Characteristics of Private Equity (PE)
• PE investors generally seek companies that are perceived to enjoy high growth potential over the long-term,
– because the target company is in industry with long-term, high-growth potential,
– because the target company is developing new products or services that when introduced are likely to garner a significant market share,
– because the target company is an active force in a rapidly consolidating industry, or
– because of any combination of these characteristics.
• With respect to the original shareholders, a private equity investment will often involve having to learn to manage the company with certain restrictions on decision making.
• Investors frequently request representation on the board of directors and rights to veto actions relative to certain key management and operating issues.
• In some cases, the investors will even seek direct participation in the day-to-day management of the company. Investors may also wish to provide technical assistance, technology or management services to the company.
• To take care of the illiquidity of shares, and in order for the investor to be able to realize an acceptable return on its investment, the investor will insist upon negotiating an acceptable exit strategy at the outset of the investment.
• Such strategies may include taking the company public (IPO), selling the company to a third party (trade sale), selling the shares back to the original shareholders (pursuant to a put provision in the agreements of the private equity investment) or selling the shares to a third party.
Private Placement Process
Preparation of PPM
• Once the company has decided to seek private equity, the first step will be the preparation of a detailed business plan or private placement memorandum ("PPM") that describes the Company's business and operations, summarizes its business strategy, describes the relevant market, includes financial statements and detailed financial projections.
• The drafting of PPM should be a comprehensive but concise presentation. Investment banks take an active part in preparing PPM.
• Simultaneous with drafting of the PPM, investment bank usually develops a detailed contact plan based on a selective premarketing process. The heart of the plan consists of a list of potential "lead" and "follow-on" investors that may include venture capital investors, mezzanine funds, pension funds, insurance companies and high net worth individuals.
• The due diligence review is essential to formulating a valuation by potential investors. It involves verifying the assets, liabilities and contractual obligations (including any existing or potential contingent liabilities) and financial condition of the company.
In order to prepare for the due diligence to be carried out by interested Investors, the company, with advice from its legal counsel, will be responsible for selecting, organizing, and making available for review all relevant documents. In addition, the company will typically arrange for investors to meet at length with management and tour the company's facilities.
• Typically, after a potential investor has performed due diligence and has indicated a serious interest in making an investment, the parties will want to negotiate a term sheet or equivalent letter of intent which sets forth, in detail, the principal terms and conditions on which the investment will be made.
• Those terms and conditions will be influenced by the amount to be invested, the level of ownership the investment represents, the type of business the company operates, the company's financial situation, and the type of investment (development stage, strategic investment in an ongoing business, recapitalization, or troubled company turnaround).
• The single most important issue to be addressed in the term sheet is determining the value of the company.
• Other important issues relating to the financial terms of the investment, including the schedule on which capital is to be invested and the nature of the investment (convertible debt, debt with warrants, common stock, preferred stock, etc.), are resolved at this term sheet stage. In most cases, the term sheet also addresses issues relating to company governance and the relationship between the Investors and the original shareholders.
• The amount of negotiation on these issues and the extent of the detail included in the term sheet or letter of intent will influence, in an important fashion, the negotiation of the relevant agreements. To the extent the
parties are able to reach a detailed agreement at the term sheet stage concerning these issues, there will be a corresponding reduction in the amount of time required to negotiate the documentation of the investment.
• Typically, there is significant negotiation between the principals that occurs at the term sheet stage. Once the terms and conditions have been agreed to by all the parties, legal counsel will incorporate the terms into draft documentation.
Securities purchase agreement and Shareholders’ agreement
• This generally includes both a securities purchase agreement (containing the price, the nature and terms of the shares, the conditions to closing the investment, the representations of the parties and any indemnity obligations), and a shareholders' agreement, which regulates all aspects of the relationship among the company's shareholders, including the resolution of any controversies that may arise among the parties.
• Therefore, because of the pivotal role it plays in the success of the investment, the shareholders' agreement should be drafted in such a way so as to protect all shareholders, represent their interests, and anticipate any kind of controversy by providing an adequate mechanism for its resolution.
• It will be the lawyers' responsibility to produce documents that set forth, in a clear manner, all the terms and conditions negotiated by the parties and provide a workable arrangement for the management of the company.
Note on PPM
Private Placement Memorandum And Regulation D