May 09, 2017
As family offices trend toward direct private investments, it is important to consider minority protections and exit options in the context of investment negotiations. Direct private investments often mean greater control over investments, but require negotiated protections in order to ensure that partners or controlling shareholders do not prejudice minority investments by family offices. Further, while fund investments have a specified timeline for the return of capital to investors, family offices typically are not constrained by artificial investment horizons and as a result must also consider exit options adapted to their investment philosophy.
Recent trends indicate that family offices (whether single-family or multi-family) have begun shifting their investment focus to direct private investments and away from investing in private equity funds, hedge fund investments, funds of funds and asset managers. As family offices have grown and become more sophisticated, they have sought to replace fund investments with direct investments in private companies, seeking higher returns, lower fees and more control and transparency over investments. Beyond sourcing and valuing investment opportunities, assuming such direct investments do not result in voting or management control for the family office, it will be important for family offices to consider: (i) how they can best protect themselves and their investments vis-a-vis their investment partners, which may include other family offices, and (ii) exit options for these direct investments. This paper examines a number of minority protections and exit options that should be considered by family offices in this context.
Minority protections are important considerations for family offices, as they often invest as minority or joint venture (JV) shareholders and may not have voting or management control over the organizations in which they invest. While there may be certain minority protections available by law, depending on the jurisdiction in which the investment target is incorporated or organized, meaningful minority protections should be added as a matter of contract under investment agreements, shareholders’ agreements or joint venture agreements. These sorts of agreements establish how the shareholders or partners will work together and set the ground rules for their relationship. Family offices should consider including the following minority protection provisions when negotiating these agreements:
1) Corporate Governance Provisions—Depending on the structure of the investment made by a family office, there may be various levels of corporate governance to consider. If a family office makes a direct investment in an operating company through a minority interest, then there is only one level of corporate governance that will be of concern (that of the investee, the operating company). If, however, a family office makes an investment in an operating company through a JV or strategic partnership with another investor (e.g., a holding company or special purpose vehicle), then corporate governance at the JV level should also be taken into consideration.
a. Board Seats—Often, with direct investments of 5% or more, investors may negotiate for the ability to appoint or recommend members to the board. The number of seats over which the investor has such rights may increase based on the relative size of the investment.
b. Veto Rights and Supermajority Voting Requirement—Veto rights and supermajority voting requirements (both at the board level and at the shareholder level) allow a minority investor to protect its investment by preventing a majority shareholder or controlling interest from making decisions that may not be in the best interests of minority investors. Generally, veto rights and supermajority voting requirements will not apply universally to all decisions (especially decisions made in the ordinary course of business). Typically, they cover significant situations such as the sale of the company or a substantial portion of its assets; amendments to incorporation documents and by-laws; the issuance of capital stock; the incurrence of indebtedness; or the pledging of company assets to secure the incurrence of indebtedness.
2) Preemptive Rights—Preemptive rights allow existing investors to subscribe their pro rata share of new capital stock, thereby protecting them against dilutive equity offerings.
3) Restrictions on Transfers of Equity Interests—Depending on the circumstances, minority investors will seek protections to ensure stability in the shareholding of the company.
a. Lock-up Provisions—It may be important for minority investors to lock-up controlling/operating shareholders or partners and key management in order to prevent them from immediately selling their interests and exiting the company, which would leave minority investors with an operating company with no management or operational expertise.
b. Additional Transfer Restrictions—Equally important, a minority investor may have invested partially on the basis of the relationship developed with the controlling shareholder, and it may want to prevent sales (or significant sales) that may (substantially) transform the composition of the shareholder group. Naturally, controlling shareholders may also seek to restrict sales by minority investors.
c. Rights of First Offer and First Refusal—In closely held companies, rights of first offer and first refusal are often used to regulate sales by minority shareholders. These rights give the controlling shareholders the right to either make an offer to purchase shares that a minority shareholder wishes to sell or to match the price offered by a third party to the minority shareholder. It is crucial to negotiate clear rules applicable to these mechanisms.
d. Tag-along Rights / Drag-along Rights—Tag-along rights allow a minority investor to exercise an option to “tag along” with the sale of another shareholder’s stake (generally a majority investor). This option will usually require that the tag-along must be on the same terms and conditions as those of the initial selling shareholder. Conversely, “drag-along” rights allow a majority shareholder to sell all of the company to a third party by forcing the minority shareholder to sell on the same terms and conditions.
4) Jurisdiction, Governing Law and Dispute Resolution—Minority shareholders need to consider the reliability of the legal system of the jurisdiction of the company in which they plan to invest, and if necessary choose to seek that an alternative law (e.g. New York law or English law) govern the investment agreements. In appropriate circumstances, arbitration outside of the jurisdiction should be used to resolve disputes.
While family offices are likely familiar with initial public offerings (IPOs) and sales to third parties as exit options for their minority equity investments, there are certain contractual provisions that may be helpful in protecting or providing for exit rights, which are discussed below:
1) Registration Rights and Valuations—Investors in private direct investments often look to IPOs as good exit options. To this end, investors making private direct investments may wish to negotiate registration rights allowing them to piggy-back on any primary offering of shares by the company. Minority investors may also wish to negotiate contractual provisions allowing them to require the company to engage an investment bank and complete an independent valuation in the context of any potential public offering of shares in order to “force” an IPO.
2) Put Option—Put options allow investors to protect the value of and exit their investments when other liquidity options fail. Generally, put options are subject to certain trigger events or only exercisable upon the lapse of a certain amount of time, and will set forth a formula for the calculation of the put price payable by the remaining shareholders or joint venture partners to the exiting investor or controller.
3) Redemption Rights and Liquidation Preferences—Applicable only to preferred stock investments, mandatory redemption and liquidation preference provisions allow preferred equity investors to force a company to repurchase an investor’s preferred equity. Redemption rights may be optional or mandatory, and usually apply only after the lapse of a certain amount of time. Liquidation preferences give preferred equityholders a preference right based on a certain formula payable upon the occurrence of specified liquidation events with respect to the company, such as a bankruptcy or reorganization. Normally, liquidation preferences are set at the rate of the initial investment, but other formulas may be negotiated, including the ability to participate ratably with common equity in any remaining distributions following the payment of the liquidation preference.
4) Tag-along/Drag-along—The tag-along and drag-along rights described above are equally important in consideration of exit strategies.