•      The relative advantages and disadvantages of the principal methods.

Exit Methods
      There are two principal typ...
IPO disadvantages

x     Higher costs. There will be additional costs for the selling shareholders and the
company such as...
Common devices used in investment agreements in relation to exits include:
•      Exit control covenants.
•      Managemen...
Advantages and disadvantages: trade sales

Trade sale advantages                           Trade sale disadvantages

Ratchets. This mechanism allows management to share in the growth of a company by
either an actual or a notional redistrib...
•        Piggy back registration rights These allow a shareholder to include the registration of a sale of
In practice, therefore, the burden of giving warranties on a trade sale exit often falls on
the management team. Managemen...
The preparation of an information memorandum on the company being offered for sale. The
memorandum is not as detailed as a...
The advantages of this process for the sellers    The disadvantages are:
•     Maintaining control over the legal    ...
hands of the management backed by the investor as the purchaser usually insists on taking over
the management on completio...
to ensure compliance with corporate governance rules, such as the appointment of independent
directors, an audit committee...
About the Authors:

                     Koen Vanhaerents, Partner
                     Office: Brussels
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Corporate Finance Venture Capital Exit Routes


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Corporate Finance Venture Capital Exit Routes

  1. 1. www.bakernet.com/BakerNet/Practice/Corporate/Venture+Capital+Private+Equity/Description/Default.htm Corporate Finance Venture Capital Exit Routes Comparing the most popular methods of releasing venture capital By: Koen Vanhaerents (Brussels) and Helen L. Shroud (London) Contact Information is provided below Private equity houses (or venture capitalists) set up funds which are used principally to invest in equity and equity-related securities of companies in the private sector (investee companies). Whilst the venture capital market has in the past been to some extent volume driven, fund managers now tend to make fewer investments, concentrating on quality deals of higher value. In addition to wanting to maximise returns, they need to demonstrate that performance has been consistently good so as to be able to attract new money from their investors for further funds. The pressure to make sure that each investment pays off is consequently greater. An inherent part of the investment strategy of a venture capitalist is the timing of the sale of its interest in the investee company (the exit). Typically, investors look for a return between three and five years after the original investment. Statistics published by the European Venture Capital Association indicate that the average actual exit takes place after eight years. Timing is also of vital concern to the management team. Management will not want the exit to take place at a time which does not suit the business or their own vested interests. Another vital aspect of the process is the choice of method of exit. The method ultimately chosen will impact on the venture capitalist, the investee company and its management. However, the parties often give insufficient attention to exit planning at the time the investment is made. There is no foolproof way of guaranteeing how an exit will happen. The investment cycle involves too many uncertainties for that. However, parties to the investment can try to put themselves in the best position to take advantage of opportunities which arise. All parties will derive advantages from factoring into the original negotiations decisions which will influence the end of the investment arrangement. It is therefore important for all parties to address: • The range of exit methods commonly used. • How and by whom the decision as to timing will be made. • Other contractual devices which can influence the ultimate outcome.
  2. 2. • The relative advantages and disadvantages of the principal methods. Exit Methods There are two principal types of exit route: • A trade sale. A trade sale is a sale of the shares or business assets of an investee company by way of a private sale agreement. • An initial public offering (IPO). An IPO is the offering of shares to the public, normally followed by the listing of the shares on a stock exchange. The general perception is that an IPO will generate a higher price than a trade sale. However, this is not necessarily the case and there are in fact advantages and disadvantages for all parties in both trade sales and the IPOs (see boxes “Advantages and disadvantages”). The capital gains tax consequences for the seller vary from country to country. However, as a general rule, the sellers’ position is the same on a trade sale as on an IPO. Other exit options are: • Recycling - a sale to co-investors or other private equity houses (secondary buy-out). • A buy-back by the company or management. As market conditions become more turbulent, the number of IPOs seems to be decreasing. The expectation is that the number of trade sales and secondary buyouts will increase correspondingly. Moreover, there is increased competition between venture capitalists as the level of investment increases but the number of appropriate deals decreases. Advantages and disadvantages: IPOs IPO advantages Popular with management. An exit through the stock market seems to be favoured by management, since it allows them to remain in place and in control. Having a range of institutional shareholders is often preferable to management rather than one shareholder with ideas on future direction which are different from their own. Also attractive stock options plans might be linked to a flotation of the shares. Dual track. Preparations for an IPO often provoke a pre-emptive trade bid which allows the venture capitalist to follow a dual track approach. Retained shares. Investors may continue to share in the future growth through their retained shares. Position of underwriters. Normally no warranties on the business have to be given by the venture capitalists to the underwriters. However, in certain jurisdictions the seller may have a statutory liability which could go beyond liability as to valid share title. In addition, the venture capitalist company may have placed one of its own employees or managers as a director in the target company and he or she may retain liability under the prospectus. 2
  3. 3. IPO disadvantages x Higher costs. There will be additional costs for the selling shareholders and the company such as the preparation of the prospectus and investment bankers’ fees. x Market risk. Illiquidity of the markets or an unexpected downturn may result in an IPO being aborted. x Image. The message has to be simple. For certain companies, it may prove difficult to convince the market and the analysts of the real worth of the company. x Less than full exit. Often an IPO does not provide for a full, clean exit. The venture capitalists are often required to show confidence in the future growth of the company. Indeed, sometimes only a partial sale is possible at flotation, often just sufficient to recover the initial investment, either directly or in the green shoe (or over-allotment option) period (see below “Preferential flotation rights”). After the IPO, liquidity may be restricted, either through contractual or regulatory obligations or as a result of the state of the markets. Ongoing risks. A continued shareholding results in continued risks: x The special rights normally granted to venture capitalists at the outset of their investment to protect their interests are usually abolished on an IPO. Underwriters and market authorities tend to dislike the continued existence of special rights for certain shareholders. The special rights may include board representation with veto, tag-along and information and inspection rights. x Continued board representation may result in additional liability, which cannot always be covered by insurance. x Potential restrictions on the subsequent ability of the investor to sell the shares may apply under insider dealing restrictions at the time when the director representing the venture capitalist is an insider. Quite often, a shareholders’ agreement is entered into with the (other) controlling shareholders covering matters such as board representation rights, special pre- emptive rights and transparency issues. Preparing for exit The parties may take several precautions at the outset of the investment to prepare the way for a trade sale or IPO. The investee company and its management should be aware of the obligations and incentives relating to the ultimate exit which they are likely to be asked to take on by the venture capitalists. They will need to consider the impact of these on their own position both for the duration of the investment and on the exit itself. 3
  4. 4. Common devices used in investment agreements in relation to exits include: • Exit control covenants. • Management covenants. • Ratchets. • Put options. Exit control covenants. It is fairly standard to see a covenant from management and the investee company acknowledging that: • The investor is subscribing for shares to make a return on its investment. • Management will therefore use reasonable endeavours to arrange a trade sale or flotation before a certain date. In practice this type of clause may be difficult to enforce. Ascertaining what is meant by reasonable endeavours is not a straightforward process. It might be extremely difficult to prove breach unless management went so far as simply refusing to discuss the issue. Also, if management is being difficult when a sale is initiated, a prospective purchaser may be put off. However, an exit covenant will at least help to focus minds on the exit strategy throughout the life of the investment. The covenant may be made more effective by including specific arrangements as to how and by whom the exit will be controlled. The investment documentation may specify: • Who has the right to force an IPO or trade sale. For example, 15% of the shareholders or the majority of the shareholders. • The method of establishing the selling price, for example, through a pricing committee, the composition of which can be agreed in advance. • Who is allowed to sell how many shares and when. Often sophisticated procedures are set up to demand, in particular, an IPO subject to specific time limits for making the demand and minimum intervals between two demands. Clauses of this type sometimes provide for the appointment of an investment bank to make an IPO report covering the IPO value, the timing, the required reorganisation and other related issues. Sometimes, the request for an IPO has to be accompanied by a commitment by an investment bank to underwrite the transaction. A sanction mechanism may have to be provided to make the arrangements work. This could be achieved through a put option in favour of the investors against any shareholder refusing to co-operate (see below “Put options”). Management has vested interests in the exit decisions which will ultimately be taken, particular in relation to: • The life cycle of the company. Management may have strong views at any given time on whether a sale, merger or flotation is the next step for the business. • Management’s own job security (see boxes “Advantages and disadvantages”). • Effect of timing on any performance-based ratchet (see below “Ratchets”). 4
  5. 5. Advantages and disadvantages: trade sales Trade sale advantages Trade sale disadvantages Premium. Notwithstanding a widespread x Management opposition. Management often belief that IPOs provide for good returns, a opposes a trade sale, especially if it has a trade buyer may also be willing to pay a substantial stake in the company or if existing premium for reasons such as synergy, market management may not fit into the management share or market entry. culture of the trade buyer. They will be aware that a change in the ownership of the company may Simplicity. The procedures involved in a result in them losing their jobs. trade sale tend to be cheaper than an IPO and quite often faster and simpler. However, if a x Confidentiality. In most cases the best tender procedure is used, the process might candidate buyers are often close competitors. The become complex and take more time. due diligence process might therefore be comfortable. It could result in the disclosure of One buyer. Only one buyer has to be confidential information which, notwithstanding convinced of the deal. In an IPO investment good confidentiality agreements, is transferred to bankers and the public at large have to be the competition. handled. x Warranties and indemnities. Purchasers from Full exit. Trade sales will normally venture capitalists should be aware that certain provide for a clean, full exit. private equity companies apply and enforce a strict no-warranties policy (see below “Negotiating warranties”). Management may therefore wish to negotiate into the investment agreement an element of control or influence over the decision making process. Similarly, mezzanine and bank lenders may wish to influence the ultimate choice of exit route. The influence of the latter would depend on how heavily endebted the investee company is and on its relationship with its banks. Management covenants. The venture capitalists will not want to discover unexpected revelations about the investee company when due diligence enquiries are being answered, a prospectus is being prepared or a data room is being set up for a controlled auction (see box “Controlled auctions”). Venture capitalists will therefore seek to ensure that the target company covenants in the investment agreement to produce regular management and financial information in line with strict reporting standards. The covenants will often mirror the reporting requirements the venture capitalists themselves owe to their own investors. Not only is this good corporate practice in any event, but the venture capitalists will be in a position to monitor through the life of their investment just when is the optimum time for an exit. 5
  6. 6. Ratchets. This mechanism allows management to share in the growth of a company by either an actual or a notional redistribution of their shares and the venture capitalists’ shares on any exit. The distribution is usually calculated by reference to a target rate of return to the venture capitalist. To make the covenant more effective from their point of view, venture capitalists sometimes construct the ratchet so that it becomes less attractive for management if an exit has not been achieved within a certain period, whether or not the target rate of return has been met. Put options. A further alternative is to require management or the investee company (or both) to buy the venture capitalist’s shares if no exit has been achieved within the defined period. This is intended to provide for the situation where the market is static or illiquid, but is only effective if management is financially capable of funding the purchase of the shares or the investee company is legally able to do so. There are normally local law requirements on exactly how the investee company can purchase its own shares. Buybacks are only permitted in most jurisdictions if certain, fairly stringent, criteria are met (see FirstSource “Share buybacks” EC, 1998, III(2), 15). This may not in any event be the best route from the venture capitalist’s point of view: • Fixing a price at the outset (whether absolutely or by means of a formula) may not reflect the actual value of the company at the time of the buyback. • There may also be a concern that management may sell on to a third party for an increased price. This concern could be addressed by some form of clawback or anti- embarrassment clause which would allow the venture capitalist to claim a proportion of the increase in value on any subsequent sale. Encapsulating in a contract what is meant by an increase in value is not, however, straightforward and such clauses may run to many pages of drafting to ensure all possible disposals have been covered. SEC registration rights If exit through an IPO on the US securities markets is envisaged, the venture capitalist may seek appropriate registration rights in the investment documentation. These will be required not only in respect of US securities, but also for foreign securities which are offered in the US. US law requires that securities of companies cannot be sold to the public unless the sale of those securities has been registered with the US Security and Exchange Commission (SEC) or unless the sale is exempt from registration. Only the company, rather than individual shareholders, may register with the SEC. In order to be able to create an obligation on the part of the company to cause the registration of a subsequent sale, shareholders routinely request that the company in which they are considering making an investment grant them registration rights. There are several kinds of registration rights. The two most common are: • Demand registration rights These allow a shareholder to demand that a company register the sale of its securities if certain preset thresholds are met. 6
  7. 7. • Piggy back registration rights These allow a shareholder to include the registration of a sale of securities on a registration statement filed by the company for the sale of the company's securities. In this way the shareholder makes use of the registration process already in progress. This is more cost- effective for the company and reduces the number of registrations the company may have to make. In most European countries, registration rights are not required. Usually, if the company is the subject of an IPO and obtains a listing of its shares, all other shares of the company, at least those of the same class, are also considered listed or can very easily be listed without the need for a further complex listing procedure. Planning for trade sales There are certain issues of forward planning which relate specifically to trade sales, including: • Negotiating warranties. • Piggy back (or tag along) clauses. • Come along (or drag along) clauses. • Limiting contingent liabilities. • Earn outs. • Non-compete clauses. Negotiating warranties. When negotiating a trade sale a purchaser will require warranties as to the state of the business. Warranties and the associated disclosure of information which limits their scope play a part in allocating risk between the parties and determining the price the purchaser will pay for the business. Venture capitalists are likely to argue that they will not give warranty protection to a purchaser of their shares, other than a warranty that they actually own the shares. This is a conscious approach which is often adopted despite the fact that it may act as a depressant on the price. It is sometimes argued that the price discount resulting from this policy is often larger than the actual amounts which might have to be paid by the venture capitalist sellers if reasonable warranties and indemnities were given with appropriate disclosure. The arguments generally put forward by the venture capitalist are that: • It is difficult for investors who are not involved in the day to day running of the company to quantify potential exposure under the warranties. • If the venture capitalist gives warranties on exit, it will be prevented in practical terms from distributing the proceeds of sale to its investors until the limitation period for claims has expired. • Venture capitalists may be seen as deep pockets, especially where management is the only other shareholder or where management continues to be involved in the business. It is fairly common for the venture capitalists to try to pre-empt any argument on this issue by including an acknowledgement by management in the investment agreement that the venture capitalists would not be required on an exit to give any warranties other than as to title to shares. 7
  8. 8. In practice, therefore, the burden of giving warranties on a trade sale exit often falls on the management team. Management tends to resent this position as the perception is that the venture capitalists are receiving the same return as them and that they are not being compensated for the increased risk. Whether management at the outset of the investment or a purchaser on exit can persuade the venture capitalists to give warranties will depend to a large extent on relative negotiating positions Where they are persuaded, they are still likely to seek financial caps and tightly drawn limits on duration. The following options are available as a means of dealing with venture capitalists' reluctance to give warranties and the buyer's reluctance to accept warranties from management only: • An asset deal followed by the liquidation of the target when the contractual limitation periods have expired. In an asset deal, assets (and related liabilities) are sold by the shareholders. In this scenario the shareholders may therefore escape having to give representations and warranties, but have to wait for the liquidation proceeds remaining after the settlement of the liabilities which were left with the target. • Putting a fixed amount in escrow as the sole amount available for recovery under the warranties and indemnities, subject to a fixed period for claims. • Entering a contribution agreement to try to ensure that management pays first in order to encourage greater attention by management to potential claims. Controlled auctions Investors are constantly having to be creative in finding an exit route which gives them as much flexibility as possible. The last five years have seen a considerable increase in the number of controlled auctions. This procedure involves the following steps: 8
  9. 9. The preparation of an information memorandum on the company being offered for sale. The memorandum is not as detailed as a prospectus on a flotation but its contents are usually the subject of some verification by lawyers and financial advisers. Confidential information will be disclosed at this stage. The sellers should consider drawing up a confidentiality letter (see FirstSource "Confidentiality letters", EC, 1996, 1(3) , 23). Prospective purchasers lined up by financial advisers are asked to make an indicative offer for the target on the basis of this document. Bidders in the higher range are invited to proceed to limited due diligence in a data room and are asked to confirm their bids and submit their proposed amendments to the sale documentation which the seller's lawyers will have prepared. A preferred purchaser is usually selected on basis of price offer and proposed contract amendments. However, it is not uncommon to have further rounds if there is enough interest. The preferred purchaser is given exclusivity for detailed negotiations. 9
  10. 10. The advantages of this process for the sellers The disadvantages are: are: • Maintaining control over the legal • Cost documents and the timing of the • Having to put in place substantial process. infrastructure with no guarantee of an • Keeping confidential documents from ultimate buyer. competitors at the early stages, to • Sometimes the process takes control of avoid "fishing expeditions". the transaction. Often it is better to • The ability of the financial advisers to conduct a bidding war with a few use the perceived competition to keep interested parties and then proceed the price up. straight to a regular trade sale. • Considering insurance cover for liability under warranties and indemnities. Piggy-back (or tag along) clauses. This type of clause requires management to ensure that if they receive an offer for their shares, the intending purchaser also acquires the venture capitalist's shares on the same terms. This is very common where the venture capitalist has only a minority stake. It may also be coupled with an absolute veto for the venture capitalist on any share sale by any other shareholder. Thus it will be able to choose whether to refuse to let the sale proceed or sell along on the same terms. Come-along (or drag alone) rights. The come-along clause is almost the reverse of the piggy-back clause. It enables a venture capitalist to ensure it can sell all the shares of the investee company. If it finds an exit for its shareholding it can require all the other shareholders to sell their shares on the same terms. Since this could operate unfairly where a venture capitalist has only a minority shareholding, it is often used where it has over 50% of the shares or is drafted to apply only where it an persuade other venture capitalists or other shareholders who together own at least 50%, to sell. The percentage will vary according to the particular deal structure. Limiting contingent liabilities. The venture capitalists will strive to ensure that the exit sale agreement does not make them directly liable for any future liabilities of the company and that no obligations have been inadvertently accepted by the use of the words "jointly and severally" anywhere in the document. On an asset sale, whilst the venture capitalist may not have given any warranties to the purchaser, it may nonetheless find itself as a shareholder in the remaining shell company. The venture capitalist in this situation may face liabilities which have not been passed on to the purchaser either because the purchaser would not accept pre-transfer liabilities or because certain identified actual or contingent liabilities have been retained. Earn outs. Venture capitalists tend to dislike compensation which is deferred and linked to future results (earn-outs). Management control of the company will often no longer be in the 10
  11. 11. hands of the management backed by the investor as the purchaser usually insists on taking over the management on completion. Also, extremely difficult issues can arise in the calculation of an earn-out, especially in relation to tax. If the compensation is linked to objective factors, deferred compensation tends to be more acceptable. Factors could include: • The fact that no previously undisclosed liabilities surface within the limitation period. • The outcome of an application for a vital licence or patent. • The outcome of the renegotiation of certain contracts. Non-compete clauses. In a trade sale, the buyer tends to ask the venture capitalists for a non-compete clause. The purpose is to restrict them from re-investing into the same sector, making use of inside knowledge acquired through the target. A venture capitalist will think carefully before agreeing to this as it will not wish to restrict future investment potential of its funds or the activities of its managers. It may instead ask the purchaser to rely on an obligation that it will not poach employees or customers of the business. It is sensible also to consider alternatives, such as the use of a Chinese wall which requires the venture capitalist to ensure that information resulting from one investment is not used to structure an investment in a similar business area. Contractual documentation may also include a prohibition on particular investment managers being involved in the structuring or management of a competing investment. Planning for IPOs Often the investment agreement will not determine on which market the IPO will take place as a number of complex and unpredictable issues will influence that decision. The emergence of different markets for growth companies, such as AIM, EASDAQ and EURO.NM, is a relatively recent development (see FirstSource "EASDAQ" EC, 1996, (I(2), 22). From the issuer' s point of view, the decision will depend to some extent on a comparison of the rules in each market on: • Thresholds for admission. • Costs of maintaining the listing. • Publication of financial information. • Dual listings on other markets. • Multi-jurisdictional IPOs. The devices which may be used, preferably at the time the investment deal is structured, to make the company more suitable for an IPO. The investment agreement may contain an obligation to convert the company from one company form into another or an obligation to set up a holding company of which the shares can be floated. Also, arrangements can be made in order 11
  12. 12. to ensure compliance with corporate governance rules, such as the appointment of independent directors, an audit committee and a remuneration committee. Preferential floating rights. Venture capitalists are able from time to time to obtain preferential flotation rights which allow them to exit before the other shareholders. Preferential rights may apply at the time of the IPO or in the over-allotment option (or "green shoe"). The over- allotment option is an option granted to the underwriters to obtain from the company or the selling shareholders additional shares up to, for example, 39 days after the IPO. The option is also used by the underwriters to stabilise the price of the shares in the period just after the IPO. Allocating costs. It is usually appropriate to make arrangements to determine who will pay the costs related to the IPO. Quite often the company is obliged to cover them, although from time to time the selling shareholders pick up certain costs. The costs concerned include: • The fees, commissions and discounts for the investment banks. • Legal fees of the counsel to the issuer. • Legal fees of the counsel to the selling shareholders. • Listing and quotation fees. • Printing expenses. • Accounting fees. • Roadshows. Minority protection. Investors aiming at an IPO exit are likely to be anxious to make sure that the minority protection granted to certain minority shareholders automatically lapses on an IPO. They will want to know that an IPO cannot be blocked by a minority. Such investors will want the investment agreement to provide for the lapse of: • Any special minority veto or pre-emption rights at board or shareholder level. • All other transfer restrictions and preferences as far as dividends or liquidation rights are concerned. This is often achieved by converting preferred stock into common stock at IPO. This technique is easier to implement in common law, rather than civil law, jurisdictions. Minority shareholders may wish to resist these moves and protect any residual rights they have for the long term (see FirstSource "Minority squeeze outs" EC, 1998, III(3), 29; EC, 1998 III(4), 29; EC, 1998, III(7)., 53)). 12
  13. 13. About the Authors: Koen Vanhaerents, Partner Office: Brussels Practice Group: Venture Capital & Private Equity Education: University of Leuven (B.A., 1985; Lic. in Law, 1986); University of California at Berkeley (1987) Contact: koen.vanhaerents@bakernet.com Helen L. Stroud, Partner Office: London Practice Group: Corporate Education: University of Manchester (1980); College of Law at Chester (1981) Contact: helen.stroud@bakernet.com Regional Contacts: We welcome you to learn more about our venture capital and private equity capabilities, wherever your business takes you. For further information, please contact: Global North America Bruce Zivian (Chicago office) Marc Paul (Washington DC office) 1-312-861-8940 1-202-452-7034 Asia Pacific Europe/Middle East Kien Keong Wong (Singapore office) Marwan Al-Turki (London office) 65-434-2688 44-20-7919-1823 *This article is based on presentations given by the authors at a seminar hosted by the firm's European Venture Capital Group in Paris in October 1998. **This article is provided for informational purposes only and should not be deemed as legal advice or a legal opinion. 13