How minority investors can protect their interests
We anticipate that private companies will increasingly look to raise capital from minority investors to enable otherwise robust businesses to grow or ride out the ongoing Coronavirus pandemic. Investors should take care to understand the rights that may and may not be available to them. The foremost challenge for a minority investor is balancing:
- the majority shareholders’ desire to retain control of the business; and
- its own need to (1) protect its investment throughout the lifecycle and (2) control (to a degree) the exit process.
The legal terms will also be influenced by the structural and economic terms of the transaction, such as the level of rollover, size of any sweet equity pot, amount of debt to be raised, and ranking of securities as between shareholders. As a result, there are fewer “rules of thumb” as to what constitutes standard market practice and a carefully considered approach to the legal terms will be essential.
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Key controls over investment
1. Board control
Typically, on a minority investment, a private equity investor will have less control over the composition of the board and (absent specific agreement to the contrary) will not be able to change the management team. However, a sponsor is often able to exert influence over the board through its right to appoint one or more investor directors and any rights to appoint an independent chairperson or nonexecutive director. This should be balanced with the rights of majority shareholders to control the board, and consideration should be given to the circumstances in which that balance should be tipped.
2. Step in rights
Additionally, in certain circumstances (e.g. following a “default event”), a private equity investor will want enhanced rights which enable it to “step in” and protect its investment. These enhanced rights will typically include:
- Voting rights: increased voting rights by disenfranchising shares held by other investors or giving voting rights to the investor’s non-voting shares (e.g. preference shares);
- Board control: additional rights to appoint directors and/or remove existing directors;
- Emergency funding: the ability to provide emergency funding on a non-preemptive basis (typically subject to a catch-up right for the other shareholders);
- Operation of the drag: the ability to operate the drag-along provisions without regard to any conditions which would otherwise apply (e.g. delay, value floor, etc.); and
- Appointing third party advisers: the ability to appoint third party advisers to advise on strategic options, which the board must consider and/or implement in good faith.
3. Veto rights
Finally, whether a minority or majority investor, there are certain fundamental operational decisions and matters that a private equity investor should ensure it has veto rights over. This list is often extensive, though typical examples include:
- borrowings outside of the existing debt finance arrangements;
- material acquisitions and disposals of assets;
- amendments to constitutional documents;
- returns of capital;
- share issues or reorganisations; and
- changes in the nature of the business.
On minority investments, a private equity investor may be asked to concede veto rights to other shareholders, such as a founder shareholder no longer actively involved in the operation of the business. Any concessions should be carefully considered, particularly in respect of rights that apply following a default event, as the investor should not fetter its ability to protect its investment.
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Key mechanisms to influence an Exit
1. Drag positions
As a minority investor, a sponsor may be unable to negotiate a traditional “drag-along” provision. To bridge the gap and provide the private equity investor with enough flexibility to achieve an exit, the other shareholders may be more willing to accept a drag-along mechanism where:
- Delay: the drag-along only becomes operable after a specified date following completion;
- Shareholder acceptance: a set threshold of other shareholders must approve the transaction;
- Value floor: a minimum return must be achieved by dragged shareholders as a condition precedent to the operation of the drag-along mechanism; and/or
- ROFO: the other shareholders have a right of first offer (“ROFO”) before the drag-along mechanism can be triggered.
Conversely, majority shareholders may seek the ability to drag the private equity investor into a sale. Careful consideration should be given as to whether such a right can be accepted, and what limitations are required (e.g. value floor, delay, etc.) in order to ensure any sale occurs on terms financially acceptable to the private equity investor.
2. Other mechanisms
If the private equity investor is not able to negotiate drag-along rights, it may be able to negotiate alternative means to influence an exit, including:
- “exploding” or “stepped” coupons on the investor’s preference shares or loan notes which take effect after a specified date following completion;
- rights to receive a guaranteed dividend or to require some or all of its loan notes or preferences shares to be redeemed on a specified date following completion; and/or
- provisions requiring all parties to work together to achieve an exit by a certain date, and rights for the investor to appoint third party advisers to advise on an exit if it has not been achieved by the pre-set date.