"A buyer's market?": the effect of the credit crunch on technology and the investment market

July 18, 2008

The apparent strength of the UK economy as little as 12 months ago has been exposed to harsher times following, amongst other things, the credit crunch. Generally economic confidence has declined for both consumers and business. So how has this affected investment and M&A activity in the ebusiness and wider technology sector?

Focus on smaller deals

Our experience and that shown by anecdotal evidence suggests that investments and M&A activity in the technology sector has held up relatively well. In particular, in the small to mid-cap markets where there is continuing appetite for internet and new media businesses. Those with recurring revenues and subscription models are amongst the most sought after.

“It’s all relative”, said one of our clients. What he meant is that investment and M&A activity for tech companies has not slowed down to the same extent as for other businesses. “Partly this is because tech companies cannot sit still in the highly competitive environment in which they operate”. That is part of the story. The other is that the big deals are simply not happening to the same extent as before and so there is an increasing focus on smaller deals in the tech sector.

Cautious investors?

What is abundantly clear is that the prevailing climate is much more cautious. Deals are taking much longer to get going than before. Understandably, the basis on which deals are being undertaken is changing. Valuations are becoming more realistic and there is a sharp focus on investors protecting their downside.

Protect your downside

This is manifesting itself in a number of ways:-

• Dividends: investors have a keener interest in securing dividends either during the course of an investment or as part of an exit. The rights attaching to their shares will typically provide that dividend rights are cumulative. The coupon will also rise if the projected exit date is missed.

• Mandatory redemption: investors are also seeking to include provisions which confer some downside protection should this be the only basis on which an exit can be achieved. Returns sought on a mandatory redemption can exceed significantly the original entry cost.

• Involvement in management: investor appointed directors will increasingly play a proactive part in the development of the business rather than a monitoring role. They will often have useful connections for the benefit of business. The performance of the executive management is closely monitored. Investors now seek to reserve powers to themselves enabling the early replacement of underperforming managers and are not afraid to use these rights.

• Share options: investors are not inclined to accept dilution on the exercise of management options. This is particularly true where a second or third round of funding is required before an exit can be achieved.

• Investor preference on proceeds of a liquidation or sale: investors are seeking specified multiples, often two or even three times the original investment, to be returned to them before any amounts are distributed to other shareholders. On a sale, the original investment will be repaid first from the proceeds of sale. The investor will then participate in the remaining proceeds of sale with all other shareholders based on the rights set out in the articles.

• Price based anti-dilution: investment agreements now commonly contain measures whereby if the company were to issue shares at a price which valued it at less than when the investor first subscribed, the conversion rate on convertible stock previously acquired by the investor will be adjusted upwards in its favour usually at the expense of management.

• Milestone funding: where investor financing is intended to fund business operations and not to repay outstanding debt, milestone funding can be used. Under this arrangement investors agree to release money contingent on the satisfaction of certain negotiated milestones relating to, for example, revenues or the completion of certain transactions or steps in the projected growth of a business.

• Valuation adjustments: if the business fails to achieve negotiated milestones there is often a downward adjustment to the company’s valuation and a corresponding upward adjustment to the ownership interest held by the investor so as to put it in the same economic position as if it had invested at the lower valuation.

• Drag along rights: in addition to obtaining tag along rights investors will seek to secure drag along rights to ensure that they can “force” an exit in certain pre-determined circumstances. This is often the subject of a tense negotiation given that the investor will not itself give any warranties or indemnities on a sale save as to title to its shareholding.

• Negative control: although the presence of wide ranging contractual protections for investors is not new there now appears to be a greater willingness to use these rights to “steer” a business in the direction which will protect the investors investment.

Although the above examples are not new they figure much more prominently at a time when it is necessary for investors to protect the downside. After all, “it’s a buyer’s market so what do you expect?”


Related pages:

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Tax and Incentives more

Technology, Media & Digital more

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