What to Expect If a Private Equity Firm Acquires Your Company
Holland & Knight LLP
September 10, 2009
William Mutryn- Northern Virginia
Marisa C. Terrenzi- Northern Virginia
Even in today’s down economy, M&A activity remains robust in the defense and government products and services industries – although there is not as much activity as there was in 2007 and the start of 2008. Despite the economic downturn, in addition to strategic buyers, more and more private equity firms are seeking investment opportunities in government contractors located in the Greater Washington Metropolitan Area. So if you are a seller, what should you expect if you agree to be acquired by a private equity firm? The following are seven key areas that you can expect to be part of the acquisition process.
- Leveraging. Although there are exceptions to the rule, private equity firms usually leverage their target companies to the maximum extent permitted by lenders in order to enhance the probability of achieving their targeted returns.
- Senior Bank Financing. In today’s market, such leverage might be in the range of 2.5x to 3.0x of the target company’s 12-month trailing EBITDA. Due to the current credit crunch, private equity firms face challenges in obtaining bank financing. More transactions than usual fell apart in 2008 and the first part of 2009 due to private equity firms being unable to secure adequate bank financing of their proposed acquisitions.
- Mezzanine Financing. Private equity firms attempt to obtain additional financing subordinated to the bank (senior) loans which usually requires higher interest rates (which in some instances are accrued) and warrants.
- Seller Financing. Private equity firms may request that the target company owners accept payment of a portion of the purchase price by promissory note. Any such promissory notes would be unsecured and subordinated to any bank financing of the transaction and the target company. The target company owners usually attempt to negotiate for certain minimal financial covenants to be included in any such promissory note(s), such as maximum senior debt incurrence levels. Such promissory notes are normally paid in full upon a refinancing, sale of the company, or by such other agreed upon maturity dates.
- Roll-over Equity. Private equity firms generally expect that all or some of the owners of the target company will accept equity of the acquiring company as partial consideration for the sale of the target company. Such owners may be required to “roll over” anywhere between 10% and 40% of their equity into the acquiring corporation.
- Tax Treatment. As a selling owner, the structure of any roll-over equity transaction should be considered carefully. The selling owner may receive some cash for his or her target company shares (which would be taxable as capital gains) but then be required to pay taxes on the fair value of the roll-over equity – leaving less cash left over for the selling owner after the acquisition. In some circumstances, it is possible to structure the transaction on a tax-deferred basis so that the selling owner would not pay taxes on the receipt of the roll-over equity, deferring taxes until a subsequent liquidity event. The selling owners’ accountants and tax attorneys should be involved in the process as early as possible to ensure such issues are considered when structuring the transaction.
- Preferred Versus Common Stock. Private equity firms may hold preferred stock or common stock in the acquiring company. In some transactions, the selling owners receive the same equity as that held by the private equity firms; however, private equity firms may hold preferred stock and then expect the selling owners to hold a junior preferred stock or common stock. Preferred stock may carry dividends, a liquidation preference, rights to convert to common stock, special voting rights and other preferential rights. Private equity firm transactions vary greatly. It is very important, as a selling owner who will receive roll-over equity, to understand the distinctions, if any, between the different classes of equity to be issued by the acquiring corporation to the private equity firm and the selling owners.
- Shareholder Rights. Since the selling owners will be minority owners of the acquiring company, it is important to understand what type of shareholder rights and restrictions will be attached to the roll-over equity. Typically, some of these rights and restrictions are the following:
Rights:
- Preemptive rights (rights to purchase additional shares in future equity issuances, subject to customary exceptions)
- Registration rights (if the acquiring company goes public, the right to sell the roll-over equity on registration statements effected by the acquiring company)
- Tag-along rights (right to participate in liquidity events initiated by the private equity firm/controlling shareholders)
Restrictions:
- Equity transfer restrictions (subject to estate planning exceptions)
- Company repurchase rights if a manager-owner ceases his or her employment relationship with the acquiring company or its affiliates
- Drag-along rights in favor of the controlling shareholder (the controlling shareholder having the right to require all other shareholders to participate in a liquidity event initiated by the private equity firm/controlling shareholders)
- Management Fees. Private equity firms may receive a transaction fee upon closing of the transaction and also may receive annual management fees or advisory fees for add-on acquisitions, paid by either the target or the acquiring company. For middle market transactions, transaction fees generally can be as low as 0.20% and as high as 3%. Management fees tend to be based on the target company’s size but for middle market companies may range between $100,000 to $3 million per year. Also, after closing, the target company would normally pay the attorneys' fees of the private equity firm.
- Management/Chemistry With Partners. As a manager-owner who will have "skin in the game" for years to come, chemistry with the private equity firm partner is very important. Prior to completing a deal, a manager-owner should perform some of his or her own due diligence which should include talking to other portfolio companies of the private equity firm. Will the private equity firm be hands-off or hands-on with respect to day-to-day management? Will the firm want to put in place its own selected executive team or keep the existing management team in place? Will the target company serve as a platform for future acquisitions or is the target company a complementary acquisition to the private equity firm’s existing platform company? How will future acquisitions affect the ownership percentage of the manager-owner’s roll-over equity?
- Management Incentive Plans. Private equity firms seek to align management’s interests with their own, so they also will put into place management equity incentive plans. Such plans may include the issuance of restricted stock, phantom stock, stock appreciation rights or options. Such plans may constitute between 10% and 20% of the outstanding equity of the acquiring company, on a fully diluted basis. Any grants to executives under such plans are generally subject to vesting over three to five years.
- Employment Agreements and Non-competition Covenants. Private equity firms generally expect key manager-owners to enter into employment agreements with longer terms (e.g., three years) than what would be expected by a strategic buyer (e.g., one to three years). In addition, as with any acquisition transaction, selling owners and key managers would be expected to enter into non-competition and non-solicitation covenants.
- Government Contractor With Facility Security Clearances and Private Equity Firms With Foreign Ownership. If the target company is a government contractor with a facility security clearance, such target company needs to be concerned about the National Industrial Security Program foreign ownership, control or influence (FOCI) requirements. Therefore, the percentage of foreign ownership of the private equity firm and the citizenship of those individuals it intends to appoint to the board of directors become important considerations for the deal. The target company may need to put in place a FOCI mitigation plan as part of the transaction, obtain CIFIUS approval and Defense Security Service (DSS) consent.
Protecting Your Interests
Acquisitions by private equity-sponsored firms are becoming more frequent. Owners contemplating a sale would be well served by having, very early in the process, discussions of their goals and structuring objectives with legal, tax and financial advisors who are experienced in transactions involving private equity firms.
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