In continental Europe businesses are still highly dependent on commercial lending. While some of them have tapped the debt and equity capital markets, the reluctance of com-mercial banks to finance CAPEX or R&D absent a very strong balance sheet has left a va-cuum. But the financing needs may not justify a public rights offering. In such cases, a contingent equity facility may be the answer.
What is a contingent equity facility?
In last year's roadmap I wrote about private investments in public entities (PIPE). A PIPE is a private transaction between a single or a limited number of investors and the target company, which is listed on a stock exchange. This feature distinguishes the transaction from a public rights offering. The investor(s) and the target company enter into a negotiated agreement setting forth the investment terms. The contingent equity facility (also called equity line) is a variation of a PIPE, the main difference being that the company, at its discretion, can issue shares over an agreed time frame with a pricing formula based on the future share price and trading volume to the investor.
The company pays a capital commitment fee to the investor, who undertakes (in advance) to purchase the shares issued up to a certain threshold (typically below the notification requirement, in most jurisdictions, 5%) in case the company so requires. The investor can usually choose to hold on to the shares or sell them on. The investor, however, would typically commit not to hold on to shares exceeding the threshold. The commitment to subscribe is a very firm commitment (and this is fundamentally different from lines of credit) subject to very limited conditions such as only shares trading, no change in business (but nothing related to financial standing of the target company), etc. Therefore the conditional equity facility could also be drawn if the target company is in financial difficulty (e.g. to avoid breach of gearing covenants). The contingent equity facility allows equity to be raised at relatively low cost (no bank underwriting cost, no prospectus requirement, no “road shows”) in an opportunistic way (without subscription period and without taking the risk of market volatility), tailor made (in small tranches, for which an underwriting would be too expensive) and without placement risk.
Main legal implications
There are two decisive elements. First, the management of the target company needs to determine if entering into the conditional equity facility is in the best interest of the target company and compliant with applicable law. Whereas management’s determination in relation to the former is more to protect itself from liability, an adverse determination would not affect the validity of the investment agreement in most jurisdictions.
That is different, however, in relation to compliance. In most jurisdictions financial assistance rules prohibit a stock company from financing (directly or indirectly) the acquisition of its own shares or from paying consideration for a third party committing to acquire its shares. Capital maintenance rules typically provide that transactions between a shareholder (and in most jurisdictions a prospective shareholder) are entered into on arms’ length terms. Now, at the time of entering into the investment agreement, the target company only agrees to pay to the investor a standby fee (typically in the range of 1-2% of the facility amount). If the target company does not draw under the facility, the only expense to the standby company is the standby fee. As such, in most jurisdictions, payment of the standby fee would not be considered a financing of the acquisition of the target company’s shares or consideration for a commitment to subscribe for shares, but rather consideration to the investor for keeping funds available to honour draw down requests similar to standby fees paid to banks under credit facilities. The standby fee must be arms’ length (which is the same as for fees paid to a shareholder-bank). To be on the safe side, the fee should not be substantially higher than for credit facilities of similar amount.
The second decisive element comes into play when the target company draws under the facility. As outlined above, one of the main advantages of the conditional equity facility is that the target company can draw small tranches which it could likely not efficiently place in a public rights offering at very short notice (typically subscription is within 10 to 15 days upon drawing). A prerequisite for that is that the target company has in place (or can put into place) authorised capital and the terms contemplated by the investment agreement are within the authority granted to the management board (e.g. authority to exclude subscription rights, to issue agreed type of shares, minimum issue price and restrictions as to purpose of issuance, etc). Typical issues relate to the possibility to exclude statutory subscription rights (which in most jurisdictions is only possible if justified and is particularly difficult if the investor only offers cash).
A related topic is the issue price. The investor would typically agree to subscribe at a discount over (typically weighted average) share price in the range of 5%. In most jurisdictions, management is not free in its determination of the issue price when exercising the authorised capital but must avoid dilution of existing shareholders and consider the financing needs of the company (which under normal circumstances means, management needs to obtain the best price available). The conditional equity facility therefore should only be used where management can argue that the (discounted) price is the best price in the given circumstances (e.g. because shares could not efficiently be placed in those tranches, the target company needs equity which could not be obtained in a public rights offering at short notice, etc.). Affected shareholders typically have a right to challenge the management’s decision to exclude their subscription right and its determination of the issue price within a certain period and to also seek compensation for damages. The company may also seek compensation for damages from management and/or the board of directors for failure to consider its financing needs. The investor, on the other hand, is usually only exposed in certain limited circumstances (e.g. intentional infliction of damages).
In most European jurisdictions a target company would be obligated to announce any event that could have a material effect on its share price. It is widely accepted that capital measures qualify for such notification requirements. What is not so clear is the timeline (ie, from the management’s decision to exercise authorised capital or only upon approval by the board of directors) and the required detail of the announcement. Practice substantially differs by jurisdiction.