What is meant by private equity?
Private equity (PE) describes professional investment into a privately held company, usually one limited by shares. Depending on the stage in the business lifecycle that the company is in, and the risks of investing in the company, and the types of investor that invest in it, the PE investor may call itself a range of names, from business angel investor, a development capital investor, a venture capital investor or a private equity investor.
Why are PE firms such an important source of capital to private companies?
If a privately held company limited by shares wants to raise equity finance, by law it cannot just issue new shares and sell them to anyone.
There are only three possible ways to raise new capital. The company can sell shares to the certain members of the public, principally existing shareholders, employees and the close family members of both. It can convert to a public limited company (a PLC) and sell shares to anyone, although doing so requires it to have paid-in capital of at least £50,000. Or it can seek investment from a “sophisticated” investor.
Professional investors and high net worth individuals fall into this last category. They are able to determine the risk of investing into the business, and they are assumed to be able to “afford” to lose the investment should the business fail.
What legal documents are involved in a PE investment?
There are a number of documents involved in an investment transaction: the shareholders agreement (sometimes called the investment agreement in these circumstances if it also deals with the subscription for shares); the articles of association; directors service agreements; and loan agreements. While each document covers a separate part of the deal, they are inter-related.
The provisions of the documents are likely to be those key ones covered on the term sheet to which all parties have broadly agreed, plus others that the founders are unlikely to have seen before.
Attention should be paid to all provisions to make sure that they do provide for the same deal that the founders expect.
The shareholders agreement
The majority of the investment agreement is likely to cover two sets of relationships: those between the private equity investor and the founder-owners; and those between the shareholders and the directors of the company (who may be the same people).
A PE investor invests in order to make a financial return. Along with the other terms standard in such an agreement, what will be important to it, him or her is:
- control of the business strategy, particularly relating to exit so that it can sell its shares at a profit
- control of the management through veto rights – restrictions on decisions directors can make without prior shareholder approval, and the ability to appoint and remove directors to the board
- control of share issues and transfers so that control of other matters cannot be diluted
- control of decisions to borrow or issue dividends
- protection of intellectual property and restrictions on competition if founders leave
- continuation of key staff (likely to be the founders) within the business
In addition, a PE investor is likely to require a large number of warranties from the founders. Warranties are promises as to the state of the business that are otherwise difficult to ascertain during the process of due diligence. For example, the shareholders might warrant that there are no obligations to third parties that could result in a financial payment to settle. If a warranty is found to be false, the PE investor can seek damages from the founders (the sellers of the share capital) to make good the negative impact on the investment valuation. Because the “price” of an untrue warranty is so great, private equity investors use them to force the shareholders and directors to disclose information, rather than as a means of redress.
If a funding round has attracted investment from multiple investors, then the shareholders agreement may also cover the relationship between those investors. However, alternatively, these might be covered in side-letters (private agreements) of which the founders are not aware. Another solution to issues of control might be for the company to issue multiple classes of share that each hold different rights, so that different aspects of control important to each investor separately can be given.