Achieving a successful private equity fundraise
In this issue of Strictly Boardroom we look at some of the issues to consider when a well-established and ambitious private limited company wishes to raise substantial investment from an investment fund in return for shares (an equity stake).
This type of transaction is commonly known as a private equity fundraise or a private equity investment.
Fundraising of this kind can sometimes involve more than one investor, operating in a syndicate, with one fund playing the lead card and the others following suit. For the purposes of this article we have assumed that the investment is being made by a single investor.
This article also assumes that the investor is an institutional private equity fund. Private equity investment can be provided by a wide variety of non-institutional investors including friends, family members, business angels and even trade suppliers. Whilst such investors undoubtedly fill a funding gap – for example, where there is a lack of security for debt funding or where the amount of the investment required is below the entry point for institutional private equity funds – non-institutional investors can often be unpredictable. Non-institutional investment terms and structures can vary wildly, day-to-day support can be inconsistent and there can be lack of certainty about further investment rounds should circumstances make this necessary. In contrast, institutional investors tend to behave in a more predictable way and often have deeper pockets from which to follow their investment.
So, what role do lawyers play in the process? The company’s lawyers may have been advising the fundraising company (we’ll call it TradeCo) for some time, advising on such matters as governance issues, transactions, funding options, contracts and so on. Indeed, some of this advice may be ongoing during the fundraise. But, as soon as it becomes clear that a private equity investment is likely to go ahead, the shareholders of TradeCo will generally enter into a separate engagement with the same or different lawyers for personal advice in relation to the investment. They need to do this because it is the shareholders of TradeCo who will be ceding ownership of the company to the investor and therefore the shareholders who need independent advice on the investment terms and documentation. The investor will appoint its own lawyers to act for the investor and the investment vehicle.
An investor will almost always insist that its investment goes into a newly-formed investment vehicle or holding company (we’ll call it HoldCo). In such an arrangement, HoldCo will normally acquire the shares in TradeCo from its current shareholders who will ‘move upstairs’ to become shareholders in HoldCo. The ongoing relationship between the investor and TradeCo’s former shareholders will be structured within HoldCo and TradeCo will simply become a wholly-owned trading subsidiary of HoldCo.
Once confidentiality agreements are in place and discussions have reached a positive stage, the investor will issue a term sheet to the shareholders and/or board of TradeCo and it is time to negotiate and document the deal.
So, here are our tips for a successful private equity fundraise:
Take the time to explain to your advisers your objectives – This may sound obvious, but it is essential that your legal advisers and financial advisers understand why you are raising the funding and what you intend to do with it. For example, do the current shareholders want to take some money off the table now to de-risk themselves personally? How will the investment be used to accelerate the growth of the business and over what period? How much control are the current shareholders prepared to cede? Knowing the answers to questions like these will help your advisers support you in the judgment calls that need to be made along the way.
Choose a fund that shares your values, aspirations and exit plan – Private equity investors want to create value for themselves and their co-shareholders. Whilst it varies from fund to fund, as a general rule of thumb, private equity investors want to at least treble their investment within three to seven years and then exit by selling the company or having their equity stake bought out. It can be an intense and sometimes uncomfortable experience for a management team that has been used to having total control and doing things their own way. So, it’s really important to pick the right fund. The best fund for your business will share your vision, bring management and sector expertise to the table, be able to open doors and be flexible enough on exit timing to take advantage of changing market sentiment. You will see a lot of their investment manager and board appointees along the way, so personal chemistry and an open ongoing dialogue with them is clearly important too. With interests and aspirations well-aligned, your investor colleagues should become valuable business friends.
Never underestimate the importance of the investor’s term sheet – Except for confidentiality, any exclusivity period and any obligation to pay abort fees, investors’ term sheets are not legally binding. But they do set the ground rules for formal negotiations and so you should always take legal and financial advice on them. Term sheets will record who the investor will be, whether the company will be used to raise debt to fund the investment (a leveraged investment), how much will be paid for the shares and if there will be co-investors (a syndicated investment). It will also set out how shares will be categorised and allocated, how the investment is to be released and used and what restrictions there will be on the transfer of shares going forward. It will detail loan note and loan stock terms, how the board and management team will be structured and controlled and how investment and ongoing monitoring fees are to be calculated and paid. Dispassionate and objective eyes are a great asset at this point. If during the negotiation of the term sheet, it starts to look likely that the investor cannot or will not offer what you need, withdraw gracefully by agreement. You need to be able to look potential future investors in the eye when you say you have never had an investment application turned down.
The devil is in the detail of the investment documentation – The signing of the term sheet will trigger a flurry of further activity and documentation. The key documents will be the investment agreement and, potentially, a separate share purchase agreement. The share purchase agreement will deal with the purchase of TradeCo’s shares and the investment agreement will establish the relationship between the new shareholders in HoldCo. Other important documents will be HoldCo’s new articles of association, service agreements for the management team and the loan note instrument(s) which will govern the terms for repayment of any loan notes. Across these documents, there will almost always be a tussle over issues such as investor’s veto rights, the wording and scope of warranties and operational procedures at both board and shareholder level. Experienced legal and financial advice will be needed in relation to the negotiation of this documentation. It is essential for all involved that the documents dovetail with one another and are consistent in terms of their liability, scope and limitations. Not only will these documents determine the future relationship with the investor, in good times and bad, but also, most importantly, the exit strategy.
Apply due diligence to the investor’s due diligence process – This is not a good time to bury bad news, however tempting this might be. Skeletons have a habit of falling out of cupboards at precisely the wrong moment. Managing an investor relationship is not only about delivering your forecasts but also about managing expectations and maintaining trust. Work with your advisers to determine how best to respond to due diligence requests to achieve the best outcome for all concerned.
Not forgetting to keep running the business – Again, this may sound obvious, but fundraising can be a hugely distracting process. Raising funds can be a pyrrhic victory if you find the performance of your business suddenly drops because the management team has taken its eye off the ball.