Some of the most important negotiations in private equity and venture capital financings involving growing companies reflect the reality that later investors invest at higher values than founders and other earlier investors.
Consequently, a liquidity event may produce a bonanza for the earlier investors while creating a disastrous outcome for the later one. Early investors may even profit from a sale in which the later investor loses money. U.S. private equity investors acquiring minority stakes, including in large recapitalization transactions, almost universally seek, and companies generally grant, protection in some form against these outcomes. This article examines the liquidity event protections that investors and companies have historically employed in U.S. and European markets, and focuses particularly on the evolution of the “qualified sale” concept.
Historically, protective provisions in U.S. deals relating to liquidity events have taken two basic forms, one for sales of the company and one for public offering exits. When the liquidity event is an initial public offering, for many years standard investment terms have included a “qualified initial public offering,” or QPO, concept. A QPO provision provides for the automatic conversion of preferred stock into common stock at the closing of the offering, thus eliminating preference, blocking and other special rights such as anti-dilution protection, if the issuer goes public at a price to the public at or in excess of a specified multiple of the investor’s initial cost, such as 2x, 3x, 4x, etc.As QPO provisions have evolved over time, additional requirements have become customary elements of the definition. These include a requirement that the IPO occur on the NYSE, the Nasdaq National Market, the London Stock Exchange or one or more other blue-chip exchanges, a requirement for a minimum level of proceeds, and sometimes a requirement for a minimal level of public float. Taken together, these provisions are designed to prevent a transaction that achieves a listing but leaves the investor stranded in an illiquid position without the benefit of its preferences and other protections. Typically left unaddressed are problems such as those associated with a sharp drop in the issuer’s share price in the after-market before the investor can gain liquidity and an inability of the investor to participate in the IPO.
When the liquidity event is a sale of the company, the protective provisions used by U.S. investors historically have been less refined. Frequently, investors have simply sought the right to block any sale of the company, full stop. If the sale produces a favorable return on reasonable terms for the senior investor, why would the investor block the sale? If the return is marginal, well, that’s exactly what the blocking right is designed to protect against, is it not? U.S. venture capital financings generally adopt this relatively simple approach, although other protections such as preferences that are a multiple of invested capital also occur in venture financings with some frequency.
In many instances, however, entrepreneurs do not want minority investors to have veto rights if they, the board and a majority of the issuer’s shareholders believe that a sale is the best course. Investors who insist on sale blocking rights when negotiating with company owners who hold tightly to this view risk losing deal opportunities if a compromise cannot be found. To address the potential impasse, over time company sale protections in U.S. deals have evolved to incorporate elements analogous to QPO previsions and to relate more closely to target return hurdles, particularly in larger, later-stage private equity investments and recaps. Specifically, the tension between company owners seeking flexibility and investors seeking protection has led to the development of the “qualified sale” concept.
A basic “qualified sale” provision provides that an investor’s blocking rights on sale will drop away if the sale produces a specified level of return, usually expressed as a multiple of the initial investment (2x, 3x, 4x, etc.), sometimes as a target price per share, and less frequently also including a minimum internal rate of return requirement. At this level, the investor has received an acceptable if not a spectacular return, and the investor and the company can move on to new ventures and opportunities. Qualified sale provisions sometimes also include adjustments to the investor’s ownership percentage designed to achieve target returns for the investor in moderately successful and quasi-downside situations or to provide additional incentive equity (generally on a tax advantaged basis) to other owners and management in successful situations.
A “Q-sale” provision tied to a benchmark return is thus a useful way to address the differing concerns of investors and other company owners. But such a provision leaves a number of questions unanswered. What if, for example, the consideration offered by the buyer consists of restricted or highly illiquid securities of uncertain value? What if the securities are freely tradable but only in very thin markets, with great volatility and/or low volume? What if the investor’s position represents a large proportion of the issuer’s outstanding shares? What if some of the sale consideration is contingent or deferred? What if some (or a lot) of the consideration is held in escrow or otherwise subject to indemnity claims?
Issues such as these have come to the fore in a number of recent versions of “qualified sale” provisions. This may reflect in part the critical importance of company sale exits in a market in which IPOs have become nearly non-existent, at least for the time being. In any case, recent U.S. transactions involving latest generation “Q-sale” provisions tend to address some or all of the potential concerns in a variety of ways. These include:
* Requiring that the consideration comprising the benchmark level of return consist entirely of cash and/or “liquid securities”;
* Defining “liquid securities” to exclude items such as contingent payments, escrowed funds and (sometimes) promissory notes;
* Including specific parameters for what constitutes a “liquid security,” which can include (ideally from the investor’s perspective) immediate salability without legal or contractual restriction, listing on one or more of the most established exchanges, requiring minimum levels of issuer market capitalization and/or public float, and in some cases further refining liquidity concepts by establishing requirements for trading volume and/or the maximum size of the investor’s stake as a percentage of the issuer’s total equity capitalization; and
* Including provisions that address what happens if the holders of preferred stock take a disproportionate share of the liquid consideration at closing to satisfy their hurdle requirement, such as a readjustment of the consideration once contingencies are resolved and final proceeds determined. In such a situation, the other investors would typically have a larger proportionate share of the escrowed, contingent or other illiquid proceeds than the investor when they are finally distributed.
In the United Kingdom, private equity investors, as contrasted with venture investors, have tended to invest far less often in minority positions, except as part of a consortium formed to acquire a controlling stake. In this context, the consortium itself will control the exit process by having veto over an exit and a drag-along right, which invariably will be unfettered. The consortium members will negotiate amongst themselves in the transaction documentation a mechanism for how the powers of the consortium to force an exit may be exercised by them. The triggers will typically be unanimous agreement amongst the consortium members or, in the absence of agreement, a combination of achieving a target return and a minimum holding period having elapsed.
It is only in U.K. venture capital deals that non-institutional investors could force an institutional investor to sell. For this to happen, the non-institutional investors would have to together constitute a majority of the shareholders and “Q-sale”- like conditions would have to be satisfied. Non-cash consideration, deferred consideration and the possibility of sale proceeds being clawed back in the future tend not to deter institutional investors in the United Kingdom when calculating whether or not a target return has been achieved. The usual approach is to ascribe a net present value to these forms of consideration. Ideally, the parties will agree what that net present value is, and in the absence of agreement the calculation will be made by the company’s auditors or an independent expert (usually one of the large accountancy firms or an investment bank) acting as an expert not as an arbitrator.
“Q-sale” provisions are related to, but in ways different from, drag-along provisions and traditional preferences. They simply set forth the conditions in which sale blocking rights will be waived, in advance. They typically do not attempt to resolve in advance all of the terms on which an exit will occur, such as indemnification. They supplement and co-exist with preference provisions. The degree of detail, and indeed whether investment terms will include a Q-sale provision or even a block on sale at all, will inevitably depend on the circumstances of the deal and the relative leverage of the parties. If the definition of Q-sale becomes overly complex and extensive, at some point the provision can have the effect of full blocking rights and negotiations may collapse.
The qualified sale concept tends to help facilitate closings by bridging gaps between the positions of investors and companies. Accordingly, the provision is likely to be a permanent and evolving part of the U.S. private equity investment landscape, particularly if strategic sales continue to be the predominant avenue of liquidity for investors in growth companies and as large minority recapitalization transactions continue to occur. It may increasingly become a part of the U.K. landscape as large growth equity investments by firms such as
John LeClaire is a partner and chair of the Private Equity Group at Goodwin Procter LLP; Mike Kendall is a partner in the same group; Nicholas Plant is partner in the corporate department of SJ Berwin LLP.