The Critical Terms of a Minority Investment
The following is an overview of critical terms of a minority sale. Highly experienced and skilled M&A advisors and lawyers will be needed to guide you through what will be a highly complex transaction.
Minority investors nearly always demand a security, usually preferred stock, that is senior in rights to the owner’s common stock. This preferred stock is convertible into common stock on specified terms. Preferred stock, however, nearly always comes with provisions that are often disadvantageous to the owner of the company. Here are some of the more common features:
• Convertible Preferred (investor-friendly). With this structure, upon a liquidity event, the investor would either: (1) If the valuation were greater than when the investment was first made, convert their preferred into common stock and share pro rata with other common shareholders in the sale proceeds, or (2) If the valuation were less than when the investment was first made, opt to receive back their original investment. The presence of a liquidation preference or accumulated dividends may enhance this already great benefit to the investor.
• Participating Preferred (even more investor-friendly). This provides the investor with their initial investment plus a return on their money. The net effect is the investor that bought a certain percentage of the company often receives more than that percentage of proceeds upon liquidation.
• Liquidation Preference (investor-friendly). By definition, preferred stock has preference over common stock in a liquidation scenario. But investors often negotiate a “hyper” liquidation right, a multiple of their investment. For example, an investor with a 3X liquidation preference on a $10MM investment would receive up to the first $30MM upon the sale of the company.
• Anti-dilution Rights (investor-friendly). There are a couple of flavors here. A “full ratchet” anti-dilution provision (investor-friendly) essentially protects an investor from any reduction in their percentage ownership due to the sale of future equity. So, an investor with this protection who owns 25% of the company will always own 25% of the company, regardless of future equity sales. This operates to force the owner to take “super-dilution” when future equity is raised. In other words, the 75% owner of a company valued at $10MM who sells another 25% of the company to a new investor would not see their ownership stake reduced by 25% down to 56.25%. Rather, they would be forced to take the entire 25% dilution out of their own stake, resulting in their ownership stake being reduced to 50%. The original minority investor would remain at 25%. Generally, the anti-dilution protection is accomplished by forcing the company to issue additional stock to maintain the protected investor’s ownership percentage.
A “weighted average” anti-dilution provision (investor-friendly, but not as much as full-ratchet) provides some anti-dilution protection to the investor, but not as much as the full-ratchet variety. And there are two main varieties of this feature. “Narrow-based weighted average” provides that a subsequent sale of equity will protect against dilution to the original investor using the total amount of preferred shares as the denominator for calculation purposes. “Broad-based weighted average” provides that a subsequent sale of equity will protect against dilution to the original investor using the total amount of all shares on a fully diluted basis as the denominator for calculation purposes. The broad-based method results in less protection to the original investor than the narrow-based method.
• Redemption Rights (investor-friendly). These give the investor the right to force the company to repurchase their preferred shares after a specified time, often 5-10 years. And at what price? There are several ways this is handled. It might be at a predetermined or fixed dollar amount set forth in the investment document. It might be at fair market value, as determined by an appraiser, either with or without a discount for the minority nature of the interest.
• Dividend Rights (investor-friendly). Basically, this provides that the investor will earn a dividend on their investment. It attempts to guarantee a return on investment in the amount of the dividend. Generally, these dividends are cumulative, meaning they accumulate from year to year and are paid out at the time of a liquidity event. And they may accrue on simple (more owner-friendly) or compound (more investor-friendly) bases.
• Registration Rights (investor-friendly). This gives the investor the right to, after converting their preferred shares into common shares, have their shares registered with the SEC. Registration, which makes the securities tradeable, could enable allows the investor to force an initial public offering. The timing of the right alters the favorability. An owner-friendly option would only allow conversation from preferred to common following an IPO. A more investor-friendly version would delay the registration rights for a period.
• Right of First Offer (ROFO) (investor-friendly). Think of this as the right to make the first offer to purchase shares from the company or owner. The right always exists and does not need to be triggered. Rather than react to another offer made to the company or owner, the investor is allowed to make a first offer.
• Right of First Refusal (ROFR) (even more investor-friendly). Think of this as the right to match an offer made by a third party to buy equity in the company. The right is triggered when the owner receives an offer from a third party. The investor holding the ROFR then has the right to step in and purchase the shares on the same terms as the third-party offer. This right operates to make a sale to a third party difficult if not impossible. They simply don’t want to spend energy on trying to buy an asset that the prior investor has a first right to.
Difference between a ROFR and ROFO? The right of first offer gives the investor the right to submit the first bid on the sale of stock, and the ROFR gives the investor the right to match a third-party offer made to the owner.
• Co-Sale Right (investor-friendly). This allows an investor to “piggyback” or “tag along” on any sale the owner contemplates. On the same price and terms. The reason this is investor-friendly is that an owner may have a finite demand for the stock and the existence of this right forces all sellers to accept a pro rata sale of their shares. Together with the ROFR, this gives the original investor the right to buy shares before the owner can sell them to a third party. The overall effect is to discourage third-party stock sales.
• Drag-Along Right (investor-friendly). The most investor-friendly version of this allows the investor to force a sale of the entire company.
So, to sell a minority interest or not? There may be a lot of demand and, as a result, the valuation may be attractive. With solid knowledge of terms that may apply and how they operate, an excellent M&A advisor with significant experience negotiating the terms of the transactions, and a premier M&A lawyer who can provide the best articulation of your rights vis-à-vis the rights of your minority investor, this could be a viable alternative to an outright sale.
Traversi & Company is a premier sell-side M&A advisory firm - a boutique investment bank - serving the lower middle market. Visit us here.
