The Wild West Of Growth Equity

What is clear is that growth equity as a sector is hot. In the past decade or so, and with an increasing level of velocity, growth equity has received substantially more attention and focus as a discrete sector of private equity. An ever-growing number of investment firms, many with very different historic roots ranging from venture capital to buyouts, converge in this sector. These investors seek what growth equity pioneers like TA Associates and Summit Partners originally sought—superior returns by investing in profitable companies with more growth potential than mature companies and lower risk of capital loss than investing in start ups. 

Unfortunately, growth equity transactions can sometimes seem to take place in an environment resembling the Wild West, where anything can and sometimes does occur. Here, transactions—substantial minority investments, smaller buyouts and other hybrids—l have not been publicized and analyzed with anywhere near the degree of detail that classic buyout or VC transactions are. There is also generally a lower level of shared understanding by transaction parties, which is sometimes a product of investors coming to the table from very different backgrounds.

Pricing is one example where sector confusion may arise. In venture capital, an investor’s valuation reflects all of a company’s existing equity (including vested and unvested incentive equity for employees), plus a pool of authorized but unissued equity for future incentive equity grants that will be needed to propel growth. The investor’s valuation is not diluted by these awards, and there is no adjustment or credit given for the exercise price of options. In a buyout, vested options are included in determining the selling price per share and the exercise price of options is credited to the common equity, as the transaction is a terminal event. In growth equity transactions, positions can vary on this issue, with issuers and their current owners occasionally arguing for buyout-like treatment, which is more favorable to the existing investors. More commonly, however, pricing in growth equity transactions reflects the methodology used in venture investments.

Investor protections are a second area where confusion can arise. Generally, a growth equity investor is joining a company at a much higher valuation than prior investors. Such an investor has a legitimate interest in assuring that a liquidity transaction that produces a gain for existing investors but a loss or a minimal gain for the growth equity investor does not occur without its approval. In many cases, especially those involving rapidly-growing companies in frothy markets, growth equity investors may agree to a lesser set of blocking rights than a classic VC investor, sometimes as the price of admission to an attractive company. In come cases this can involve an investment in common stock with limited contractual protections.

A third area in which widely variable results can occur involves indemnification (see accompanying chart). In venture deals, it has been customary to have a set of representations that simply survive closing, sometimes for a fixed duration.In a buyout, by contrast, market participants are very familiar with the minuet (or in some cases the slam dance) of escrows, caps, baskets and time limits (and an ever expanding list of additional provisions) that are designed to apportion liability for known and unknown problems and limit the sellers’ exposure in the absence of fraud. Where does a growth equity deal involving both an element of capital infusion and an element of liquidity fit?

A recent survey of over 70 growth equity deals closed in the past several years conducted by the Goodwin Procter Private Equity Group offers guidance on market outcomes for indemnity provisions in such transactions. The survey found, among other things, that:

• Over one-third of all transactions had venture-style indemnification, having neither a limitation on the survival period of the representations and warranties, nor a cap less than the full purchase price;
• Indemnification caps as a percentage of the investor’s check size in deals that had caps were significantly higher than comparable caps in M&A transactions as a percentage of acquisition price;

There is of course no single “correct “ answer or approach for all aspects of growth equity deals. Relative leverage, location, sector, the amount of dollars taken off the table by the existing stockholders, and the personalities of the parties all matter.

As growth equity matures into a better defined sector of private equity, we expect that a more universally understood set of terms and understandings will evolve along with it.

John LeClaire is a co-founder and chair of the private equity group at Goodwin Procter LLP; Anthony McCusker is partner and co-chair of the technology companies practice; Mike Kendall is a partner in the firm’s private equity and technology companies practice