Management's advisers have a key role to play in ensuring that management's expectations are realistic and do not go beyond the investor's red lines whilst also ensuring management's position is appropriately protected.
This article explores some of the legal issues facing management and how they might seek to address those concerns.
Leaver provisions
This is one of the most sensitive areas for management as the leaver provisions impact their potential financial returns. In short, these provisions ensure that if a manager ceases to be an employee their shares may be offered for sale at a set price.
Within the leaver provisions, there are typically a number of categories of leaver – e.g. 'good', 'intermediate', 'bad', etc. – that will determine (i) whether a manager's shares are subject to compulsory transfer and (ii) the price they receive for those shares. Managers are often fearful that the provisions could be abused so that they lose their shares for little or no value. In light of this, managers will seek to have a narrow list of circumstances that are within their control in which they can be forced to sell their shares without realising any growth in value or potentially lose value already created.
From the perspective of the investor, these provisions are a key tool to ensure that management are committed to the target business for a set period before they can realise any meaningful return on their investment. The investor will be keen to stress that the leaver provisions actually protect managers in the event they are not a leaver as the prospect of a leaver retaining their shares (and therefore continuing to benefit from the efforts of the remaining managers) will not sit well with the remaining management team. Commonly. Investors will seek to clearly define 'good' and 'bad' leavers, and for 'intermediate' leavers to be a catch-all category in which the value of a leaver's sweet equity is subject to value vesting.
Protection of rollover amount
Where managers are also sellers under the acquisition documents, an investor will likely insist upon the managers reinvesting a proportion of their sale proceeds – typically between c.40% and 50%. This reinvestment, or "rollover", will usually take the form of an exchange of some of management's shares in the target for shares in newco or the sale of management's shares in the target and the investment of part of the cash proceeds for shares or loan notes in newco.
It is generally accepted by managers that the leaver provisions will apply to their sweet equity as the purpose of cheaply priced sweet equity is to incentivise them to generate enhanced value on an exit. However, rollover shares represent value already crystallised in respect of management's past efforts. Therefore, management understandably feel they have already contributed something of value and will argue that the rollover shares should be excluded from the leaver provisions.
From the investor's perspective, they want to ensure that management have sufficient skin in the game to motivate them to grow the value of the new group. As such, the rollover is often viewed by investors as a standard requirement of any buyout and so they may resist management's contention that it should be excluded from the leaver provisions entirely. Investors sometimes argue that rollover equity should be subject to compulsory transfer where a manager leaves in circumstances that are sufficiently serious and within their control – e.g. fraud, criminal conviction, etc.
Variation / anti-dilution
Managers will be keen to ensure that if there is any change in the terms of the investment, they are treated in the same way as the investors and their investment will not be diluted by any further issue of shares. While there are circumstances where this may not be possible (e.g. in an emergency fund raising situation) they will be keen to ensure that the general principle of equality of treatment is generally adopted.
The management team should have specific regard to future M&A plans and how much sweet equity is reserved for those transactions. They will reasonably argue that funding for further acquisitions should be via third party debt so as not to dilute their equity. Investors will sometimes agree a financial threshold below which funding for M&A activity will be financed through debt facilities. Beyond that threshold, management should have the right to invest on the same terms as the investor in order to maintain their equity percentage.
Warranties and limitation
The management team will usually be required to give warranties to the investor under the investment documents in relation to:
- the reasonableness of the business plan;
- the accuracy of the information in each manager's management questionnaire; and
- the factual accuracy of the due diligence reports.
If any of the warranties given by management are untrue, the investor could bring a claim against them for breach of contract. Although an investor would be unlikely to sue its management team (unless it is a sufficiently serious breach), the prospect of being sued will understandably be a cause of concern for management.
Where management are not receiving any material cash proceeds as part of the buyout, they might consider the inclusion of the following provisions in the investment documents to reduce their potential exposure under the warranties:
- the inclusion of customary limitations – e.g. time periods for bringing claims, financial thresholds linked to a multiple of salary, etc.; and
- the ability to set off any potential warranty liability against any shareholder debt instruments.
Any financial limit should be a sufficiently high amount to ensure that the managers take the warranties seriously, but not so high as to make them reconsider doing the deal.
Our recognised private equity team delivers pragmatic, innovative and straightforward advice to investors and management teams in private equity transactions in the UK and Europe.
We bring a wealth of experience of private equity investments to ensure that you can achieve your commercial aims and protect your position. Please reach out to the authors of this article if you have any queries or questions regarding buyouts or Private Equity investments more generally.
We would like to thank Faith Baker for her contributions to this article.
