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Private Equity and MBOs

How to Sell Your Business or Attract Equity to Grow Through a Private Equity Buy-Out

Date : March 2014

Author/s : Jeff Mansfield / Kieren Parker

Article 6 of 9 For private business owners or managers looking to sell

their business or a stake in it, or to fund its next stage of

growth, this is the sixth in a series of nine articles which provide a guide to understanding private equity and the

private equity buy-out process.

On-going Involvement as Managers or Owners

Management, sweat equity and sweet equity

A feature of PE investments is the opportunity for management to share in the risk and reward of the

business as equity owners. PE firms reserve a

significant minority stake in the portfolio company to incentivise management and to align managers'

interests with the PE owner. There is no set formula for

the dollar amount that managers are expected to invest, other than it needs to be meaningful in the context of

their personal situation, so that the loss of the

investment would not be a painless experience. (In smaller companies which may not be sizeable enough

to attract PE investment but may attract VC

investment, managers are commonly founders who already own an equity stake, so the dynamics are

probably different.)

The structure of management incentive schemes is

driven to a large extent by tax planning. For example,

schemes may comprise 'sweat equity', meaning ordinary shares in respect of which management pays

fair value, alongside 'sweet equity', meaning

instruments or rights that increase the value of management equity relative to other shareholders,

depending on the success of the investment. Putting

aside their complexity, management incentive schemes can be lucrative, but come with the risk of managers

losing some or all of their 'sweat equity'. They are

discussed further in the summary of common terms in shareholders agreement in Article 8 – Things to Expect

in a Share Purchase Agreement when Selling Your

Company.

The new owners might put in place a second tier

incentive scheme for the level of managers below the

CEO, CFO and other senior executives. Indeed, certain

tax rules encourage broad based employee schemes

which are open to 75% of the employees.

Although the alignment of management with the PE

firm through common ownership is real, it will not

escape managers that the PE firm's investments are diversified across all portfolio companies owned by the

fund, and probably across more than one fund. By

contrast, managers are exposed solely to their own portfolio company, meaning the opportunity to earn

significant wealth comes with a concentrated risk of

loss.

Owners retaining a minority stake

For owners remaining partially invested, the terms of their equity ownership will likely be simpler than

management, reflecting their less active role in the day

to day business. Moreover, depending on the size of their stake and their ongoing involvement, the equity

held by an owner accustomed to control could feel more

like a passive investment. Regardless, a PE firm will see the owner's participation as an important partnership,

which together with management is key to a successful

investment.

Financing Structure

Even after the global credit crunch, PE firms are likely to want to introduce debt to fund the acquisition of the

target company and leverage their own investment. The

appropriate amount of debt will depend upon the nature of the target company's business and its balance

sheet. It will be important to review financial covenants

in any financing documentation to ensure they do not create any undue stress on the target company's

operations.

In addition to debt, PE firms may structure their own

investment as convertible notes or preference shares in

the target company, rather than ordinary shares. It will be important for managers investing in the target

company, and owners remaining as shareholders to

understand the terms attaching to any convertible notes or preference shares.

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Shareholders' Agreement

The shareholders' agreement is one of the foundations

for a prosperous relationship between the new owners.

It establishes the legal framework of that relationship, regulating the rights and restrictions of the parties in

the way the company is run, significant decisions are

made and shares are issued and sold. The shareholders' agreement can also set down markers about matters

such as the business plan and the timeframe to exit.

Like any legal document that supports a good relationship, it will hopefully be put in the bottom

drawer. Much of business life involves dealing with the

unexpected though, such as a need for further capital or a CEO resigning, which makes the shareholders'

agreement an important tool to guide the parties to

deal with the matter without delay and without deadlock, and move on.

A summary of the provisions commonly found in a shareholders' agreement is in Article 9 – Things to

Expect in a Shareholders Agreement for a MBO.

Kieren Parker, Senior Associate

Telephone +61 2 8915 1o13

Email kieren.parker@addisonslawyers.com.au

Jeff Mansfield, Partner

Telephone +61 2 8915 1o16

Email jeff.mansfield@addisonslawyers.com.au

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reproduced, stored in a retrieval system or transmitted without prior written consent. This document is for general information only and cannot be relied upon as legal advice.