CRITICAL LEGAL ISSUES IN PRIVATE
EQUITY DEALS
September 2003
By Gregory P. Cirillo
Partner, Wiley Rein & Fielding
703.905.2808
gcirillo@wrf.com
© 2003 Wiley Rein & Fielding LLP ✦ Washington, DC ✦ Northern Virginia ✦ www.wrf.com
An entrepreneur’s first private equity transaction is generally a breakthrough
event for the entrepreneur and the business. The business will emerge from
the transaction as a transformed entity, flush with needed cash, but also often
with new management, new shareholders and different objectives. When
you make the decision to pursue private equity, you set in motion a process
that has its own momentum; and unless a major obstacle arises, the deal
will proceed to closing. It is critical, therefore, that owners and executives
understand and agree to their common objectives at the outset—before the
private equity deal gains momentum.
WHAT IS PRIVATE EQUITY?
Private equity is the broadest term used to define equity investments in
companies that are not publicly traded. By most definitions, private equity
encompasses venture capital, angel financing, institutional finance and private
placements. In practice, the term private equity is often distinguished from
venture capital as being: (a) generally larger in dollar amount, (b) targeted at
When you make the more mature businesses, and (c) representing “bigger money” interests
decision to pursue meaning that the ultimate investors in the funds are often institutional rather
private equity, you set in than individual.
motion a process that has The Tuck School of Business at Dartmouth has an on-line glossary of private
equity terminology at: http://mba.tuck.dartmouth.edu/pecenter/resources/
its own momentum.
glossary_s_z.html.
ESTABLISH THE OWNERS’ OBJECTIVES
The interests and objectives of business owners will be inherently different from
the interests and objectives of a new capital source. Unfortunately, owners
often defer any consideration of their interests and objectives until they are
sitting at the table with a private equity source. As a result, the private equity
players—who do this for a living—may dominate the deliberations to an
unreasonable extent. The best time to discuss these interests and objectives is
prior to your meetings with private equity sources.
CONTROL
Are the current owners interested in giving up some or all of the day-to-day
control of the business? Some private equity is passive—preferring to allow
the existing management to stay intact. Others play a more active role, and
may have specific plans for revising or redirecting your business plan.
HORIZON, EXIT & TRANSITION
How long do the current owners intend to remain involved in the business? Do
they have a second generation of management ready (or expecting) to step
in? If the current owners have a plan for disposing of their interest business
(selling it whole, in pieces or IPO), then that should be discussed. New capital
may have a different plan or “exit strategy.” You can have more than one exit
strategy operating in a business, but the two strategies must mesh.
2
© 2003 Wiley Rein & Fielding LLP ✦ Washington, DC ✦ Northern Virginia ✦ www.wrf.com
YOUR NEGOTIATING TEAM
The business of negotiating the terms of new capital is not ordinarily within
the core competency of most businesspersons. Unless you retain qualified
support—financial and legal—you risk being outgunned by the capital players
who do this for a living. Add skills where you need them, and maintain your
independence from the private equity source.
The private equity source often will recommend that you engage financial or
legal talent of their choice. Their primary objective is to make certain that the
deal is staffed with qualified professionals—and that is a mutually beneficial
objective. Their secondary objective is ensure a fast, smooth closing, with a
minimum of negotiation. (The private equity source has to answer to their fund
members; and administrative costs are often scrutinized. The best deal for
the private equity source is the proverbial “cookie cutter” deal.) That is not a
mutually beneficial objective.
Your professionals should be experienced in private equity deals, very familiar
Unless you retain qualified with your objectives, and beholden solely and exclusively to your best interests.
support—financial and
legal—you risk being VALUATION—THE 800 (OR 400?) POUND GORILLA
outgunned by the It may be an exaggeration to say that valuation is everything, but it is fair to
say that it is the most important element in any equity transaction (including
capitalplayers who do any debt transaction where there is the ability to convert to equity, or where
this for a living. warrants are issued).
To put it most simply, if you have a business today valued at $10 million, and
you bring in equity of $5 million, the new investor(s) will expect to own 1/3 of
the equity of the company post-closing ( 5 /15ths of total equity). If your business
is instead valued at $5 million, that same equity investor(s) will expect to own
½ of your business post-closing ( 5 /10ths ).
The amount of capital that you seek from equity sources is determined by your
business plan. Your valuation will determine how much of your company that
you must hand over in order to get that capital and pursue your business plan.
So, the control of your business may be determined by its valuation. The most
important things you can do today, before approaching private capital sources,
is to understand your business’s value, and more importantly, take whatever
steps you can take to enhance that valuation. For example, you may need to
wait several financial quarters or year in order to present a stronger valuation
picture. In addition, you can use convertible debt, or redeemable equity to
earn your way back into control.
Once negotiations with private equity begin, you should focus on valuation,
and get that set in stone as early as possible in the process. Equity sources
may explain that they are engaging in on-going due diligence, and valuation
will not be determined until a later date. That is fine, provided that: (i) you do
not tie yourself to this equity source prior to determination of value, and (ii) you
do not foreclose other possibilities during their due diligence process.
3
© 2003 Wiley Rein & Fielding LLP ✦ Washington, DC ✦ Northern Virginia ✦ www.wrf.com
OTHER KEY ISSUES
Dilution and “Ratchet”
Absent some agreement to the contrary, any new equity entering a company
dilutes the interests of the existing equityholders. Private equity sources will
attempt to protect themselves with anti-dilution provisions that allow them to
preserve their relative position. Anti-dilution provisions vary significantly from
simple pre-emptive rights (the right to participate in a future equity deal at
the offered price) to “ratchet” clauses which automatically increase the equity
percentage in the event that a future round of equity financing is done at a
lower valuation (a “down round”). A full ratchet clause protects the existing
equityholder, but is viewed negatively by new capital sources. It is all highly
negotiable.
Warrants and Convertible Equity and Debt
Warrants are simply agreements to sell stock at an agreed price, and upon the
occurrence of specified events. Convertible debt is a contractual right whereby
The control of your a debt financier can elect to convert some or all of its outstanding debt to
equity, at an agreed valuation ratio; and convertible equity (generally preferred
business may be stock) is convertible into voting stock. In some cases, these features are used
determined by its to give an added “kicker” when the business is successful; and in other cases,
it is used to trigger a change in control (in favor of the financier) if the business
valuation. is not successful.
Extraordinary Voting and Control Issues
Private equity is “smart money” in that it enters a business with clear objectives
and knows how to achieve them. If the new equity does not have voting
control of the business, then these objectives are often captured in specialized
provisions in the Articles/Certificate of Incorporation, the Bylaws or a
Shareholders Agreement. There is nearly an infinite variety of special voting/
control mechanisms, but they include: (i) establishment of “reserved” seats
on the board of directors, (ii) creating supermajority vote (at shareholder and
board level) requirements for certain transactions, (iii) cash-out rights
triggered by certain events or dates to permit an equityholder to liquidate its
invesment, and (iv) “tag-along” or “drag-along” rights that permit the minority
shareholder(s) to participate in stock sales and public offerings of stock.
The private equity sources require these specialized clauses to protect their
investment. In transactions where the business owner gives up control, these
clauses should be considered as means to protect the original owners.
The Business Deal with the Private Equity Source
Your relationship with the private equity source will, itself, be a business
contract. The private equity source will earn a fee based on the deal closing,
but also perhaps a service fee. The private equity source will seek some
degree of exclusivity, and a restriction on competing negotiations. These
restrictions are customary, but must have significant limits. As indicated above,
it is important to preserve independence from the equity source; and that
includes the ability to “cut and run” under appropriate circumstances.
4
© 2003 Wiley Rein & Fielding LLP ✦ Washington, DC ✦ Northern Virginia ✦ www.wrf.com
CLOSING THOUGHTS
One issue that has not been discussed above is simple bargaining power.
The terms of a private equity transaction are dictated by the posture of the
business. The business is either on the cusp of success and needing cash to
fuel success, or the business is in trouble and needs capital to regroup and
rebuild. In the latter case, the term of the private equity will be more onerous
It is our view that most and less negotiable. Nevertheless, it is always beneficial to invest energy and
private equity transactions resources in negotiating and documenting the best possible terms.
are fair and positive Many articles of this type begin with a “parade of horribles” or a list of “traps
experiences. for the unwary” to grab your attention. It is our view that most private equity
transactions are fair and positive experiences, and a negative tone seems
inappropriate. Observing the recommendations above, we would hope that
you will avoid the “horribles” and “traps.” Any new equity investment presents
an infinite range of options, and by exploring those options, you can generally
reach a mutually beneficial conclusion with new capital sources.
This publication of Wiley Rein & Fielding LLP is for informational purposes only and
does not contain or convey legal advice. The information herein should not be
used or relied upon in regard to any particular facts or circumstances without first
consulting a lawyer.
5
© 2003 Wiley Rein & Fielding LLP ✦ Washington, DC ✦ Northern Virginia ✦ www.wrf.com
ABOUT THE AUTHOR
Gregory P. Cirillo is a Partner in the firm’s Aerospace & Aviation, Business &
Finance and Internet & E-Commerce Practices. He advises clients on a wide
array of transactional matters, including acquisition and finance of capital
assets, venture formation and structure, debt and equity funding, mergers and
acquisitions and strategic alliances.
His experience included equipment-backed financing and leasing involving
aircraft and aerospace assets as well as acquisition, disposition and licensing
of tangible and intangible technology assets.
.
Gregory P Cirillo Mr. Cirillo is Founder and Chairman of the Northern Virginia Technology
703.905.2808 Council’s, Aerospace Technology Committee. He received both is A.B. and
gcirillo@wrf.com J.D., cum laude, from Georgetown University.
6
© 2003 Wiley Rein & Fielding LLP ✦ Washington, DC ✦ Northern Virginia ✦ www.wrf.com