Client briefing
October 2005
How to negotiate private equity
agreements
Introduction
Key Issues
What is a private equity transaction? Private equity transactions in the UK market
range from venture capital through development capital of various types to latestage buyouts (management or leveraged buyouts/ MBOs or LBOs). Private equity
institutions have in recent years predominantly led late-stage buyouts.
Management-led transactions still exist but these tend to be in the low or mid range
of late-stage buyouts. For the purposes of this article a private equity transaction is
a typical UK MBO/LBO structure with a single private equity institution as Investor
and a UK management team. The investor takes a majority equity stake in the new
company (newco) structure with management taking a minority stake.
Drivers of the transaction structure
The balance of power
Transaction documents
Provisions of the equity documentation
Private equity transactions can at first glance appear complex - effectively three
transactions within a transaction (debt, equity and acquisition) with many different
moving parts. This article explains how one particular component of the transaction
(the equity arrangements) works, by focusing on the commercial drivers of the parties
involved, the principal documents entered into by those parties and the key
provisions within those documents. It also seeks to highlight the common
approaches of the investor on the one hand, and management on the other hand, to
negotiating these provisions.
The following diagram illustrates a typical UK MBO/LBO structure. The need for
three newco vehicles is driven by tax structuring requirements (principally the
desire of the investor to obtain tax deductions for the target group in respect of
the interest on the shareholder debt) and the desire of the banks to be structurally
preferred to the investor's shareholder debt and the equity in topco.
Investor
Management
e.g 10%
e.g 90%
Ordinary
Shares
Shareholder debt
(loan notes; DDBs;
PIK notes)
Banks
Topco Ltd
Midco Ltd
Senior/Mezz
Debt
If you would like to know more about the
subjects covered in this publication or our
services, please contact:
Simon Cooke +44 (0)20 7006 1375
Bidco Ltd
To email one of the above, please use
[email protected]
Target
UK/552884/01
Clifford Chance LLP, 10 Upper Bank Street,
Canary Wharf, London, E14 5JJ, UK
www.cliffordchance.com
Client briefing
How to negotiate private equity agreements
2
Drivers of the transaction structure
Why has the typical structure for the documentation of UK private equity transactions developed as it has? This has
been driven by the underlying requirements of the parties to a transaction.
The Investor's motivation
•
To protect the investment of its underlying fund investors in the target business (in which it has a large financial
stake and limited knowledge of the business itself) and to enable its investment to grow in a controlled manner;
•
To be able to realise its investment (that is. effect an exit), to control the exit process and to ensure it can exit 100%
of the business in a tax efficient manner;
•
To be able to incentivise the management to work to grow the value of the business;
•
To control the valuable equity in topco and control who benefits from an increase in its value over the life of the
investment.
Management's motivation
•
To run what it sees as its business without undue restriction from the majority institutional shareholders (that is, the
investor);
•
To be adequately compensated and incentivised to work hard and to grow the value of the business, ideally through
an equity stake in topco;
•
To ensure that its minority equity interest is adequately protected from actions by the majority investor and that any
gain in value of its equity interest as the business grows in value is achieved in a tax efficient manner.
The balance of power
Where does the balance of power as regards negotiation of the equity documentation lie? This will depend on the facts
of each individual transaction but unless it is a management-sourced deal and/or the business is very reliant on specific
individual members of the management team, it is probable that the investor will hold the position of power. There is
logic to do this - the investor is committing most of its equity financing to the transaction and is acquiring control of the
business. It would, therefore, ultimately expect to hold a stronger negotiating position.
Having said this the investor will be keen not to completely dominate or be overly aggressive towards the management
team in the context of the negotiation of the equity documentation. It will want to preserve a good working relationship
with the Management going forward and it also has its reputation in the market to think about. No private equity house
will want to be seen as treating its management teams poorly or unfairly. Accordingly, the investor is likely to take a
reasonable and rational, if firm, approach to negotiating the equity documentation. It will also usually be prepared to pay
(as part of the overall deal costs) for management's legal representation for the purposes of the negotiation.
Key Transaction Documents
The following constitute the main documents commonly used in relation to the equity aspects of a private equity
transaction:
Document
Principal Purpose
Subscription and
shareholders/investment Agreement
Contains topco/midco equity and shareholder debt subscription mechanics;
investor rights and management obligations and res trictions; and provisions
governing the operation of the business going forward.
Articles of association of topco
Provisions controlling the constitution and share capital of topco.
Shareholder debt instrument
Constitutes the shareholder debt (for example, loan notes/deep discounted
bonds/payment in kind or PIK notes), which forms the majority of the equity
funding.
Management service agreements
Sets out the detailed terms and conditions of each manager's employment with
topco/one of its subsidiaries.
© Clifford Chance Limited Liability Partnership September 2005
Client briefing
How to negotiate private equity agreements
3
Document
Principal Purpose
Warrant instrument
If warrants to subscribe for equity in topco (akin to share options, usually
exercisable on an exit) are to be issued to the lending banks (commonly
mezzanine lenders only) this document contains the terms and conditions of
those warrants.
Intercreditor/subordination/ priority
Deed
Document which contractually provides that the bank debt ranks in priority to
the shareholder debt and equity.
Manager's questionnaire
A manager's confirmation regarding his/her personal position (for example, no
previous criminal offences, bankruptcies).
Provisions of the equity documentation
The majority of the provisions can be found either in the investment agreement or the articles of topco, together with the
management service agreements. The important provisions can be categorised under three broad headings: those
relating to the investor controlling its investment; those relating to management's equity stake; and those relating to the
investor's ability to exit its investment.
Controlling the investme nt
Board control
While the usual position will be that day-to-day control of the business will remain with management, the investor will
ultimately require the ability to control the board of directors of topco, particularly in circumstances where something goes
wrong. In the ordinary course, however, it will require the right to appoint one or two representative non-executive
directors, while retaining the right as majority shareholder to appoint additional directors if the need arises. It is also
becom ing increasingly common in late-stage LBOs and MBOs for the Investor to require topco to adopt a corporate
governance structure similar to that of a listed company (for example, using an audit committee and a remuneration
committee) as best practice. Management generally recognise the Investor's requirement ultimately to control the board
if it feels it needs to. They might, however, require some input on the appointment of additional non-executive directors
to the board, for example any non-executive chairman who is to be appointed. This would normally be limited in the
equity documentation to a right of consultation rather than an absolute veto right on the part of the management.
Contractual control
The investment agreement will typically contain a set of veto rights in favour of the investor. The Investor's intention is
not to get involved in the day-to-day operation of the Business, but certain operational decisions will require permission in
advance from the investor. The veto rights would generally be split into core corporate concerns (for example, changes
to topco's constitution, winding up of topco) and operational concerns (for example, entering into material contracts or
capital expenditure, making material acquisitions or disposals of assets, appointing senior employees or directors). As
with board control, management generally accepts that the investor requires a level of control over the operations of the
business it owns. So long as the financial thresholds as to what constitutes, for example, material capital expenditure,
there is generally limited negotiation over the veto rights.
Management warranties
This is often one of the most emotive issues for management and one that can result in much negotiation. From the
investor's perspective, these warranties are not about financial recompense if the business turns out not to be what the
investor thought it had acquired (unlike those obtained in the sale and purchase agreement from the vendor). Instead,
the warranties are aimed at obtaining disclosure from the management of all possible issues relating to the business that
may not otherwise have been disclosed to the investor through its financial, commercial and legal due diligence process.
The warranties would typically be given in relation to such things as the accuracy of the due diligence reports
commissioned by the investor in relation to the business; the business plan going forward and the personal position of
the management team. In most cases these warranties will be limited to management's awareness of giving the
warranties, which should, if they are well advised, enable them to get comfortable with giving a properly drafted set of
warranties. In terms of liability for breach of warranty, the investor will not be seeking potentially to bankrupt a manager
but will look to have him or her put a sufficient amount at risk to extract a so called hand on heart disclosure from the
manager in response to the warranty. The common position reached is either an amount equal to the manager's annual
salary (or a multiple thereof) or an amount equal to the investment that the manager has made for his or her equity stake
in topco.
Restrictive covenants
Typically an investor will require non-compete, and non-solicitation of customers/clients and employees of the business,
covenants from each of the management team for a period after they have left employment with the business. The usual
© Clifford Chance Limited Liability Partnership September 2005
Client briefing
How to negotiate private equity agreements
4
negotiating point here is the duration of these covenants, with typical periods ranging between one and three years.
Management might seek to argue that their service agreements contain restrictive covenants and so they need not be
included in the investment agreement. From the investor's perspective, however, the covenants are more enforceable if
in the investment agreement (and might be for a longer duration) and so it will require the covenants to be included. For
consistency, the investor will want to ensure that the scope of the covenants in a manager's service agreement match
those given in the investment agreement (other than in respect of duration).
Positive covenants
The investment agreement will oblige management to procure financial and other information relating to the business is
provided to the investor on a regular basis (for example, monthly managem ent accounts, annual budget and annual
accounts) in order that the investor is able to monitor its investment. If the investor has US investors in its underlying
funds, it is likely that such investors will require management rights pursuant to ERISA (US Employee Retirement Income
Security Act) to enable them to obtain favourable tax treatment in the US in relation to their investment in the Business.
If this is the case, management will be obliged to procure that these management rights are granted. Management will
also be obliged to implement the corporate governance structure required by the Investor and put in place all appropriate
insurances (including directors' and officers' liability insurance). All of these provisions are usually acceptable to the
management team, provided they are given enough time to prepare financial information for delivery to the Investor.
Minority protection for management
One of the management's drivers is to protect its minority equity interest in topco. The most common area of contention
here is anti-dilution protection. As majority shareholder and (ultimately) in control of the topco board, the investor might
otherwise be able to issue new shares in topco diluting management's equity stake. But an investor will not want to
agree in the equity documentation any restrictions on its ability to raise further equity capital in topco. It will generally
offer management pre-emption rights on new issues of shares (that is on a put up or shut up basis - if management does
not put up its share of the subscription monies it must shut up and be diluted) but if, for example, when raising new
finance the investor must put in additional shareholder debt as well as ordinary equity, it might require management to
invest in this strip rather than simply acquiring ordinary equity (effectively for a much lower value than the investor
acquires its equity). This becomes difficult for management as they are unlikely to be able to fund a full strip investment
and so will probably be diluted.
The investor might also be prepared to grant management a small number of veto rights. Common examples include the
group entering into transactions with related parties of the investor other than on arms' length terms, substantially
changing the nature of the business and making changes to the articles of topco that would adversely affect
management's equity stake. Management might seek further rights in the documentation but the investor is unlikely to
be willing to grant any substantial extras. The investor will usually want the ability to override the minority protection
rights in certain situations in order to be able to act quickly and with flexibility. The most obvious example is to effect a
so-called rescue financing, where the business is in financial difficulties and requires financial restructuring on a quick
timetable. As this is a practical concern in the best interests of the business and all the shareholders, management
tends to accept this override provision in principle.
Management equity
A large part of the rationale behind the whole MBO/LBO concept is that the investor provides financial support to the
business and strategic guidance but does not get involved in the day-to-day operations of the business. This is left to the
management team that the investor has picked to run the business on its behalf. In order to get the maximum out of the
management team it must be properly incentivised to work to grow the business and create value for the investor. It is
widely considered that giving management or employees an ownership interest or equity stake in the business for which
they work is one of the most effective ways of incentivising them to work hard. In accordance with this traditional model
management will, in addition to the terms of their employment set out in their respective service agreements, be offered
ordinary equity in topco at the outset of the transaction. This equity will, however, be subject to certain specific
restrictions.
Management shares
In order to keep this incentivisation tool as effective as possible, the investor wants to keep the equity in topco in the right
hands, that is, those of its current management team. Accordingly, the articles of topco will prevent management from
transferring those shares without the consent of the investor. Management will seek to negotiate certain exceptions to
this blanket transfer restriction and commonly the investor will allow management to transfer to immediate family
members and family trusts, provided that such persons agree to comply with the relevant compulsory transfer provisions
of the articles. Management might also request the ability to transfer its shares within the management team. This is
usually unacceptable to the investor as it could result in a mis -match of individual managers' holdings and prejudice the
incentivisation rationale behind the original allocation of the management equity.
Topco's articles will also include compulsory transfer or leaver provisions if any manager ceases to be employed by the
business. Again, this is to ensure that the equity in topco remains in the hands of those who are able to work to enhance
the value of the business. This is not the case for a manager who leaves. Accordingly the leaver provisions will provide
© Clifford Chance Limited Liability Partnership September 2005
Client briefing
How to negotiate private equity agreements
5
that the investor (or, sometimes, the board or the remuneration committee of the board) may require a leaving manager
to transfer his shares, usually to a replacement employee, another member or members of management or to an
employee trust that will look after those shares pending allocation to another manager in the future. The concept of the
leaver provisions as being a necessary feature of the MBO/LBO model is generally recognised by management - they
would also not want one of their number to benefit from an increase in value in the business if that person was no longer
working to create that value. The central concern of management when negotiating these provisions is how much they
will be paid for their shares when required to transfer them.
Good leaver/bad leaver provisions
The traditional way in which this is approached is to categorise a leaving manager as either a good leaver or a bad
leaver, with the price payable for his shares upon leaving depending on which category he falls into. This is another
emotive area for management when negotiating the equity documentation as, potentially, a manager could be sacked
having worked hard for the business for a period and nonetheless be entitled to none of the increase in value of his
shares in topco over that period. From the investor's perspective it sees itself and the management as being bound
together in the investment for the life of the investment and only those who are there at the end should benefit from any
increase in value in the business other than in limited circumstances.
Typically, good leaver categories include death (although aggressive investors may seek to exclude suicide from this
category!); retirement at usual retirement age; and permanent sickness or incapacity. The most obvious of the bad
leaver categories is dismissal for gross misconduct or so-called hand in the till offences, which is invariably accepted by
management. The contentious area is causes of cessation of employment that fall between the two obvious categories.
From an investor's perspective if a manager resigns voluntarily then this should be a bad leaver event. Management
tends to want circumstances constituting constructive or unfair dismissal to be in the good leaver category, but the
investor usually resists this, given the potential width of these concepts. Ultimately this is a matter for negotiation and
can result in there being a third intermediate leaver category.
The most common position is that if manager are categorised as good leavers they will be paid the market value for their
shares at the time of leaving, if required to sell them pursuant to the leaver provisions. If they are categorised as bad
leavers they will be paid the lower of either the market value of their shares, or what they paid for them when they
originally acquired them. Market value will either be agreed by the parties or referred to the auditors of topco, or another
independent valuer, for expert determination.
Service agreement - cross default
One further provision sometimes requested by the In vestor tends to be a contentious one - that which states that if a
Manager commits a material breach of the Investment Agreement this will constitute grounds for summary dismissal
under his service agreement, thereby entitling the employer to terminate his employment without pay in lieu of notice. In
addition, summary dismissal will almost certainly result in the leaving Manager being categorised as a bad leaver, which
would mean he obtained no additional value for his shares in topco. For obvious reasons Management does not tend to
take too kindly to this "double whammy", the main argument being that the employment terms and the good leaver/bad
leaver provisions relating to the equity stake should be kept separate. From the Investor's perspective this is not entirely
a valid argument as the reason the Manager is being issued shares in the first place is because of his role as a Manager
and employee of the Business. A compromise could be to specify those material provisions of the Investment
Agreement (e.g. warranties, restrictive covenants and positive covenants) to which this "cross-default" clause should
apply.
The exit
One of the fundamental drivers for the Investor in the transaction is that it has the ability to exit its investment in the
Business. Linked to this is the importance for the Investor to have the ability to force the sale of 100% of the share
capital of topco. If it is not able to deliver 100%, this will be likely to impact adversely on the amount a third party
purchaser would be willing to pay for the Investor's majority stake - no purchaser would relish buying a company with a
minority interest. Accordingly the equity documentation contains provisions that enable the investor to achieve its aims in
relation to exit.
Setting the ground rules
The investment agreement will usually contain provisions requiring the co-operation generally of the management team if
the investor sees a potential exit option, whether this be a sale or an Initial Public Offering (IPO) of the business. In
addition, in the current climate investors are keen to ensure that the documentation extends these co-operation
obligations to circumstances in which the investor requires the business to be refinanced with additional and cheaper
debt, enabling the investor to take out some of its investment before a full exit (usually via a repayment of shareholder
debt). In addition the investment agreement will make it clear that no warranties will be given by the investor at exit in
relation to its stake in topco other than as to title to the shares. The main contentious provision in this area is that the
investor will often require a provision that management will give customary warranties relating to the business on an exit.
Management generally does not like committing to such obligation so far in advance of the eventual exit, even though the
© Clifford Chance Limited Liability Partnership September 2005
Client briefing
How to negotiate private equity agreements
6
provision is unlikely to be enforceable due to lack of certainty (that is, as to the terms of the relevant warranties). In light
of this, the investor is sometime willing to drop this provision.
Forcing an exit
To ensure that the investor can deliver 100% of the share capital of topco, the articles of the company will contain socalled drag-along rights in relation to the shares owned by management. If the investor finds a buyer for its shares in
topco it can force the management to sell its shares to the third party purchaser on the same terms (that is, drag them
along). Management will generally accept this provision but will, if well advised, require that the sale to third parties be
on genuinely arms length terms and that the management will be paid the same amount per share for its shares as the
investor. If the investor agrees to receive share-for-share (or other non-cash) consideration for its shares in topco, it is
very unlikely to give management a cash-only option for its shares in topco, because this would probably prejudice
negotiations with the purchaser and/or the return the investor would obtain on its investment.
The quid pro quo for Management to the drag-along rights, are so-called tag-along rights that will usually be included in
the articles of topco. These say the investor cannot sell the majority or all of its shares to a third party purchaser without
also requiring the purchaser to acquire management's minority stake in topco on the same terms (that is, management
can tag along on the sale). The investor will always agree to grant the management tag-along rights in these situations
as it is only fair that if the investor is exiting its investment, management is also allowed to take the benefit of its hard
work over the life of the investment and participate in the exit.
As the market for IPOs has picked up, investors are keen to retain the ability to achieve an exit through an IPO of the
business. It would be practically impossible to effect an IPO without the co-operation of management (as they will play a
vital role in presenting the business to potential investors) so the management co-operation provisions in the investment
agreement must also extend to an IPO situation. It is legally possible to include provisions which would allow the
investor to force an IPO of the business if it sees the right opportunity (although these need to be carefully drafted in
order to ensure that they are not unenforceable on grounds of uncertainty), but the practical position remains that if the
management is against the idea, the IPO is unlikely to happen.
Principles remain despite increased complexity
Despite a reputation across the profession as a very specialist area, private equity as a concept is not by any means
rocket science. Specific elements of these transactions have evolved through market practice over the years, resulting in
private equity transactions being done in a certain way, with only some of the provisions within the relevant
documentation tending to be heavily negotiated.
Having said this, this article is based upon a very traditional, simple UK MBO/LBO structure, with a single private equity
institutional investor. As the private equity industry has developed, the market has become more sophisticated. Many
more private equity players than in the past have raised large amounts of money from their fund investors. Coupled with
fewer attractive assets for sale, private equity investors are now looking at larger and more complex transactions, often
joining together as a consortium or equity club to undertake these deals. However, the basic tenet of the investor's
rationale for undertaking the transaction, and its relationship with the management team of the target business, is
consistent with the structure described in this article, even on the more complex transactions of today's competitive
market.
This Client briefing does not necessarily deal with every
important topic or cover every aspect of the topics with which it
deals. It is not designed to provide legal or ot her advice.
www.cliffordchance.com
If you do not wish to receive further information from Clifford Chance
about events or legal developments which we believe may be of interest
to you, please either send an email to [email protected]
or by post at Clifford Chance LLP, 10 Upper Bank Street, Canary Wharf,
London E14 5JJ.
Amsterdam n Bangkok n Barcelona n Beijing n Berlin n Budapest n Dubai n D üsseldorf n Frankfurt n Hong Kong n London n Luxembourg n Madrid n Milan n Moscow n
Munich n New Yor k n Padua n Paris n Prague n Rome n São Paulo n Shanghai n Silicon Valley n Singapore n Tokyo n Warsaw n Washington, D.C.
© Clifford Chance Limited Liability Partnership September 2005