The lack of active pursuit by a company’s management to create an exit can pose a major problem for investors. There are however various ways in which investors can force an exit. Maurits Bos, partner at law firm Benvalor, explains the methods most commonly used.
Investors and founders will generally both wish to work towards a successful exit of their company. Especially when the company has a nice exponential growth curve and lucrative exit opportunities arise. Unfortunately, not every startup follows this much desired growth pattern.
Some companies go bankrupt and some will show only moderate success. In the latter scenario, this may result in founders being less inclined to look for exit opportunities in advance. Instead they’d rather opt to keep things going a bit longer, in order to achieve the dreamed exit-scenario in a later stage.
The lack of active pursuit by a company’s management to create an exit can pose a major problem for investors. This is especially true for investors operating in an investment fund, since these funds are usually set up with a limited life span and need to be dissolved upon expiry of the fixed term.
In order to apply to this, the fund-managers need to divest the funds’ assets and distribute the proceeds to the funds limited partners. Hence, one way or another, they must sell their investments.
There are various ways in which investors typically to force an exit as and when they want. I will explain a few of the most commonly used methods below.
One way of facilitating an exit is to insert an obligation for the founders of a startup to work towards an exit after expiry or a certain period (usually between 5 to 7 years, callled the ‘Exit Horizon’). In the mildest form, this clause entails ‘reasonable efforts obligations’ for the management (and the founders) to strive for an exit within expiration of the Exit Horizon.
Since this is a relatively vague obligation, unless management obviously frustrates the exit plans, it will be difficult for the investor to actually force an exit or claim that this clause is being breached.
Clauses with more severe obligations may force the founders/management to engage a corporate finance advisor to orchestrate and facilitate the sale of the company. And to oblige the founders/management to use their best efforts to facilitate, and fully cooperate with, the sales process and the related due diligence.
In the event that the management does not provide sufficient cooperation with the sales process (at the investor’s discretion), the investor may also be granted the right to replace the management and install more motivated directors to effectuate the exit take point in the sales process.
Dragging founders out
Drag along rights are typically granted to shareholders representing a (super)majority of the shares in a company. When making use of the drag along right, the majority is generally able to force the other shareholders to co-sell their shares (and hence effectively drag them out) to a prospective buyer who wishes to acquire the entire company.
Thresholds (only against a higher valuation than the one against which the investor invested) or restrictions in time (only after x years) are often agreed upon and need to be passed before being able to enforce the drag-along in respect of the investor.
Investors however also often use the drag-along mechanism to be able to force an exit, usually after expiry of a certain period of time. If for instance the agreed Exit Horizon is exceeded without an exit having occurred, the drag along arrangements may pertain that the investor is then able to exercise the drag along right on its own in order to force the exit.
In order to protect the founders, certain limitations can be implemented. Like a minimum valuation that is required for the investor to be able to trigger the drag along right. Or the clause initially only being enforceable in the event of under performance of the business plan or requiring at least one or more other shareholders to agree.
In addition, for the founders it is desirable to try and include a mechanism that gives them the right to buy out the investor before the investor is able to force them out by using the drag-along mechanism. This could be done in the form of a right of first refusal (rofr). This entails that if the investor has found an interested third party to buy all shares and effectuate the drag along right for, the investor has to offer the founders the opportunity to purchase the shares against the same price and terms as agreed with the prospective buyer.
This means that the investor will have to disclose to the prospective buyer that once a principal agreement has been reached (and quite some costs and time will have been spent by the prospective buyer), he will first have to go back to the co-shareholders to give them the chance to match the prospective buyer’s offer. This is generally undesirable for the investor, given that he will potentially not be able to finalize a deal after having invested time and money. This consequently may scare-off prospective buyers. Giving co-shareholders a rofr will therefore often be fiercely contested to by investors.
An alternative that is less controversial to investors, and may be easier to negotiate for founders, is a right of first offer mechanism. This entails that if the investor wishes to force an exit by using the drag along right, the founders/co-shareholders are the first to be granted the opportunity to make the investor an offer (rofo) (or that the investor will have to present the co-shareholders with a proposal containing the price and terms against which it is willing to sell its shares). If the offer is not accepted, the investor is free to offer its shares to a third party and exercise its drag along right, provided the offer is better than the refused offer pursuant to the rofo-right.
Redemption rights grant the investor the right to require the company to repurchase the investor’s shares and hence give the investor an exit (again often enforceable after the Exit Horizon has been exceeded). The redemption price is often equal to the agreed liquidation preference, including accrued and unpaid dividends. But other redemption prices are also used (for instance a multiple of the liquidation preference, a fair market value notion, or the original purchase price plus a fixed annual percentage). Generally speaking the returns for an investor when enforcing redemption rights will be less spectacular, but it gives the investor a way out in the event it is running out of time.
A growing company is unlikely to have the cash required to meet the redemption. The company will then not be able to repay the investors when they exercise their redemption rights. In such a scenario, the redemption clause will primarily function as an instrument to force the management to pursue an exit on a short notice. This may again result in a forced sale of the company or (part of) its assets. From the point of view of the company, mandatory redemption clauses are highly unattractive. Obviously, the exercise of a redemption clause may be the cause of a fierce clash between the founders and the investors.
Attention should also be paid to the limitations imposed by Dutch law. Restrictions apply to the redemption of shares which in short entail that the board of the company cannot resolve to effectuate a redemption of shares if either (i) the equity position of the company prohibits redemption or (ii) the company will not be able to meet its payment obligations in the foreseeable future as a result of the redemption.
These requirements are created to protect creditor’s rights in the case of a repurchase of shares by the company. An alternative for a redemption clause is to have the founders grant the investor a put option, under which the investor can sell its shares to the founders in the same manner as set out above. Thus, while not technically repurchasing the shares, the same effect can largely be achieved.
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