Private investment activity by private equity investors and others is expected to pick up across the Gulf region during 2010. While this activity has been sluggish (at best) in the GCC during 2009 this has been largely due to lag factors and particular nuances of the local environment which are slowing activity rather than negating the rationale (or need in many cases) for deals to be done. M&A activity is expected to pick up too, but for a variety of reasons many potential acquisitions will be structured as investments or joint ventures (where existing owners retain a stake in the business) rather than full acquisitions. In this regard, please see our related article 'Are the M&A floodgates about to open in the GCC?'.
While there are significant opportunities for private investors in the current economic environment and value cycle, there are also heightened risks which they should seek to protect themselves against as best they can. Helpfully, investors have better leverage to negotiate deal terms which will reduce their risks, due to reduced deal competition and the shift in negotiating power in favour of investors. Rather than investment opportunities being auctioned, it’s now more often the capital seekers who are competing against each other for scarce investment capital.
Accordingly, investors should not be shy seeking investment terms which fully reflect the value of their capital in today’s environment.
Corporate Finance partner Andrew Lewis discusses some of the key terms which investors should consider when negotiating investment deals in the current market.
It’s not just about price
Price, while obviously fundamental, is only one of the investment terms open for negotiation. The opportunity exists to negotiate other terms which will significantly reduce an investor’s risk and increase the upside if the investment is successful.
Some of those terms offer downside value protection in case the investor finds it has overpaid due to information which surfaces, or events which occur, after the investment is made. In some cases they may even enable the investor to pay a higher price and achieve a “win win” with the existing shareholders and investee company, where the investor is better protected if the investment does not perform while the existing shareholders do better (alongside the investor) if the investment is successful.
Some key terms to consider
Set out below are some of the key terms (other than price) which an investor might consider on a deal by deal basis. Some are more applicable to minority investments while others are generic to any investment. Some reflect terms typically sought by venture capital and other early stage investors (who historically have been the most adept at optimising their minority positions), but they are worth considering in any investment deal (perhaps there is an element of venture capital risk for most deals done in the current environment).
- Tranching: Consider structuring the investment into a number of tranches instead of investing all the capital in one lump sum. The tranches can be matched against the investee company’s cash requirements and ideally the investor’s obligation to invest subsequent tranches will be contingent on commercial milestones being achieved. This will give the investor discretion whether to invest the balance of the investment if the investee company is not progressing in accordance with pre-agreed financial or other targets, so the investor can either cut its losses or seek to renegotiate investment terms as a condition of making the balance of the capital available.
- Start with convertible: Risk can be reduced further by providing convertible finance rather than equity at the outset. Convertibles provide all of the upside of equity while preserving a priority position for the investor over existing shareholders in the event the investee company fails or can’t return all invested capital to the shareholders. Sometimes the first tranche of an intended investment is structured as a convertible until key milestones are achieved and the investor is sufficiently comfortable with the company and management to proceed with a larger equity investment.
- Preferential equity: Preferential equity terms are particularly common for venture capital investments. Like convertibles they give the investor priority over other shareholders, but an equity priority rather than debt. The most typical preference right is for the investor to receive its capital back (or in some cases a multiple of that amount) in priority to other shareholders on exit/liquidation. Preferential dividend rights may also apply, where the preference dividends accumulate until a distribution can be made and are added to the exit preference if that occurs first. Preference rights can be used to bridge the valuation gap which typically applies between an investor and an investee company, where the investor might pay a higher price than it would otherwise be comfortable paying because of the value protection embodied in the preference rights.
- Anti-dilution: Anti-dilution rights are more common than other preference terms and provide a more limited form of equity preference, providing the investor with basic downside price protection in relation to future investment rounds if shares are issued at a lower price than the investor’s price. Usually this entails the issue of additional shares to the investor to reduce its effective average purchase price per share to either the new issue price (full ratchet) or a weighted average of the investor’s original price and the new issue price (weighted average ratchet). In either case the protection is at the expense of other existing shareholders who don’t have the protection and for whom the dilutive effect of the down-round is magnified.
The investee company will often seek a requirement for the investor to participate in the new investment round in order to avail itself of the anti-dilution protection (pay to play).
- Further investment rights: One way to leverage further upside over and above the committed investment amount is for the investor to acquire options to subscribe for further shares, or a first right to finance the investee company’s future capital requirements, at a pre-agreed price (ideally the same price as for the original investment reflecting the importance of that investment in achieving any value uplift). Unlike tranching (which is more about staging the assumption of risk), the further investment will be entirely at the investor’s option.
- Drag and forced sale rights: For a private equity/venture capital fund investor (or other investor who has a fixed investment timeframe), the success of an investment is usually dependant on a successful exit being achieved within a specified timeframe. It is usual for such an investor to seek the ability to force an exit if it has not occurred in ordinary course within a specified timeframe. Such rights usually include drag along rights which will enable the investor to procure the sale of the company as a whole (and which the investor can exercise even as a minority shareholder) and/or rights to force an asset sale or IPO. There are often practical issues enforcing such rights (in particular the right to force an IPO is fine in theory but almost impossible to implement), however at the very least they have value in clearly setting expectations.
A minority investor is likely to be faced with an expectation that drag rights can be applied by the majority to drag the investor. In that case the investor may seek minimum price conditions to apply to exercise of that right and a reasonable opportunity to find an alternative exit if it does not consider that the proposed sale optimises value.
- Tag and pre-emptive rights: Unless shares are widely held there is usually a mutual expectation that pre-emptive rights and tag along rights will apply to proposed share transfers (other than related party transfers). Any negotiation concerning such rights will usually revolve around the percentage sale threshold which triggers tag rights (which is typically anywhere between 20% and a controlling stake). Where the other shareholders will expect tag rights to apply similarly to all shareholders, an investor will need to balance a wish to be able to participate in any sale of significance (eg. 20% or more) initiated by another shareholder against a concern that tag rights might make it more difficult for the investor to exit where the investor is seeking to sell.
- Business plan: An investor should consider linking the investment to an agreed business plan (incorporating a budget), so that the investment must be applied in the manner set out in that plan and the company must otherwise follow the agreed plan (which is renewed annually by agreement). If the investment is tranched, the milestones will be drawn from the business plan to ensure the company remains on track with the agreed plan.
- Reserved matters: Any shareholders/investment agreement typically contains a requirement that specified key decisions are approved by a special majority (which could be a unanimity requirement depending on the shareholder spread, but more typically 75% or some other percentage greater than 50%) or by a named party. Those decisions typically include any significant capital expenditure or acquisitions or dispositions, any new borrowings (or the giving of any security), any alterations to share capital or the company’s articles and approval of the annual business plan (or significant departures from the approved plan). Clearly an investor will seek a wider ambit of the reserved decisions if it is acquiring a minority shareholding and an active investor will be particularly concerned to ensure that its approval is required for any departures from the business plan which formed the basis of its investment. At the same time parties should be conscious to minimising the risk that the development of the company’s business as intended can be thwarted by a deadlock over a reserved matter (perhaps by including suitable resolution mechanisms to resolve any deadlock).
- Board control: In most developed jurisdictions (including most tax haven jurisdictions which are favoured locations for any holding company) the company is controlled and governed by the board and board control is generally more important than shareholder voting control. A minority investor will typically seek to ensure that the balance of power on the board is vested in independent directors who are acceptable to the investor.
- Key person provisions: For most investments there will be certain key people (usually management personnel) who are important to the future success of the company. An investor should consider whether adequate arrangements are in place to ensure those people are sufficiently incentivised to remain with the company and to optimise the company’s success and that they are fully aligned to achieving that success. If not, provision should be made to put further arrangements in place. Depending on the type and stage of the company, such arrangements will typically extend beyond performance based bonus arrangements in the relevant employment contracts to carefully designed share plans which vest shares, and provide rights for additional shares, subject to the key person remaining with the company and achieving clear performance goals. The treatment of a key person who leaves the company usually has regard to whether they are classified as a “good leaver” or “bad leaver”.
In addition to the previous provisions, the investor should ensure that the generic provisions typical in any investment/ shareholders agreement provide the investor with an appropriate level of information and control over its investment, reflecting the value of the investment to the company in the current market. This will include ensuring that:
- the investor has appropriate board representation and voting rights at both board and shareholder level;
- the quorum provisions and manner in which both board and shareholder meetings are conducted do not expose the investor to undue risk of decisions being made without the investor being able to exercise its voting rights;
- the investor receives requisite financial and other information as and when required to monitor the investment and exercise its investor rights;
- there are appropriate mechanisms (which work for the investor) to deal with any potential voting deadlock which might jeopardise the company’s operations and its ability to achieve the business plan (including a forced buy-sell mechanism where such a deadlock arises, if that is more likely to favour the investor);
- the investor has appropriate buy-out rights or other remedies for defaults by the company or other shareholders;
- warranties are provided by both the company and existing key stakeholders (noting the limitations associated with enforcing warranties against the company which the investor has invested in), in respect of information provided and other risks existing at the time of investment.
Impact of GCC and Shari’ah Laws
Some of the terms described in this article may not comply with local laws in the jurisdiction where the investee company has its business or else may not be enforceable in that jurisdiction. In particular, conventional convertible and preference share structures do not comply with Shari’ah based laws which apply to companies incorporated in local jurisdictions in the GCC and enforcement of option rights (and shareholder agreements more generally) can also be problematic in those jurisdictions.
Accordingly it may be advisable to consider establishing a new holding company in a free zone or an overseas jurisdiction for the purposes of the investment or to adopting alternative structures which achieve similar commercial outcomes in a Shari’ah compliant way. For further information on these options please follow the links below to related articles:
There are significant opportunities for investors in the current climate but investment success will still depend (perhaps more than ever) on doing the right deal on the right terms.
The “right terms” is not just about the “right price”. Other aspects of the deal which provide downside protection, leverage further upside and enhance the prospects of the investee company succeeding can be equally, if not more, influential. No matter how cheap the price it will still be a bad deal if the investment fails, so every effort should be made to include terms which minimise the risk of losses and optimise the prospects of success. The good news is that current negotiation environment provides a better opportunity to negotiate the right investment terms. While GCC investors need to be sensitive to local factors which can limit deal flexibility in many cases there are structural options which will achieve similar results (whether they involve creation of a holding entity in an offshore jurisdiction or adopting alternative Shari’ah compliant structures).