Private Equity Law Review : New York Private Equity Lawyer & Attorney : Geoffrey Parnass : Corporate & Business Law

Shareholders of closely held, privately owned companies often worry that their voting and economic rights may be diluted if the company were to issue new securities. An issuance of new securities could diminish a shareholder’s proportionate share of profits, dividends, and other distributions. These concerns may be especially acute when a company is just starting up and its owners anticipate future rounds of equity or debt financing. To prevent these undesirable consequences, shareholders may seek preemptive rights in offerings of new securities.  

Some states provide shareholders preemptive rights as a matter of law, while others require that preemptive rights be expressly granted in a company’s state filings or its organizational documents. Delaware’s general corporation law, for example, requires that preemptive rights be granted to shareholders in a company’s certificate of incorporation. Although there is some variance among state corporation laws, a company usually spells out the terms and conditions of any preemptive rights in its shareholders’ agreement.

Preemptive Rights: Determining a Shareholder’s Ownership Percentage

Preemptive rights entitle shareholders of a company to maintain their proportionate beneficial ownership interests by allowing them to participate in offerings of new securities on a pro rata basis. When a company issues new securities, each shareholder has a right to purchase a percentage of the new securities equal to the shareholder’s ownership percentage of the company’s outstanding stock prior to the offering. Each shareholder’s ownership percentage is calculated by dividing the number of the shareholder’s shares by the total outstanding shares of the company. One of the key differences among preemptive rights provisions is the way that the amount of total outstanding stock is determined. 

Preemptive rights may be offered either on an “as converted” or “as converted, fully diluted” basis. If the preemptive rights are offered on an “as converted” basis, then a company’s total outstanding stock prior to a new securities issuance includes both the total outstanding stock of the company and the outstanding stock there would be if its convertible preferred stock and convertible debt were to convert. If the preemptive rights are offered on an “as converted, fully diluted” basis, then a company’s total outstanding stock prior to a new securities issuance includes the company’s total outstanding stock on an “as converted basis,” plus the outstanding stock there would be if all options and warrants were exercised.

When a company plans to issue new securities that are subject to shareholders’ preemptive rights, the company commonly sends each shareholder a subscription warrant notifying him of the number of shares he is entitled to purchase.

Limitations on Preemptive Rights

Whether preemptive rights are offered on an “as converted” or “as converted, fully diluted” basis, they are customarily subject to certain limitations. Shareholder agreements restrict preemptive rights by excluding, or carving out, specific securities offerings from the definition of “new securities.” Securities offerings that may be carved out from the definition of new securities include those related to:

Equity Incentive Plans. Shareholders generally do not have preemptive rights in any new securities issued as part of a board approved employee equity incentive plan or other benefit program where the primary purpose is not to raise additional capital for the company. This exception allows the company’s board to incentivize management by offering them stock options and other interests in securities, while at the same time shielding the company from the prospect of a management buyout.  

Strategic Acquisitions. Where new securities are issued as consideration for the acquisition of another business entity, shareholders’ preemptive rights typically don’t apply. This exception enables the company to enter into transactions like stock-for-stock exchange mergers, or B reorganizations, in which an acquiring company issues new securities to the target company’s shareholders in return for a controlling interest in the target, and asset-for-stock exchange mergers, or C reorganizations, in which a company issues new securities to a target company’s shareholders in exchange for substantially all of the assets of the target. By affording the company an opportunity to grow through strategic acquisitions, this exception allows the company’s business operations to benefit from synergies and economies of scale and scope. 

Equity Kickers. So-called “equity kickers,” or equity interests attached to corporate debt, issued in connection with arm’s-length debt financing transactions are often excluded from a shareholder agreement’s definition of new securities. Banks may want to couple their rights as senior lenders with an equity position in the borrowing company and purchasers of corporate debt securities may prefer bonds issued with convertible features like options and warrants. In return, the issuing company receives lower interest rates on its senior and subordinated financing.

Stock Splits and Dividends. Another exception to the definition of new securities is the issuance of common stock resulting from a share dividend, share split, or similar event that is made on a pro rata basis. In shareholder agreements involving venture capitalists, this exception is generally not included. As primary capital contributors to a business, venture capitalists have considerable bargaining power and negotiate for additional anti-dilution protections by having their respective ownership percentages preserved after stock splits.

Public Offerings. Often, there is an exception for an initial public offering or listing of the company’s shares on a nationally or internationally recognized stock exchange. Usually, the exception only pertains to certain public offerings in which the new securities represent a specified percentage of the company’s total outstanding stock or raise proceeds above a defined threshold. The qualified public offering exception is commonly included in shareholder agreements among private equity firms when the sponsors anticipate a partial or total exit from their investment by means of an initial public offering.  

In practice, shareholder preemptive rights only benefit those shareholders with enough capital to participate in new securities offerings on a pro rata basis with their fellow investors. Shareholders with limited cash reserves may find themselves unable to exercise their preemptive rights in qualified offerings of new securities and consequently discover that their voting and economic rights have been diluted. 

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A recent opinion issued by the Delaware Court of Chancery serves as a cautionary tale to entrepreneurs, venture capitalists, and others entering into LLC operating agreements in connection with start-up companies. A minority investor with a substantial stake in a company sought to dissolve the company on the grounds it had abandoned its original business plan. However, because the purposes of the LLC were worded quite broadly in the operating agreement, the court ruled against the dissolution, much to the frustration of the minority investor. Thanks go to Francis Pileggi for bringing the case of In re: Arrow Investment Advisors, LLC to my attention and providing, as usual, an excellent summary and analysis of the court’s opinion on his blog. 

 Along with two others, Noah Hamman co-founded Arrow Investment with the intention of offering advisory services to investment funds. Hamman, who held a 30% membership interest in the company, had been its CEO until he was removed by his two fellow founders as a result of disagreements over management decisions. Like many other financial services firms, Arrow’s prospects began to sink with the market’s. In response, Arrow’s management committee decided to explore other investment opportunities and sent out a notice to the company’s members requesting capital contributions to fund their new programs. Hamman disagreed with this approach and brought a petition before the Court of Chancery seeking dissolution of the LLC under §18-208 of the Delaware LLC Act, alleging that Arrow had departed from the business strategy set out in its original business plan.  

 The court noted that Arrow’s LLC operating agreement, and not its business plan, was the controlling document for determining the company’s purpose. Arrow’s operating agreement clearly stated it was formed “for the purpose of acting as an investment adviser to certain investment funds and for such other lawful business as the Management Committee chooses to pursue.” Given the broad formation clause of the operating agreement, the court ruled that Arrow’s management had not violated the purpose for which the company had been formed simply by choosing to pursue new business strategies. In the words of Vice Chancellor Strine:

Dissolution of an entity chartered for a broad business purpose remains possible upon a strong showing that a confluence of situationally specific adverse financial, market, product, managerial, or corporate governance circumstances make it nihilistic for the entity to continue. 

A company suffering disappointing financial returns resulting from a downturn in general economic conditions did not meet this standard.    

For most companies, including a broad purpose of formation clause in the operating agreement makes sense because it provides management with flexibility to adapt to changing business conditions. But founders of start-up companies should accept that the company’s eventual trajectory may not follow the one they initially conceived. 

To address this unknown and unknowable future, LLC operating agreements can institute appropriate governance procedures and potential exit provisions that would allow management and the company’s members to resolve significant disputes, or, if necessary, to part ways. Members of LLCs with substantial minority stakes, for example, may be given veto rights over certain material managerial decisions (such as when capital calls may be made to fund new business ventures) or exit rights that would allow a withdrawal from the LLC under narrowly specified conditions.        

Nobody won in the case of Arrow Investment Advisors. Hamman remains bound to a company he no longer wants to be a part of, management must continue to deal with a contrary minority investor, and the LLC itself has lost valuable time and money in defending this lawsuit. 

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Practitioners of the art of leveraged buyouts are still waiting for seller's expectations to fall in line with current realities.  You still run across sellers who believe that the multiples of the 2006-2007 period represent an eternal, fixed emblem of value. Perhaps they can't be blamed, as the multiples were around for so long.   According to Michael Berk of TA Associates, "sellers are still expecting a multiple of 10 times plus". 

My perception is that sellers are starting to read the newspapers and are beginning to get the message that the decline is valuation may be here for awhile.  But right now, to the extent deals are getting done at all, it's where middle ground on price is reached through earn outs and other forms of contingent consideration.  It's simply not possible for a seller to walk away from a closing with the same amount of cash as in the recent past.   

Before middle ground is reached, buyers too need to make peace with the current environment.  They need to believe that the fundamentals of the target business are not deteriorating further, and that credit is available at a cost that supports equity returns.  It's hard to commit equity capital in an environment where a portfolio of fairly well-rated, publicly-traded bonds can get a 20% current cash return.

Probably sooner than later, perceptions of buyers and sellers will begin to align again.  Sellers will stop thinking about the past and realize that those valuations are not coming around again any time soon.  Buyers will start to get comfortable that business conditions are stabilizing.  When that happens, a new age of Aquarius will be born.

No one likes kissing frogs, but until this middle ground is reached, PE firms will be doing a lot of that.

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Companies that have burned through what cash friends and family have been willing to provide, and still can’t get a bank loan, turn to strangers for money. These strangers go by many names, one being “venture capitalists”. 

Venture capitalists provide money when other sources are not available. Most venture capital financing goes to companies in a narrow band of industries:  technology, information services, life science and telecommunications. Because so many start-up ventures fail, venture capital tends to adopt a collective mentality, flocking toward those deals and industries that are perceived to have the greatest chance of a quick and profitable exit.

A common requirement for venture capital is a founder or CEO who has had previous successful experience with venture capital money. Also, venture capital tends to favor companies that are already far along in the development process and need funding to get a product to market.  Finally, venture capital needs to see that projected revenues will accelerate very quickly, like a hockey stick, once product development and launch are complete. New ventures in mature industries with slower growth prospects, no matter the brilliant the business plan, are not a target of venture capital investors.                                  

Once a decision is made to provide venture capital financing, the venture capitalist typically prepares a term sheet for the investment, setting out the principal terms of the transaction. The term sheet is later reflected in formal legal documents. Whatever negotiations transpire between the company and the venture capitalist occur as the term sheet is circulated. 

Venture Capital Term Sheets

The following provisions are typically covered in venture capital term sheets:

1. Fixing the “pre-money” value of the company in order to determine how much equity the new investors will receive. For example, if the company has a pre-money value of $3 million and the venture capitalist provides $1 million of capital, the company will be worth $4 million after the investment, and the venture capital will receive shares equal to 25% of the outstanding stock.

2. Defining the terms of the security the venture capitalist will receive—generally preferred stock. The term sheet will spell out the rights and preferences of the preferred stock, such as dividends (often payable in more shares of preferred stock), liquidation preference, conversion rights (how the preferred stock is converted into common stock), and anti-dilution protection (in case the common stock is split or additional shares of common stock are issued at a price that is less than the conversion price of the preferred stock).

3. Actions that require the consent of the preferred stock voting separately as a class, such as a merger or sale of the company, amending the terms of the preferred and the issuing securities with rights senior to those of the preferred. Generally, the approval of the venture capitalist will be required in order to undertake any significant event.

4. A right to demand that the company file a registration statement with the Securities and Exchange Commission covering the stock so that it can be sold in the public markets. Also, the right to participate in any registration statements filed by the company on behalf of other investors.

5. The right to elect one or more members to the board of directors.

6. Who will serve as CEO and chief technology officer of the company.

7. How much stock management will own, generally through incentive stock options, including lock up provisions prohibiting the sale or transfer of such stock except in connection with a transaction in which all shareholders participate.

8. Rights of first refusal and preemptive rights with respect to new shares offered by the company.

9. The right of the investors to participate in any sale of stock by the original founders of the company.

Venture capital generally comes in stages. Each round of capital is designed to get the company to the next stage of development. As the stages proceed, different venture capitalists may become involved, as the industry has firms that specialize in different stages of development.

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LBO deals are typically done through limited liability companies, while venture capital deals are typically done through corporations. The difference is governed by tax considerations and the expected exit strategy.

Leveraged Buyout (LBO) Deals

In LBO deals, the acquired company is typically generating taxable income—the same taxable income used to repay the debt incurred to buy the company in the first place. In venture capital deals, the company is typically not generating taxable income, as it is spending money on people and technology at least as fast as it is generating revenues. When revenues do catch up, it can shelter the income awhile longer as it burns through the accumulated net operating losses. As a result, LBO deals typically favor a legal structure that minimizes tax liability (such as the limited liability company), while venture capital deals typically don’t care about taxes, and therefore use a taxable corporation.

Venture Capital Deals

Venture capital deals, and other companies that expect to be publicly traded, are typically organized as corporations.  Corporate shares are designed to be liquid and easily traded on national stock exchanges. For this reason, most venture capital deals are made through corporations with multiple classes of preferred stock, each convertible into common shares, as hope springs eternal that the company will one day go public and mint money for the original investors.

At the present time, corporate law is more thoroughly developed than LLC law and is therefore more predictable from a legal standpoint, although this difference is quickly fading away.

Another reason that corporations are favored in venture capital deals is that they better accommodate stock options. It is difficult to grant traditional stock options to key management of an LLC. The tax code does not permit LLCs to issue incentive stock options, which are treated as capital assets rather than ordinary income, and therefore provide a significant advantage in recruiting management. Also, the exercise of the options in the LLC context can raise tricky tax issues, as capital accounts must be rearranged.  

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