Apr 01, 2015
From the Audit Committee Institute
Board Perspectives Series
At 275 new issuances, initial public offerings in the U.S. hit a 14-year high in 2014. Dollars and deals were also flowing in a revived M&A market. As a private company director and shareholder, such activity is difficult to ignore.
But putting the company in play—either to meet financing needs or manufacture investor liquidity—can take a toll on the business. At the extreme, the ongoing scrutiny and disclosure requirements of being a public company are very real. Yet, with more than $1 trillion in global private equity funds available and public corporations sitting on record levels of cash, there’s no lack of available financing for private company transactions.
Alternative transaction options—raising debt or equity, selling outright to a financial or strategic buyer, or even engineering an internal buyout—have their own pitfalls and specific implications for governance and the relationship between the board and its stakeholders. Among them include valuation and collateral, proper consideration for minority investors, earn-outs and incentives for management, the level of financial information disclosure, the sturdiness of key contracts and growth projections, and debates over long-term strategy.
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Finding an optimal path requires coordination on the part of directors, managers, and shareholders to design a transaction that facilitates the best possible outcome for the company. (D&O liability claims by minority shareholders are becoming more common, but only 28% of companies with revenue under $100 million hold D&O insurance, according to a 2013 study by Advisen and AIG.)
While a virtual queue of advisors is ready to assist the board and management on transaction structure, the board itself needs to consider the governance implications of liquidity alternatives.
In raising debt, shareholders see no dilution, but junior lenders can include warrants to sweeten the rate. Does the board have the authority to include equity-like kickers? Pitfalls here include negotiating covenants, additional reporting requirements, and the potential for an audit. This capital market has also seen the entry of non-traditional lenders to private companies—sovereign wealth and pension funds, hedge funds, and online platforms.
Raising minority equity is an attractive option for controlling shareholders, particularly to fund smaller buyouts, but comes with the challenges of a weak hand. Minority investors may attach a liquidity preference in the event of a full sale that would tilt the economics their way. In terms of governance, what rights or board representation would the minority investor receive, particularly if their liquidity preference is different? Often a minority buyer will also target a lower valuation than one for the whole business.
The sale to a financial buyer through a majority stake will focus a fine lens on management, and indeed the company’s entire operations. They will be keen to adjust the board, shift strategy and management, and their own exit. A full-scale sale to a financial buyer can result in a richer valuation, even approximating public market valuations, depending on the industry. Strategic investors can also bring full valuations, but directors must be clear on whether the synergies can truly be realized if shareholders (and management) are offered equity and earn-outs.
Funding a partial or full management buyout or the gradual sale to an employee stock ownership plan introduces even more complex tax implications and ERISA concerns (for an ESOP). Here, directors and management need to consider whether internal funding is possible and to what extent the board itself would need to integrate the emergent ownership class.
While capital is flowing, shareholders can get excited about the opportunity to take some money off the table, but directors must always be mindful. They have an ongoing duty to shareholders and the company throughout the transaction process.
KPMG Corporate Finance contributed to this article.