Following the high-profile success of some emerging, fast-growing companies, particularly in the technology sector, the last decade has seen an upward trend in growth equity as a distinct asset class.
Growth equity is a form of investment where an investor acquires a stake (often a significant minority shareholding) in a developing private company in order to finance its accelerated growth. This gives the investor exposure to potentially significant upside.
In contrast to traditional early-stage start-ups, growth equity targets typically have pre-established business models, constituting an attractive opportunity for investors wishing to mitigate some downside risk while potentially realising higher returns than what may be possible in more mature private equity buyouts.
We continue to see different types of sophisticated investors analysing potential investments in private emerging companies, including private equity firms, mutual funds, sovereign wealth funds, family offices and, increasingly, hedge funds. To successfully navigate and execute such a transaction, however, it is critical to balance investors’ usual requirements with the expectations and needs of the target company and its founders.
Traditional private equity investors and other institutional investors are accustomed to securing a robust exit framework – and overall control – from the outset of their investment. As some sophisticated investors increase their allocations to growth equity and adapt to being minority investors, an alternative approach to exit strategies is required.
“Growth equity targets constitute an attractive opportunity for investors wishing to mitigate some downside risk while potentially realising higher returns”
There are four major terms that could be negotiated in relation to a growth equity exit strategy. The first is a hurdle rate, or exit consent rights: depending on when in the target’s life cycle the investment is made, a strong minority investor may be able to negotiate a consent/blocking right if the exit price or their anticipated return is below a certain pre-agreed threshold and/or deemed too early (eg, if they cannot sell to a third party for less than X price before Y year without investor consent, or an IPO has to constitute a ‘qualified IPO’ where a minimum value has been pre-agreed).
The second is redemption rights, or put options. While relatively rare, we do see some situations where an investor’s investment includes a redemption feature (whereby the company must buy back the investor’s interests) or a put option (allowing the shares to be sold to the majority shareholders) upon the occurrence of certain events, including if, for example, there has been no exit after X years. The formula for calculating the relevant price can often lead to extensive discussions.
Third is drag-along rights. Though relatively unusual in minority investments, strong investors may be able to secure drag-along rights to trigger the sale of the company in certain agreed scenarios. This is a challenging path to take, however, as founders will likely be reluctant to give up such control. More commonly, minority investors will be able to secure tag-along rights, enabling them to participate in certain share sales by a specified majority.
Lastly, private equity investors often include a general exit intention clause in the investment documentation. Although these clauses are unlikely to be legally enforceable due to uncertainty, they may at least carry some moral force and set out the parties’ general intent from the outset.
Protections in place
As well as having some form of exit strategy in place, growth equity investors may push for shareholder rights and protections that are broader than typically seen in minority investments. For example, in the event of a significant underperformance against the agreed business plan (with different negotiated metrics), certain investors may seek terms to ensure that, in the event that any such underperformance is not resolved satisfactorily, each party shall have the right to request a full or partial replacement of the management of the company.
Another example is priority economics: significant investors will typically negotiate a liquidation preference where they are entitled to receive the return of their investment (along with any accrued but unpaid dividends) or a fixed multiple of their investment before the holders of common stock or other junior securities receive any liquidation proceeds.
Certain investors may argue, particularly where there is disagreement on the valuation, for dividends on preferred stock issued in a minority investment to also be participating (eg, with the right to share on a pro rata and as-converted basis in any dividends declared and paid on the common stock). However, participating rights are becoming less common in competitive investment rounds.
There may also be certain restrictions on any third-party transfers, often linked to timing, processes or the identity of the transferee. The growth equity investor may wish to lock up key management or other shareholders for a fixed period and prevent them from exiting the business. This can be critically important, particularly in sectors requiring deep operational expertise.
Lastly, there is the issue of reserved matters. The content of these can often be heavily negotiated and can encompass a wide variety of topics, including future financings, M&A activities, incurrence of indebtedness, appointments/removals of management, affiliated transactions, budgets, amendments to the business plan, and initiation or settlement of material litigation. There are also often discussions as to whether any particular matter should be reserved to the board-level only, to a specified majority of shareholders (or a class thereof), or to a minority shareholder as a veto.
Being a board member of an emerging company requires, of course, a different skill set to being a hedge fund currency trader or acting as a private equity investor in a mature business. Beyond capital infusion, founders will need to understand – and, in a heavily competitive situation, be convinced of – what differentiating guidance, support and procedures such investors may be able to provide the business as a value-add.
Growth equity, therefore, is not a venture capital seed investment. A successful and well executed growth equity investment often involves an organised and disciplined target company that is able to attend to an investment process, and to all the related questions an investor and its advisers may have during such a process, alongside managing and running the actual day-to-day business.
Different investors will require different levels of financial and commercial data to build conviction with regard to sustaining the exiting growth rate, the attainability of the projected growth and how the investment proceeds would assist this future growth.
There is a growing understanding in the investment community of the dynamics in a growth equity transaction. As a number of emerging companies remain private for longer, we believe a variety of investors will continue to be attracted to this asset class and consider emerging companies as potential target investments.
Exposure to the possibility of a higher upside must of course be balanced with higher risk than some investors may ordinarily be accustomed to, and with less visibility and control than they would ordinarily expect.
Notwithstanding these challenges, relevant investors may also regard the willingness of founders or existing shareholders to retain significant stakes as a testament to their collective belief in the company’s future and its continued upward trajectory.
Jeffrey Bronheim and Daniel Mathias are partners at international law firm Cohen & Gresser LLP