Key Issues When Considering A Growth Equity Investment
For both maturing companies and investors, a growth equity investment presents a variety of opportunities. For companies, a growth equity investment is an opportunity to grow, restructure or enter a new market while maintaining control over vision and strategy. For investors, growth equity presents an opportunity to own a portion of a profitable, growing company with generally moderate risk.
We have outlined some key considerations when considering a growth equity investment and how different types can be used in different situations.
Identify The Purpose And Structure
It’s essential to understand the motivation and purpose of any growth equity event. Companies should also identify where the new money will sit in its capital stack as well as any related governance rights. Additionally, it is important to lay out indemnification terms and remedies, identify any need or desire to use debt, and address any new tax considerations.
Here are some common types of growth equity structures:
Recapitalization Type 1 – Partial Redemption
- This structure can be used for majority transactions but is more commonly seen in minority investments by a private equity fund to provide some liquidity for founders and existing stockholders.
- A private equity fund puts money into a target company in exchange for shares of convertible preferred stock.
- Equity proceeds (and debt proceeds if the deal is leveraged) are used to redeem shares from target company’s existing stockholders to get to the desired post-closing capitalization.
Recapitalization Type 2 – Partial Cross Purchase
- This structure is best used when a traditional redemption does not have the desired tax outcome for selling stockholders.
- The target company declares a pro rata stock dividend of tax common preferred shares on the outstanding common shares and existing stockholders, then sells the preferred shares directly a private equity fund.
- Determine whether dividend will be tax-free for existing stockholders and ensure that existing stockholders sell the newly distributed preferred shares.
- Alternatively, a private equity fund purchases common shares directly from existing stockholders and later exchanges common shares for newly created preferred shares.
- The target company stockholders exchange a portion of their shares of target for shares of one or more classes of the holding company's capital stock.
- Rollovers allow the buyer to set up a classic leveraged buyout (LBO) structure (parent holding company and subsidiary operating company) for debt and other financing purposes.
- Rollovers in most situations (that are not “add-on” deals) can be done on a tax-deferred basis.
- Keep in mind that there can be no tax-free rollover with respect to the use of straight (or non-qualified) preferred shares.
No matter which structure a growth equity investment takes, there remain several considerations. Companies need to address board and committee representation, codify transfer restrictions and liquidity rights, outline protective covenants and blocks, and identify other customary rights.
All parties to a growth equity investment should also check with legal counsel to determine whether state or federal securities laws dictate or require amendments to the general approaches outlined above.
Finally, companies entering growth equity investments must address indemnification and remedies. These include identifying “From whom, to whom, for what…”, defining losses (actual, direct versus other damages), and how they are calculated and ultimately settled.