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1107144_1 1
Private Equity and MBOs
How to Sell Your Business or Attract Equity to Grow Through a Private Equity Buy-Out
Date : March 2014
Author/s : Jeff Mansfield / Kieren Parker
Article 6 of 9 For private business owners or managers looking to sell
their business or a stake in it, or to fund its next stage of
growth, this is the sixth in a series of nine articles which provide a guide to understanding private equity and the
private equity buy-out process.
On-going Involvement as Managers or Owners
Management, sweat equity and sweet equity
A feature of PE investments is the opportunity for management to share in the risk and reward of the
business as equity owners. PE firms reserve a
significant minority stake in the portfolio company to incentivise management and to align managers'
interests with the PE owner. There is no set formula for
the dollar amount that managers are expected to invest, other than it needs to be meaningful in the context of
their personal situation, so that the loss of the
investment would not be a painless experience. (In smaller companies which may not be sizeable enough
to attract PE investment but may attract VC
investment, managers are commonly founders who already own an equity stake, so the dynamics are
probably different.)
The structure of management incentive schemes is
driven to a large extent by tax planning. For example,
schemes may comprise 'sweat equity', meaning ordinary shares in respect of which management pays
fair value, alongside 'sweet equity', meaning
instruments or rights that increase the value of management equity relative to other shareholders,
depending on the success of the investment. Putting
aside their complexity, management incentive schemes can be lucrative, but come with the risk of managers
losing some or all of their 'sweat equity'. They are
discussed further in the summary of common terms in shareholders agreement in Article 8 – Things to Expect
in a Share Purchase Agreement when Selling Your
Company.
The new owners might put in place a second tier
incentive scheme for the level of managers below the
CEO, CFO and other senior executives. Indeed, certain
tax rules encourage broad based employee schemes
which are open to 75% of the employees.
Although the alignment of management with the PE
firm through common ownership is real, it will not
escape managers that the PE firm's investments are diversified across all portfolio companies owned by the
fund, and probably across more than one fund. By
contrast, managers are exposed solely to their own portfolio company, meaning the opportunity to earn
significant wealth comes with a concentrated risk of
loss.
Owners retaining a minority stake
For owners remaining partially invested, the terms of their equity ownership will likely be simpler than
management, reflecting their less active role in the day
to day business. Moreover, depending on the size of their stake and their ongoing involvement, the equity
held by an owner accustomed to control could feel more
like a passive investment. Regardless, a PE firm will see the owner's participation as an important partnership,
which together with management is key to a successful
investment.
Financing Structure
Even after the global credit crunch, PE firms are likely to want to introduce debt to fund the acquisition of the
target company and leverage their own investment. The
appropriate amount of debt will depend upon the nature of the target company's business and its balance
sheet. It will be important to review financial covenants
in any financing documentation to ensure they do not create any undue stress on the target company's
operations.
In addition to debt, PE firms may structure their own
investment as convertible notes or preference shares in
the target company, rather than ordinary shares. It will be important for managers investing in the target
company, and owners remaining as shareholders to
understand the terms attaching to any convertible notes or preference shares.
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Shareholders' Agreement
The shareholders' agreement is one of the foundations
for a prosperous relationship between the new owners.
It establishes the legal framework of that relationship, regulating the rights and restrictions of the parties in
the way the company is run, significant decisions are
made and shares are issued and sold. The shareholders' agreement can also set down markers about matters
such as the business plan and the timeframe to exit.
Like any legal document that supports a good relationship, it will hopefully be put in the bottom
drawer. Much of business life involves dealing with the
unexpected though, such as a need for further capital or a CEO resigning, which makes the shareholders'
agreement an important tool to guide the parties to
deal with the matter without delay and without deadlock, and move on.
A summary of the provisions commonly found in a shareholders' agreement is in Article 9 – Things to
Expect in a Shareholders Agreement for a MBO.
Kieren Parker, Senior Associate
Telephone +61 2 8915 1o13
Email kieren.parker@addisonslawyers.com.au
Jeff Mansfield, Partner
Telephone +61 2 8915 1o16
Email jeff.mansfield@addisonslawyers.com.au
© ADDISONS. No part of this document may in any form or by any means be
reproduced, stored in a retrieval system or transmitted without prior written consent. This document is for general information only and cannot be relied upon as legal advice.
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