This article focuses on transactions in which a company or business (the “target”) is acquired by a new company (“newco”) in which private equity providers, together with the target’s existing management team, or one assembled specifically for the purpose of the deal, will have a shareholding.
We look here at a few of the key legal and practical issues from management’s perspective when participating in such transactions.
Dealing with conflicting duties
Management will be pulled in different directions in private equity transactions as a result of the conflicts they have to face. For existing managers, conflicts can arise between their interest in the private equity backed acquisition vehicle and their duties as directors and employees of the target.
Care will need to be taken that their responsibilities to the target business are not overlooked while they are heavily involved in the transaction process, and managers will need to ensure that the business continues to operate as normal during this period.
Managers should obtain the consent of their employer to cover any actions that they will need to undertake in implementing the transaction, such as the time they will have to spend and the extent to which they are permitted to disclose confidential information to private equity backers.
Warranties and disclosure
The conflicts mentioned above often arise in the warranty and disclosure exercise. Warranties will be sought by newco on the state of the target; whilst the seller may be able to negotiate less extensive warranty cover as a result of management’s familiarity with the business, it is likely to be keen for existing management to share some of the liability under those warranties. Existing managers will then be involved in making disclosures against those warranties as well as being indirect recipients of those warranties as shareholders in newco. Managers will also be required to give warranties to the private equity investor under the Investment Agreement.
Other issues that will need to be resolved include the limitations on the managers’ liability under the warranties they give. The extent of a manager’s financial liability is typically capped at between one to three times salary. Private equity providers will push for the managers to be jointly and severally liable for any breaches of warranty, which, if accepted by the managers, would mean that all or any of them may be sued for the full amount of any warranty breach. From a manager’s perspective this exposes them to more than their proportionate share of any liability; although some risk can be mitigated by a behind the scenes “deed of contribution” between managers much the better approach is to seek to limit liability to a manager’s pro rata share of any claim up to the agreed cap on their liability.
A further question that will need to be addressed is whether managers will be required to give any warranties on a future sale or listing of the business and, if so, the extent of such warranties.
Conduct of the business
The Investment Agreement and newco’s Articles of Association will usually stipulate rules governing the management of the target going forward. These will include restrictions on what the management team can and cannot do without the consent of the private equity provider and/or its appointed director. Clearly management will need to be comfortable that they will be able to manage the business effectively within the confines of these provisions, and there can be significant negotiations around these restrictions to reach a position with which both sides are comfortable.
The investment documentation will also restrict managers from engaging in competing businesses and soliciting customers, suppliers or employees for an agreed period after their involvement with the target comes to an end. This period is often set at 12 months. Managers will normally need to give such covenants but thought should be given to any other interests they have. It is often possible to seek to negotiate around the edges of such restrictions.
Good leaver and bad leaver provisions
Private equity investors will usually require managers to hold their shares until an exit, and to offer their shares for sale if they leave the business. The price for the manager’s shares will reflect the circumstances of their departure, depending on whether they are classified as ‘good’ or ‘bad’ leavers. This is frequently one of the most contentious areas of negotiation given the impact which the classification can have on the value the manager receives for his investment.
A good leaver is normally someone who dies or who leaves as a result of a permanent disability or ill health. Sometimes it is also possible to include wrongful dismissal, redundancy and retirement. Managers who leave in any other circumstances are generally deemed to be bad leavers.
There will be a substantial price discount for bad leavers, and often they will only receive the lower of the subscription price paid and the fair market value of their shares. Good leavers are likely to receive the fair value of their shares, but managers will need to understand and be comfortable with the proposals for arriving at the valuation.
Drag along and tag along rights
Private equity investors will wish to ensure that they can deliver all the shares in newco to a third party purchaser, and will therefore require managers to sell their shares if an offer for newco is made. Managers should request that any of their shares that are ‘dragged along’ in this way are acquired on the same financial terms that the private equity investor is selling its shares, as well as a right to require a purchaser to acquire their shares at the same time as it acquires a controlling interest in the company (known as a ‘tag along’ right).
The costs of taking legal and tax advice on a private equity investment can be onerous for management, especially on smaller management-led buyouts, where management’s lawyers can have a more significant role and may conduct the negotiations on behalf of newco.
Management could try to obtain a costs indemnity from the target and/or the private equity fund. Where managers have different lawyers to the sellers, it may be possible for managers to reduce their costs by allowing the seller’s and the private equity fund’s lawyers to do the lion’s share of the work.
Private equity transactions can be full of risks for management, and we have highlighted only some of the issues that will need to be addressed. In addition, management will need to carefully consider the terms of their equity participation in newco, which will be influenced by tax considerations, and the terms of their employment arrangements, which will also need careful review. It is therefore important that managers take appropriate advice throughout the process.