with share rights, what happens on a transfer of shares (pre-emption rights, ‘bring /drag along’ provisions, deemed transfers, permitted transfers, possibly good leaver/bad leaver provisions) etc and should otherwise dovetail the Investment Agreement.
SERVICE AGREEMENTS – for all executive directors and key management. DISCLOSURE LETTER – your ability to qualify the warranties.
BATTING ORDER
If there are tax considerations such as EIS, then it is essential things are done in the correct order or the investor may not qualify for EIS relief.
TIMING
Set a realistic times-cale for the process and completion. Once the documents and batting order are agreed you can complete the investment and then concentrate on delivering the growth.