Private Equity and Venture Capital Investment Agreements

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  • No particular magic to terminology “ Not publicly traded” – more accurately. An investment where the co is not accessing the public capital markets (although it’s securities may be publicly traded); a private placement transaction In fact, the large US PE deals, such as the Cerberus Capital & United Rental deal that was in the press and in the Delaware courts last year regarding the $100m break fee, have all been private placements in public Co’s But in out tamer Canadian markets, PE generally is the bridge between Founder’s/Entrepreneur's equity and the public capital markets
  • PE takes many forms, and PE funds tend to specialize
  • Typically, an angel investor is a wealthy individual or group of individuals that use their own cash to invest in early stage companies and they often have an emotional stake in the company’s success. Angel investments typically would range between $25,000 and $1.5 million, which is below the radar for most venture capital funds.
  • Risk is a driving force in determining deal structure For PE/VC investors there’s now a premium on risk management. Deals are structured to minimize downside risk and provide a greater payoff to the Investor at the expense of the Founder/Entrepreneur Stage of development is a key factor in risk assessment – the earlier the stage the greater the valuation challenge and the greater the risk Stages of development: Early (includes seed, start-up and advanced early) Late (includes expansion, acquisition/buyout) LBO/Buyout Turnaround Distressed Special Situation
  • Some examples of this would be: to invest by way of convertible debenture rather than Prefferred Shares, and secure as much collateral as you can stage follow-on investments based on management performance or on achieving pre-determined milestones such as sales or earnings Negotiate steep discounts as a premium for being an early investor Bring in a co-investor with strategic value relative to high-risk areas
  • Management – not skills, but can they work as a team Market – push or pull Operations – ability to meet sales projections Financial – how much time/$ required to get to next round? IPO? Business strategy – risk of change in market Use of proceeds provisions to cover off risk areas
  • Convertible preferred equity with a fixed dividend probably the most common
  • Convertible debt with or without security Common among VC investors Debt financing with equity kicker – unlikely for PE or VC, more angels Not unusual for there to be disagreement between Founder and Investor over the success/ future growth prospects of the Co - option/ warrants and milestone investments can be structured to get around these types of hurdles investment
  • Non-financial tools include: right to board seat or observer status contractual right to company information (full, true and plain disclosure) anti-dilution rights pre-emptive / tag-along rights These things typically would be included in an Investor’s Rights Agreement
  • Most of these elements are pretty straightforward, except possibly the anti-dilution component - there’s a valuation and pricing component to dilution protection which comes into play in the term sheet; you want to buy shares on the fully diluted number of shares, taking into account all commitments to issue shares (options, warrants, convertible debt, etc) you need to be explicit about whether you’re dealing with a pre-money or post money valuation: pre-money is the value of the Co before adding the capital you’re going to get from the financing; to arrive at the post-money valuation you simply add the additional capital to the fully-diluted pre-money valuation As the lawyer, you don’t have to be knowledgeable about how you do these calculations, but you do need to know what questions to ask and what needs to be explicit in terms of language in the term sheet Then there’s anti-dilution protection: to prevent a CO from dilutive transactions, whether that's stripping out value by way of stock dividends or placing a later round of financing at a lower price than the earlier rounds two approaches to anti-dilution provisions: full ratchet and weighted average
  • Break fees have been controversial recently; long history Started with the no-shop clause – Seller couldn’t shop the deal for a period of time; Delaware Courts looked at that and said managers have a fiduciary obligation to seek the best price, so where a superior proposal came along (unsolicited so Seller didn’t actively breach the no-shop clause) the court said management had to look at the superior offer; became known as the fiduciary out; so Investors negotiated a break fee at the same time, Investors started putting conditional on financing clauses in terms sheets; so Sellers negotiated reverse break fees In Cerberus – the parties negotiated a $100m break fee and the agreement said it was to preclude other remedies, although another section of the agreement said that equitable remedies including specific performance were available. The Court held that as the agreement wasn’t clear, you had to look to the “ forthright negotiator principle ” - that is, the the subjective understanding of one party that was objectively manifested and known or ought to have been known by the other. In this case, as Cerberus consistently talked about the break fee as being the sole remedy, that was implicitly agreed to by United Rentals in the negotiations
  • I suggest that you don’t simply rely on the due diligence out if there are other conditions, such as board approval or debt financing Make each out explicit, if that’s what’s intended Even though most provisions non-binding, you have to be mindful about exposure to an implied covenant of good faith and fair dealing, especially if Seller negotiated a good faith clause in exchange for the no-shop right US generally has a doctrine of good faith in the performance of contracts and a fair number of cases have supported the concept of an implied a duty of good faith in negotiating contracts Canadian law has no express recognition of a generalized duty of good faith, but some cases have moved in that direction (Martel, SCC, 2000 obiter)

Transcript

  • 1. Private Equity and Venture Capital Investment Agreements Janice Y. Lederman Presented to Insight Information’s “Negotiating and Drafting Major Business Agreements” Winnipeg, Manitoba May 18, 2010
  • 2. Scope of Presentation
    • Deal structure
    • Essential elements of a term sheet
    • Due diligence –how much is enough?
    • Equity purchase agreements and terms
    • Warrants: when to include
  • 3. Scope of Presentation
    • Management equity
    • Down-road financing issues
    • Exit issues
    • Sample clauses
  • 4. What is Private Equity?
    • Purchase of securities not qualified by prospectus
    • Angel investors a type of private equity capital
    • PE funds most often private pools of capital, structured as limited partnerships
    • Some PE funds are public companies (Onex Capital)
  • 5. What is Private Equity
    • An experienced PE manager as GP, with pension funds, other institutional investors and high net worth individuals as LP’s
    • Funds tend to specialize - seed, start-up, growth, mezzanine, leveraged or non-leveraged buyouts, turnarounds and distressed company funds
  • 6. What is Private Equity?
    • Angel and venture capital are types of private equity
    • Angel investments tend to range between $250,000 and $1.5 million
    • VC investments typically run from $1.5 million and up, increasingly in later stage companies
    • PE typically larger, later- stage investments
  • 7. Deal Structure
    • Factors influencing deal structure include:
    • stage of development of target company
    • involvement of Founder / Entrepreneur
    • professional management / management participation
    • number of existing shareholders
    • number of prior rounds
    • stock or asset deal
    • valuation issues
    • risk management
  • 8. Deal Structure
        • “ Isolate the biggest risk in the deal and structure the initial investment so the money is used to eliminate that risk.”
        • Anthony Perkins, VC Investor
  • 9. Deal Structure
    • PE / VC investors will structure hedging strategies to minimize downside risk and co-investment strategies to share risk
  • 10. Deal Structure
    • Areas of risk
        • Management
        • Product
        • Market
        • Operations
        • Financial
  • 11. Deal Structure
    • Financial tools for managing risk:
    • Share attributes
      • Common or convertible preferred equity
      • If convertible,
        • either at a fixed number of shares or a percentage of shares outstanding at a future date
        • normally includes a fixed dividend
        • gives preference over commons (Founders) in the event of liquidation or merger
  • 12. Deal Structure
    • Convertible debt
    • Debt financing with equity kicker
    • Options and warrants
    • Staged (milestone) investment
  • 13. Deal Structure
    • Non-financial tools for managing risk:
    • Right to board seat or observer status
    • Contractual right to company information
    • Retraction rights
    • Anti-dilution rights
    • Pre-emptive rights
    • Carry-along / tag-along rights
  • 14. Term Sheet Essentials
    • A self-contained summary of the deal
    • Level of detail always open to debate, but a term sheet should be:
      • a useful road map for the drafters; and
      • a reliable reference source for the principals (assuming deal doesn’t change on closing)
  • 15. Term Sheet Essentials
    • Key Issues
      • Financial terms
        • price (valuation methodology)
        • pre-money valuation
        • capitalization table (especially if warrants outstanding)
        • dividends / interest coupon
        • warrants / options
  • 16. Term Sheet Essentials
      • Security attributes
        • dividend rights
        • voting rights
        • liquidation preference
        • conversion terms
        • redemption rights
        • retraction rights
      • - Anti-dilution protection
  • 17. Term Sheet Essentials
      • Pay-to-play provisions
      • Resale restrictions
        • carry-along / tag-along rights
        • rights of first refusal
        • co-sale agreement
  • 18. Term Sheet Essentials
      • Prohibition on certain conduct
      • Access for due diligence
      • Information rights
      • Voting rights / blocking rights
      • Proprietary information
      • Payment of expenses
      • No shop / exclusivity
  • 19. Term Sheet Essentials
      • Founders’ activities
      • Key employee lock-ups
      • IPO share purchase
      • Indemnification
      • Assignment
      • Walk-away rights
      • Confidentiality
  • 20. Term Sheet Essentials
    • Deal non-binding, but certain provisions should be made binding
    • Must be explicit about what is binding
  • 21. Term Sheet Essentials
    • Binding provisions:
      • expense reimbursement / break-up fee (if there is one)
      • No-shop / exclusivity clause
      • prohibition on certain conduct (ordinary course activity / no long-term commitments)
      • due diligence access / disclosure
      • confidentiality
  • 22. Term Sheet Essentials
    • Walk-away rights should be explicit
    • Don’t rely on the due diligence condition for walk-away rights, such as board approval or debt financing
  • 23. Due Diligence
    • A process to identify business and legal investment risk
    • Business due diligence can identify areas of concern for legal due diligence
    • Seller’s own due diligence
      • preferably before negotiations commence
      • to identify and manage risk
      • basis for limiting or qualifying representations in agreement
  • 24. Due Diligence
      • qualifications will limit Seller’s /Founder’s exposure to post-closing claims
      • issues not identified by Seller/Founder early in negotiations may either scare off investor or be used by investor to renegotiate price and terms
  • 25. Due Diligence
    • Due diligence is time consuming and expensive
    • Pressure to reduce due diligence
      • to minimize costs
      • to make the process less adversarial
      • to get to signing/closing more quickly
    • On the other hand, issues that arise late in the process can be more difficult or expensive to resolve than at DD phase
  • 26. Due Diligence
    • Key due diligence issues:
      • third-party consents and approvals
      • existing debt/equity arrangements
      • provisions in Articles / share rights
      • existing shareholder/investor agreements
      • material contracts
      • affiliate issues
      • liens and encumbrances
  • 27. Due Diligence
      • environmental concerns
      • litigation
      • intellectual property issues
      • special regulatory issues
      • change of control issues
  • 28. Equity Purchase Agreements & Terms
    • Cap Table
        • all securities, warrants, options & terms including vesting periods & strike prices
    • Multiple Investors
        • lead investors
        • ‘ majority in interest’ investors
        • which are deal critical? / who determines investor interests?
  • 29. Equity Purchase Agreements & Terms
    • Termination Rights
        • especially where multiple investors
    • Decision-Making & Control
        • right to board seats
        • when, if ever, can investors take control?
        • contractual right to receive continuous disclosure of material information
  • 30. Equity Purchase Agreements & Terms
    • Reps & warranties
        • negotiation of qualifiers, such as knowledge or materiality
        • survival period
    • Deal specific reps & warranties
        • For example, IP or financial statement disclosure
  • 31. Equity Purchase Agreements & Terms
    • Indemnities
        • negotiation of limitations on quantum, duration and types of damages exposure
        • caps, baskets, exclusions
  • 32. Equity Purchase Agreements & Terms
    • Remedies
        • reps > tort damages
        • warranties > breach of contract; rescission
        • limit rescission rights?
        • indemnity as exclusive remedy absent bad faith or fraud
        • liquidated damages?
  • 33. Equity Purchase Agreements & Terms
    • Length of time between sign and close
        • provisions related to conduct
        • ordinary course / no material changes (MAC clause)
        • assistance with obtaining third party consents
        • good faith efforts to complete closing
    • VC investments
        • expense reimbursement
  • 34. Equity Purchase Agreements & Terms
    • Other provisions
        • expense reimbursement
        • company use of proceeds
        • add-on investments
          • if milestones met, pricing and terms of milestone funding is fixed to avoid duplication of costs
  • 35. Collateral Agreements
        • Investor Rights Agreements
        • Indemnification Agreements
        • Employment Agreements
        • Confidentiality / Non-Disclosure Agreements
        • Non-Compete / Non-Solicitation Agreements
        • Voting / Control Agreements
        • Unanimous Shareholder Agreements
        • Stock Option Plans
  • 36. Warrants
    • In VC deals, can be used to bridge valuation gap between Founder and Investor
    • A sweetener/ kicker if targets met
    • Can be used as incentive to Investor to use its strategic leverage to hasten growth
    • Can be useful where investor bridging into subsequent equity round
  • 37. Management Equity
    • Typically a key difference between a PE and VC deal
    • Management in PE deal unlikely to carry more than 20%
    • Restriction on transfer of shares, except for estate planning purposes
    • Requires buy-back provisions
  • 38. Management Equity
    • VC Investor may want stock option plan for management /employees as a form of non-cash compensation to align interests
      • there will be a vesting period within which the options cannot be exercised
      • if employees leave, lose unvested options, out-of-money options and must exercise in-money options
      • options (and underlying stock) not transferable
  • 39. Down-Road Financing Issues
    • VC Deal
      • often provide for next round financing
      • may pre-arrange co-investment upon satisfaction of milestones
    • Negotiated terms regarding right of refusal for funding/blocking rights, etc. can be complicated and may have to be unwound on next round financing
  • 40. Exit Issues
    • Exit strategies
          • strategic sale
          • IPO
          • partial sale
          • employee / management buyout
          • retraction rights
    • Investor non-compete / non-disclosure
  • 41. Sample Clauses
    • [See separate handout]
  • 42. Questions?
    • Janice Y. Lederman
    • Thompson Dorfman Sweatman LLP
    • [email_address]
    • BizLawBlog.ca