A new funding round could be a good time to sort out capital complexity. We take a high level view.
Many privately backed companies go through several financing rounds and find they end up with a very complex capitalisation structure, with various classes of preferred shares, ordinary shares and deferred shares, not to mention employee incentives and debt instruments. A new funding round is a good opportunity to restructure and simplify this legacy.
In this article we’ll look at the problems a complex capital structure can cause, and how to create a more suitable structure. We’ll also examine the possible drawbacks.
Why it’s a good idea to restructure
A convoluted capital structure is not only more difficult to understand and manage; it can also leave some shareholders unfairly disadvantaged.
Founders, employees and management tend to find themselves with ordinary shares or common stock. This can leave them lower down in the pecking order and misaligned with any realistic exit, if there are tiers of shares with rights to preferred returns of capital ahead of them. The same can apply to existing investors holding junior classes of preferred shares.
Existing shares may also have anti-dilution rights that could prejudice a proposed funding round.
A complex structure may also lead to unbalanced control. For example, the voting rights of junior classes of shares could outweigh their economic interest – they might hold 60% of the shares, which could represent only 10% of the value. Each class of shares will usually have its own class rights, which makes transactions difficult.
Investors are likely to have layers of shareholder rights from many rounds of investment documentation (including consent rights), making it difficult to ensure proper governance and processes. Some investors may have written off the company, but been slow to make decisions, give consents, pass resolutions or form quorums. And there could simply be too many investor directors, making the Board unwieldy.
All this can deter external investors or potential acquirers, who find the capital structure hard to comprehend.
Putting a simpler structure in place
Creating a simpler structure can help avoid the drawbacks described above, and make future management easier. However the process does need to be carefully planned, evaluating the existing arrangements and analysing the tax implications for the company and shareholders.
Let’s look at the typical elements involved.
- Consolidating share classes
If you can obtain the necessary consents (special resolution plus class approvals), you could simplify the existing cap structure by consolidating all existing shares into a new class, for example ‘New Ordinaries’. To secure the consents, this type of across the board conversion should ideally reflect the financial interests of the various share classes.
So, for example, if it’s agreed the company is worth £5m, the company could consolidate all existing share classes into, say, 5m new ordinary shares in aggregate, with each shareholder being apportioned the number of shares equal to the proceeds they’d receive on a £5m exit.
This may mean junior classes of share become effectively worthless. In these circumstances, you might offer those shareholders a nominal write-up in their proceeds to encourage their approval – assuming their consent is needed. In turn, this would bring down another shareholder’s allocation, requiring their buy-in too. The likely scenario is that your senior shareholders would do something to compensate the minorities.
- Consolidated and amended documentation
Any fragmented shareholder documentation should be consolidated into a single investment agreement. This is a contract issue rather than something needing shareholder resolution. Unless the contracts include provision for them to be varied or terminated without consent, you’ll need the specific consent of the affected parties – which they can withhold if they wish.
- Restructuring the board
This may only be possible with a variation of existing investment agreements. Typically, the articles of association concerning investor director rights will also need to be amended.
- Boost management incentives
Consider replacing underwater options with a new scheme, or with an alternative such hurdle shares. Check the terms of the options to determine what happens to the option holders’ entitlements. The most likely outcome is that the number of shares due or exercise price will be varied to reflect the reorganisation, according to the appropriate boilerplate provisions in the relevant contracts.
- Include a buy out offer
A straightforward way to simplify the cap table is to offer to buy out minorities for an appropriate consideration. This could be a buy back by the company if it has sufficient distributable reserves, but more likely it would need to be through existing/ new investors as a secondary share purchase.
- Redeem or convert loan notes
This will almost certainly need the consent of the noteholder. They will have an absolute discretion to withhold their consent if they wish, and they might feel they’d get a more favourable outcome on liquidation (when their debt would rank ahead of all other shares). So they may feel they won’t benefit by co-operating. In these circumstances any definition of ‘Reorganisation’ in the loan notes is crucial – will the noteholders ride above the cram-down?
- Amend warrants
The company may well have warrant holders (e.g. venture debt providers). You’ll need to review the warrants’ terms to understand the capital restructure implications for warrant holder entitlements. Any such equity kicker will likely fall into a similar camp to the loan notes.
- Use pay-to-play
Incentivise existing shareholders to invest on the new round by offering a ‘pull-up or similar pay to play incentive.
- Waive or remove existing anti-dilutes
In any case, make sure you reset the base price for future funding rounds and reflect the reorganisation.
- Oil the wheels
Consider other ways of persuading junior shareholders to co-operate. Does the company or leading investors have any sort of influence. What could the lead investors do to encourage minorities to participate? Possible routes include a token buy-out of all or part of their shareholding or a contribution towards the cost of reviewing documentation.
- Get consents
At the earliest possible stage of planning a capital restructure, it’s vital to identify every person whose signature is required, and ensure the consents can be delivered.
What could possibly go wrong?
There are potential pitfalls to capital restructuring, but they’re not insurmountable if you understand and manage the risks.
One of the main threats is a legal challenge by disgruntled minorities. They may see it as a canny course of action; if they hold out and sit on a claim, it’s likely to be worth more once the company has recovered successfully following the capital restructuring. Having said that, it’s harder for a minority shareholder in the UK to bring a claim than in the US, for example, where the directors face a burden of proof to prove the ‘entire fairness’ of the transaction.
Here are some practical steps that can mitigate the risk of a claim:
- Consider directors’ interests in proposals
Wherever possible the company should task disinterested directors with taking the lead on the project, and consider setting up a board-subcommittee to avoid suggestions of lack of probity arising from an investor director’s involvement. This may be difficult given the scope of the proposals, but directors should be extremely mindful of actual or potential conflicts of interests.
- Consider wider directors’ duties
The company board also needs to be careful how it documents its proposals and motivations. They need to justify why the transaction is in the best interests of the company and it shareholders.
- Explore alternatives
The reorganisation will be much less vulnerable to challenges if there are no viable alternatives. For example, a new investor might only invest if the transaction takes place, or there’s no other interest from funders. The company needs to be sure it can’t source alternative finance on better overall terms elsewhere. Considering whether an alternative structure or mechanism could achieve your objectives will help you decide on the most effective route.
- Communication and inclusiveness are key
You’re more likely to face problems if minorities are not kept informed and feel they’ve been shut out of decision-making.
Ensure you share the terms of the proposals with all interested stakeholders. Even if you don’t need the consent of minorities, showing you’ve taken a transparent approach can help if the reorganisation is challenged. It’s also important to get consent from as many stakeholders as possible, even if it’s not strictly necessary.
- Use a binary offer approach
If possible, use a rights offer for all or at least part of the financing. Then if there’s an element of pay-to-play, it’s harder for diluted minorities to prove they were treated unfairly, because they were offered the chance to participate.
- Take advice
Get professional advice on your structuring and approach, and consider obtaining a third party valuation to validate the round price.
Are there alternatives?
We’d normally expect capital restructurings to be effected by a combination of shareholder resolutions and contractual consents/ waivers. However there are alternative mechanisms.
For example, in the UK, restructurings can be effected by a scheme of arrangement or insolvency scheme. A scheme of arrangement is a court-approved procedure under Part 26 of the Companies Act 2006. Provided the prescriptive requirements of the Act are met (including sanction by 75% or more in value of the creditors and/or members or each class of members, and following a very specific timetable) then the court approval gives a near watertight reassurance that the proposals are compliant.
And finally – watch your solvency status
Cram-downs and other material capital restructurings tend to be effected in extreme circumstances but your company board members shouldn’t be distracted from their obligations.
If the reorganisation requires third party consents that are outside your company’s control, you should have a contingency plan that allows you to start an insolvency process, if it becomes clear there is no realistic prospect of effecting the financing.
Hopefully, it’ll be a contingency plan you won’t need.