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

In our previous post, we discussed some of the customary agreements and covenants in interim investor agreements for private equity consortia. Today, we’ll describe the types of pre-closing equity syndication procedures commonly found in interim investor agreements. For large buyouts requiring significant capital investment, the initial members of a private equity consortium may want to be able to seek out other private equity investors in order to diversify some of their risk. An interim investor agreement often details how members of the private equity consortium may use the period between signing the share or asset purchase agreement and closing the transaction to solicit other investors.   

The interim investment agreement sets forth the equity investment of each of the private equity funds and their corresponding ownership percentages in Newco. This section of the agreement also outlines a mechanism for adjusting equity commitments, typically done on a pro rata basis, to prepare for possible changes in the purchase price of the transaction or the availability or cost of debt financing.   

Equity Syndication

Depending on the number of private equity firms initially involved in the consortium, the interim investor agreement may want to detail an equity syndication procedure. Although the private equity firms covenant to coordinate an equity syndication strategy, they each may also be given limited rights to syndicate on their own.     

Some of the syndication rights that may be granted to the consortium’s members include:

Direct Equity Syndication

The private equity firms may be entitled to directly syndicate a specified portion of their equity investment in Newco without the consent of the other investors. The syndicating investor may possess “drag-along rights” enabling it to compel the non-syndicating investors to sell their respective ownership interests in Newco to the new investor on a pro rata basis. The non-syndicating investors may be granted corresponding “tag-along rights” permitting them to participate in any sale of ownership interests in Newco on a pro rata basis with the syndicating investor. Each new investor is required to become a party to the interim investor agreement and execute an equity commitment letter on the same terms as the initial investors. 

“Silent” Equity Syndication

Each private equity fund may also be entitled to what are called “silent” equity syndication rights. In a silent equity syndication, a private equity firm syndicates economic or beneficial interests in an entity entirely controlled by or affiliated with the firm. This provision allows each of the sponsors to syndicate equity interests in the private equity funds investing in Newco rather than ownership interests in Newco itself. In other words, silent equity syndicatees purchase an ownership interest at the shareholder level. Since silent syndicatees are indirect owners of Newco, the interim agreement explicitly denies them governance, liquidation, or other rights to be offered to the direct owners of Newco in the definitive shareholders agreement.        

The right of consortium members to syndicate their direct equity interests in Newco is usually subject to an anti-dilution provision requiring them to maintain a minimum percentage ownership interest or dollar amount invested in Newco.

Related Post: Private Equity Club Deals: Pre-Closing Investor Agreements and Covenants

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Leveraged buyouts of companies by private equity consortia – also known as private equity club deals – often capture the headlines and the imagination of the business press. Buyouts that demand substantial equity investments, such as the $900 million injected into the failed Florida lender BankUnited Financial by a private equity group that included WL Ross & Co., the Carlyle Group, and Blackstone, often require several private equity firms to club together to come up with enough capital. Besides the large equity investment required, what distinguishes club deals from garden-variety leveraged buyouts is the need for multiple firms to agree on how the transaction will be managed. In this post, we’ll take a look at some of the chief terms of interim investor agreements among members of a private equity consortium.      

Interim investor agreements for private equity consortia are by their nature temporary: the agreement terminates either upon the successful closing of the transaction or the deal’s termination in accordance with the share or asset purchase agreement. If the transaction proceeds as planned, an interim agreement details the steps that need to be taken to complete the deal and lays down the groundwork for how the business will be operated after closing. On the other hand, an interim agreement specifies how the consortium’s members will allocate responsibility for transaction costs and other liabilities, such as reverse break-up fees, should the deal founder. The agreement is signed on the same day the private equity funds sign their respective equity commitment letters, the banks issue their debt financing commitment letters, and the consortium’s shell acquisition vehicle, or “Newco,” enters into the purchase agreement with the target company.   

A few of the principal matters typically covered in an interim investor agreement include:

Pre-Closing Agreements and Covenants

The members of the private equity consortium agree to cooperate with one another to resolve any outstanding issues with the target company, negotiate definitive loan agreements with the consortium’s lenders, execute employment agreements with the future management of Newco, and nail down any other final terms and conditions. In addition to approving the purchase agreement and other transaction documents, the private equity firms memorialize their consent to the proposed transaction structure, usually by reference to the pre- and post-closing organizational charts of Newco and its subsidiaries prepared by the consortium’s accountants. If the target is a public company, the members promise to comply with all applicable securities laws and to file all necessary documents with governmental authorities, such as filings under the Securities Exchange Act’s Regulation 13D disclosing beneficial ownership interests. 

Finally, the private equity firms confirm how Newco will be managed during the period between the signing of the purchase agreement and closing.   The interim investor agreement identifies the number of representatives from each of the consortium’s members appointed to Newco’s interim board of directors, usually in proportion to their respective equity investments. Each of the private equity funds indemnifies (on a pro rata basis) and holds harmless Newco’s interim board of directors from any claims or other liabilities arising from any error or omission by a director.   Directors appointed to Newco’s interim board are likely to become named defendants in any future lawsuit regarding the transaction, whether the plaintiff is a consortium member, one or more of the financing banks, or the target company or its shareholders.       

Definitive Investors’ Agreement

The private equity sponsors agree to negotiate a definitive shareholders’ agreement promptly after the transaction closes and may identify any special tax or ERISA matters (in the case of a public company) that need to be addressed in the definitive agreement. Most important, this section of the interim agreement incorporates by reference the private equity consortium’s investor term sheet, which summarizes the principal terms of the future definitive shareholders’ agreement. 

Advisers’ Fees and Transaction Costs

The interim investment agreement also handles the allocation of transaction fees among the private equity firms’ advisory arms and how transaction costs (including liabilities from potential lawsuits) will be handled both in the event the deal closes and in the event the deal is terminated. Upon completion of the deal, the advisory arms of the private equity firms that sourced the deal receive a transaction fee that usually reflects their proportionate ownership interests in Newco. 

The agreement also specifies how the consortium’s financial, accounting, legal, and other advisers will be paid. If the deal closes successfully, the interim agreement provides that Newco picks up the private equity consortium’s advisers’ fees and expenses. The way advisers are paid in the event of a failed deal turns on whether or not the consortium is entitled to a break-up fee from the target. If there is no break-up fee in the purchase agreement, the private equity firms will share costs on a pro rata basis. If there is a break-up fee under the purchase agreement, then the amounts received will be applied first to pay the advisers’ fees and expenses and other transaction costs, with the remainder being distributed among the private equity firms. If the deal is terminated because one of the private equity funds fails to finance its equity commitment, the defaulting private equity firm will indemnify the non-defaulting firms and be liable for all transaction fees, expenses, and other liabilities.     

A private equity consortium’s interim agreement typically also requires confidentiality and specifies whether disputes will be resolved through arbitration or judicial process. In our next post, we’ll explain how interim investor agreements address the consortium members’ equity syndication procedures.

Related Post: Private Equity Club Deals: Equity Syndication

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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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