It’s currently a sellers’ market for founders and management teams of growth companies in the Technology sector. With the number of private equity funds in the UK at an all-time high, the opportunity for a sale and roll-over to create a PE-backed platform company has never been better. But how do founders maximise value and manage their risk in such a transaction? In this article, we consider recent market trends and provide tips on the art of what is currently possible.
Taking control of the sale process
Competition in auction sale processes is currently very strong which allows sellers to set the detailed terms on which they are prepared to transact. A seller’s leverage is at its greatest in the early part of a process and so key terms should be considered and set down at the outset, with bidders asked to respond on/mark-up each of the points when submitting their final offers.
Locked box pricing mechanism
These have become de rigueur in UK processes which means working capital discussions are brought up front and post-completion adjustments are avoided, which gives more certainty from a seller’s perspective. A locked box mechanism locks down cash and debt balances at a recent month-end date. A detailed working capital paper is then prepared and this forms the basis for negotiation of the enterprise to equity value bridge. Sellers should also consider using a value accrual mechanism for the period between the locked box date and completion.
Warranties, indemnities and insurance
With the warranty and indemnity insurance (W&I) market becoming ever more competitive and developed, the scope and nature of insurance protection is evolving. For example, £1 liability caps for founders on business warranties (not fundamental warranties such as title and capacity) and the tax covenant on a primary buy-out is starting to become feasible. Of course, this comes at a premium cost and bidders might not be prepared to take the exposure on the gap between the warrantors cap and the policy excess.
On secondary buy-outs, we are seeing warranties given by management on an actual knowledge basis with such knowledge qualifications “scrapped” from the W&I policy. This can provide a good solution for both buyer and seller in a number of cases.
In relation to tax covenants, “synthetic” covenants are now available, although for reasons of cost it is often thought better for there to be a negotiated document and for a £1 liability cap to apply.
The key to making the best use of W&I and managing risk through the different product terms becoming available is getting out in front of the auction process by testing the market and presenting positions to potential buyers which have been confirmed as insurable. Every deal will be different, and the options need to be considered on a case by case basis.
The percentage of roll-over varies from deal to deal depending on the value of the transaction, the investment criteria of the PE House, and the personal circumstances and ambitions of the founders and any selling managers. That said, it is not uncommon to see reinvestment percentages of between 30% to 50% of sale proceeds. This provides the PE House with comfort that interests will be aligned, full disclosure will be given, and the sellers will remain incentivised and fully engaged in building value to an exit. Any roll-over of sale proceeds should be into so called “institutional strip” – the same class(es) of share and loan notes – held by the PE House and rank pari passu.
To incentivise senior management “sweet equity” or another form of management incentive security is also likely to be on the table; sweet equity is a separate class of shares awarded to management, typically for nominal value, to enable them to share in sale proceeds on a secondary sale or IPO.
Leaver provisions are contractual terms that apply to shares held by employees enabling compulsory transfer upon cessation of employment. In some cases, leaver provisions can be dis-applied altogether in relation to the institutional strip held by founders/management on the basis that it has been paid for out of their sale proceeds. If this is not negotiable, then any compulsory transfer for a leaver should be at market value only.
As to sweet equity, leaver provisions will apply and detailed attention should be applied to the terms, including the scope for time vesting and the meaning of good/bad/intermediate leaver. Given the current sellers’ market, with good advice, a fair and balanced set of provisions can be laid out up front in the auction term sheet.
The precise scope for minority protections will turn on the economics of the deal and do vary significantly from deal to deal. These range from tag rights (absolute or pro rata) which are common place, through pre-emption protection, director appointment rights, information rights and veto rights over changes to constitutional documents, to at the other end of the scale, operational consent rights. Detailed consideration should be given at an early stage to the most appropriate blend of protections for the deal in question.
Tax and estate planning
If left to the last minute, good tax and estate planning becomes very difficult and can result in material value leakage. Capital treatment and entrepreneur’s relief is the standard objective for UK resident tax payers both in terms of the primary founder buy-out and the subsequent secondary sale of the platform company, subject to the current individual lifetime allowance of £10m. Permitted transfer provisions to family members, family trusts and controlled corporate vehicles should enable estate planning for the secondary sale.
In the current market the art of the possible for founder and management is evolving and developing all of the time. So the key to maximising value and minimising risk is, as ever, about getting good up to date advice, explore your options and planning the process.