8 Legal Points to note during a Liquidity Event

8 Legal Points to note during a Liquidity Event

Flashing back to Part 1, a liquidity event is an exit strategy for investors to convert their equity into cash and occurs when any of the following typical change of control events takes place:

  1. merger
  2. acquisition
  3. sale purchase – part or whole, shares or assets
  4. leveraged recapitalization – debt to finance purchase of equity
  5. ESOP
  6. IPO of a company

The occurrence of liquidation, dissolution or winding up of a company may also be included as a liquidity event.

Continuing on from Part 2: 8 Considerations before the liquidity event, which in summary talked about the below 8 considerations, we now move on to Part 3: 8 Legal Points to note during a liquidity event.

  1. Types of entities involved
  2. Cash receipts or pay-outs
  3. Escrow Consideration
  4. Type of Equity
  5. Value of Equity
  6. Local Laws
  7. Effects on Employment
  8. Tax matters

As if Part 2 were not exciting enough, here is where the real exciting part comes. Here are practical things to take note of DURING the event itself. You’ve flirted ideas with your buyer/investor and finally there is some understanding and mutual agreement after a courtship process.

However, here is where you will need to get really cautious and have a full understanding on what each part means and why it is done. The below is a far from exhaustive list but points out some essential points to note.

 

8 Legal Points to note

 

At the liquidity event itself, the following legal issues should be considered:

  1. Representations and warranties in contract containing the liquidity events that could make or break a deal

Sometimes overlooked as standard clauses, a target is willing to give any and all representations and warranties that an acquirer is looking for. But this could be quite dangerous as the sale and purchase agreement will invariably contain indemnity clauses and this will affect the deal. In a sale and purchase agreement, certain specific representations and warranties are covered within the substantive part of the agreement itself and many so-called standard clauses are covered as an annexure, schedule or attachment to the main agreement. The standard clauses are mostly the sum total of the experiences of professionals and standard templates that have evolved over time. Involvement of local lawyers is required. Misrepresentations could have serious legal repercussions.

 

  1. Covenants (to do or not to do something) and obligations. On pre-closing, closing and post-closing

As with all financial transactions, a buyer would seek to protect his money and delay payment until all conditions are satisfied and a seller would agree to do anything to receive the pay-out at the earliest. Incapacity to pay, failure to fulfil conditions, non-receipt of corporate and statutory approvals are some of the factors where the deals fall through. Post-sale, many negative covenants such as non-disclosure, non-compete, non-solicit and non-circumvention would continue to operate and can operate against the seller/target and affect the future operations of the target.

 

  1. Special rights that are covered in the agreement, such as options, transfer, approvals, put-call, drag-tag along, lock-ins/lock-ups, share-asset price ceilings

Liquidity events call for perusal and scrutiny of past and future contracts for sale and purchase, subscription and shareholders agreements. Many corporate, statutory and regulatory approvals are required. The constitution or articles of the target may also contain special rights of existing shareholders. In some occasions, agreements between shareholders may be privy and enforceable between shareholders and not involve the company. In these circumstances, the company will not be liable for the contract inter se shareholders unless these rights are enshrined within the constitution documents.

 

  1. Indemnification, liabilities and remedies. Who bears consequences

Liabilities and indemnification thereto vis-à-vis the seller are called for misrepresentations and failure to comply with conditions of transfer. Similarly, the buyer can also be liable by forfeiting his deposit at the time of signing a contract as well as be liable for indemnification for non-payment/non-fulfilment of conditions of the contract. Legal liabilities should be monitored during and after the liquidity event.

 

  1. Set offs. Does cash pay-outs or equity issuance create set-offs on price and valuation?

If projections are not met or if conditions fail during the course of a transaction that does not involve a bullet payment, this will affect the cash pay-out as well as issuance of equity. Some events for set-offs in terms of cash and time may be mitigated by force majeure clauses. Even in bullet payments, if negative covenants are violated, the seller can still be dragged into litigation and set-offs may not mitigate the risk.

 

  1. Other contracts relating to or effecting the liquidity event

The occurrence of liquidity events affects many other factors in the target. Investors will seek blanket clauses covering their investment in the present and near future and will look out for other contracts entered into by the target that affect the valuation of the company or its shares. The other contracts would include existing shareholders agreement, deeds of adherence, options agreements, voting agreements, warrants, management agreements, key employee agreements, debt instruments and agreements, share subscription agreements, constitution documents – where the company is bound to do or not do certain acts. Documents such as warrants may also contain provisions for protection when public acquisitions take place. Normally, a due diligence covers these issues. Negligence of a proper due diligence affects the investor greatly rather than the target.

 

  1. Governing law. This is particularly relevant on cross-border transactions

Some countries provide specifically for the place where the cause of action arises and thus bring the parties within that jurisdiction. Some countries may completely ignore the governing law and protect its citizens, individuals and corporates. The governing law also matters as contracts are interpreted differently, whether under civil law or commonwealth law or general law by different countries. There have been instances where the governing law is of a jurisdiction different from the nationalities of both parties.

 

  1. Dispute resolution. Arbitration, mediation or local courts

Alternate dispute resolutions such as mediation, arbitration and conciliation may mitigate consequences when heads of the respective parties meet, but these may be exercises in futility. Where the parties are from different countries, treaties between the countries where the parties reside will dictate whether a judicial order passed can be enforced against the penalized party. Many parties settle for international arbitration which can be slightly more expeditious than established court systems. This is because arbitration takes only a particular matter into consideration whereas the courts have to handle all matters relating to its jurisdiction.

Stay tuned for the LAST part of the series: 8 Points on Initial Public Offerings

For partnerships, speaker and general business enquiries with 2iB Partners:

Contact Person Dylan Tan
Designation COO
Email Dylan@2ibpartners.com

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8 Considerations when Preparing your Company for a Liquidity Event

8 Considerations when Preparing your Company for a Liquidity Event

Liquidity events are usually an exciting and most looked forward to event in the business cycle. For some it means injection of new growth capital, for others it means cashing out their multi-million dollar exits. While it is certainly an event to look forward to, it is also something that should be planned towards.

Flashing back to part 1, a liquidity event is an exit strategy for investors to convert their equity into cash and occurs when any of the following typical change of control events takes place:

  1. merger
  2. acquisition
  3. sale purchase – part or whole, shares or assets
  4. leveraged recapitalization – debt to finance purchase of equity
  5. ESOP
  6. IPO of a company

The occurrence of liquidation, dissolution or winding up of a company may also be included as a liquidity event.

Here are 8 Considerations in the preparatory stage:

 

8 Considerations

 

Types of entity involved – company, trust, JVs. Regulation in cross-border related events.

Far as regulations are concerned, foreign direct investment regulations play a role in control over the target as well as limits on the amount of investment. Some countries place a particular valuation method over others and these will have to be adhered to. Compliance and recognition of an entity within the books of the target regarding the transactions would vary depending upon the type of entity. If a branch office of an acquirer is involved, there would be other considerations.

 

Cash Receipts or Pay-outs: in full or instalments. Earn out provisions. Shares or assets.

If the liquidity event amount is low or the target’s financial statements readily manageable, it could mean a bullet payment of a cash transaction. However, if the valuation is high, the pay-out may be partly in shares or partly in cash. The cash to be paid out will be based on performance and milestones achieved by the target over a period of time. This tends to keep the founder in place for an extended period and limits risk for the investor. If payment is made over a given period and liabilities emerge, the cash consideration could be affected as indemnities would kick in. A public company divestment or sale would result in a direct cash transaction with direct market price without valuation asymmetry.

 

Escrow consideration

One of the biggest considerations for the target is completing the transaction in the minimum time frame. An acquirer may make an offer out of belief that the transaction would pay for itself, and the question of whether the acquirer pays on time or has the capability to pay is relevant. Post-transaction, it would be difficult for the target to roll-back. Setting up an escrow or obtaining bank guarantees would be a way to offset the risk to the target. However, this may meet with resistance as no party would like to tie up their funds over a period of time where it can be put to other use. Many acquirers would also leverage the same funds by committing to different projects at the same time.

 

Type of equity. Voting provisions, restrictions in transfers, convertibility

Some liquidity events involve ordinary share transactions and some preference share transactions or a combination of both. The transactions may also be in the nature of bonds and convertible instruments. These shares may carry different voting rights. Some are compulsorily convertible at a given period and some indefinitely – meaning over a long period of time. Some countries may have restrictions on different classes of shares and shares carrying different voting rights. Targets may convert shares into one class before triggering a liquidity event. The manner of shareholding in private companies would be governed by documents such as shareholders or subscription agreement.

 

Value of equity. Volume weighted average if listed company

Valuations of shares may vary. Some of the methods are: Asset pricing (intrinsic value) – which are based on the real value of the assets; market value basis (yield basis or earning capacity) – where the effective rate of return on investment in terms of a percentage is taken into consideration; fair value basis – the mean of intrinsic value and yield value; return on capital – where predetermined or expected rates of return are applied; price-earnings ratio – the ratio of the market price of the share to earning per equity share; DCF – discounted cash flow where discounting of the profits (dividends, earnings, or cash flows) of the shares in the future and a final value on such disposal. In the case of listed companies, some use a fixed period volume weighted average of the existing share price and add a premium to it to make a public offer or tender. Goodwill is a factor that needs to be factored in while calculating the cost of equity. Much consideration may be swept under the goodwill valuation.

 

Local laws governing payment and transfer

Foreign direct investment or FDI regulations play a role in contracts for sale and purchase of shares involving different countries. It also addresses control over the target and limits on the amount of investment. Some regulations stipulate the valuation methods used. Compliance with registration of new owner and the type of entity would vary. For instance, some jurisdictions do not recognize trusts and only its trustees. While some countries may permit compensation for projected loss, others do not. Different countries also have different treatments on law and tax involving future equity, restrictions on different classes of shares and shares carrying different voting rights.

 

Effects on employment – local and international in cases of cross-border related events

Acquisitions on occurrence of liquidity events must take into consideration the effect on employment within the target. Post-acquisition may result in less than desirable effects on the economics and hence post-valuation of the company itself. In addition, effects on employment may hinder the liquidity event especially when trade unions are involved. Many governments take special care to see the labor market is not affected and this in turn affects the liquidity event.

 

Tax matters – double taxation in cases of cross-border related events.

During the sale of shares, taxation may be a driving factor for the type of shareholder who may be a trust, a listed company or as in the US a C-Corporation or an S-Corporation. Similarly, purchase may be made by a similar entity. In some cases, a joint venture may attract different tax considerations. Further, consideration should be given to double taxation avoidance agreements where tax paid in a country can be offset or credit claimed in the home country.

 

Stay tuned to Part 3: 8 legal points

For partnerships, speaker and general business enquiries with 2iB Partners:

Contact Person Dylan Tan
Designation COO
Email Dylan@2ibpartners.com

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8 Steps to Preparing your Company for a Liquidity Event

8 Steps to Preparing your Company for a Liquidity Event

This is part 1 of 4 of an introduction to Preparing your Company for a Liquidity Event:

  • 8 Step Preparation
  • 8 Considerations
  • 8 Legal Points
  • 8 IPO Points

What is a Liquidity Event?

First and foremost, a liquidity event is an exit strategy for investors to convert their equity into cash and occurs when any of the following typical change of control events takes place:

1.      merger

2.      acquisition

3.      sale purchase – part or whole, shares or assets

4.      leveraged recapitalization – debt to finance purchase of equity

5.      ESOP

6.      IPO of a company

The occurrence of liquidation, dissolution or winding up of a company may also be included as a liquidity event.

This is usually an exciting and most looked forward to event in the business cycle. For some it means injection of new growth capital, for others it means cashing out their multi-million dollar exits. While it is certainly an event to look forward to, it is also something that should be planned towards.

Here are 8 steps that should be considered in the preparatory stage:

8-Step Preparation

Determine the team that will be involved in the transaction as well as the effect of laws and business in cases of cross-border related events. Apart from conducting an internal due diligence and legal audit which would help in sanitization and preparation, the following steps may be considered while preparing for a liquidity event.

1. Notes

Depending upon the type of liquidity event, the document providing for the liquidity event such as convertible notes, instruments for future equity, share purchase or stock acquisition agreements, funding and investments agreements should be reviewed. Any action needs to be sanitized before occurrence of the liquidity event.

It is also highly important to note where the important clauses are in each of these contracts and how they can be manipulated.

E.g:

Sample Liquidity Event Clause in a Share Purchase Agreement:

Upon the occurrence of a Liquidity Event (as hereinafter defined), the Borrower shall prepay the outstanding Principal Amount of all Notes in accordance with the redemption prices (the “Mandatory Redemption Prices”) set forth below (expressed as a percentage of the outstanding Principal Amount being prepaid), together with Interest accrued and unpaid on the outstanding Principal Amount of the Notes so prepaid through the date of such prepayment and reasonable out-of-pocket costs and expenses (including reasonable fees, charges and disbursements of counsel), if any, associated with such prepayment.  If a Liquidity Event shall occur during any Loan Year set forth below, the Mandatory Redemption Price shall be determined based upon the percentage indicated below for such Loan Year multiplied by the Principal Amount which is being prepaid.  For the purposes hereof, “Liquidity Event” means (i) the occurrence of a Change of Control, or (ii) the liquidation, dissolution or winding up of Parent or Borrower or of one or more of Parent’s Subsidiaries that, individually or in the aggregate, constitute a material part of the business, operations or assets of the Credit Parties and all of their respective Subsidiaries, taken as a whole.

2. Valuation

Obtain company valuation, of shares or assets, around liquidity event for negotiation. Many good deals fall apart due to unrealistic expectations of founders. While you cannot have unrealistic expectations, you shouldn’t have one that is too low either. In negotiations, it is always helpful to have an independent 3rd party valuation.

3. IP Portfolio

Identify and register all IP of the company, obtain licenses, review licensed products. Having an independent IP valuation would also help in the negotiation process since it is always cause for price differences.

4. Finance

Appointment or change in financial management. Exchanges in different countries will have different requirements for financial managers.

5. Audit

Conduct an audit to analyze revenue recognition and depreciation and amortization policy. Exchanges in different countries will have different requirement for audits.

6. Corporate & Contractual Compliance

Updating and review of minute books, confidentiality or non-solicitation or non-compete contracts, book of contracts, corporate records, accounting records, ESOP, third party consents.

7. Statutory & Regulatory Compliance

Updating of approvals and licenses, company law authority reporting, employment law compliance and tax compliance.

8. In-house counsel

In-house counsel will assist in controlling cost and preparing documentation as well as avoiding pitfalls. While most see the role as an additional cost centre, this may prove untrue. An in-house counsel knows exactly which areas to concentrate on, the right questions to ask and the right people to approach. On the broader scale, this would result in less time spent and lesser cost attached.

Stay tuned to the next few parts!

If you would like to learn more about Preparing your Company for a Liquidity Event, we are holding a 4-hour Masterclass on the 13th of November, 2017 at Singapore Business Federation Centre.

 

Early Bird discount available till 4th of November, 2017!

Click on the below to find out more!

For partnerships, speaker and general business enquiries with 2iB Partners:

Contact Person Dylan Tan
Designation COO
Email Dylan@2ibpartners.com

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read more

Why M&As Go Wrong

Acquisitions that are rushed can result in problems and challenges after closing in a transaction: Some of the reasons why M&As go wrong are:   1. Assumption Asymmetry Leaders and owners may over value a target by making assumptions including...

read more

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