Selling to private equity: What sellers and management teams should understand

Selling a business to a private-equity investor, or to a trade buyer backed by private equity, can be an attractive way for shareholders to realise value while securing investment, strategic support and experience to help take a business through its next stage of growth.

Depending on the transaction, founders and management teams may sell all or part of their holding, reinvest alongside the buyer, remain involved in the business and participate in a later sale. No two transactions follow the same model. Where shareholders retain equity or management continues in an operational role, the sale may also involve new investment, governance and employment arrangements. The important point is to understand how those arrangements work together as one connected package as the transaction takes shape.

The headline price is only part of the deal

The valuation and headline consideration will understandably be important. In a PE-backed transaction, though, sellers and management should also understand how and when consideration will be paid, whether part of the proceeds will be reinvested, whether any amount is deferred or contingent, and what contractual exposure may remain after completion.

It is equally important to consider whether founders or senior managers will remain involved as directors, employees or consultants, and what the proposed arrangements mean in practice for control, decision-making and a future exit. These matters are often documented across a number of interlinked agreements rather than in the share purchase agreement alone.

The legal role is to help ensure that the contractual arrangements properly reflect the agreed commercial deal and that the implications of continuing ownership and involvement are understood before documents are signed.

Rollover equity: A continuing investment in the business

A common feature of selling to private equity is rollover equity, sometimes described as reinvestment. This is where a founder, shareholder or member of the management team reinvests part of their sale proceeds into the new acquisition structure.

Rollover equity can provide an opportunity to remain financially invested in the business and participate in value created during the next period of growth. It should therefore be viewed as a new investment in its own right, rather than simply as deferred sale proceeds.

In some transactions, particularly where an investor is pursuing a buy-and-build strategy, the investment structure and principal equity terms may already form part of an established model. The investor may be acquiring and integrating several businesses, with a view to maintaining a coherent structure and broadly consistent arrangements for the wider group.

That can mean that the terms of reinvestment are not wholly bespoke and that the scope for negotiation may be more limited on some points. This is not unusual, nor is it necessarily adverse to continuing shareholders. A consistent framework can support future acquisitions, clear governance and an aligned approach to a later exit.

The practical task is to understand the framework being proposed and focus on the provisions that materially affect the individual’s continuing investment, role and future flexibility.

Those may include:

• Where the new investment sits within the acquisition structure
• The economic and voting rights attached to the shares
• The information available to minority shareholders
• The effect of future funding or incentive arrangements on dilution
• Transfer restrictions and permitted transfers
• Compulsory-transfer, drag-along and tag-along arrangements
• The consequences if an individual leaves the business, including good-leaver and bad-leaver treatment.

The tax and financial consequences of reinvestment require specialist input. From a legal perspective, the focus is on ensuring that the shareholder understands the terms of the continuing investment, how they operate within the investor’s wider model and where focused discussion is appropriate.

Governance arrangements: Clarity supports collaboration

Continuing shareholders will usually need to consider the governance arrangements that will apply after completion. These may be contained in the company’s articles of association, a shareholders’ agreement or other investment documents. The documents need to work together, and their combined effect should be understood before they are finalised.

In a buy-and-build context, the investor may seek a governance framework that can accommodate future acquisitions and additional management shareholders without requiring the arrangements to be renegotiated each time. That is often a legitimate commercial objective. For continuing shareholders, the important question is how those arrangements apply to them in practice – including their role in decision-making, their information rights, the circumstances in which additional capital may be required and the way their equity may be affected as the group develops.

The detail will vary from deal to deal, but the arrangements commonly address:

• Board composition and appointment rights
• Matters requiring investor consent or board approval
• Information rights
• Future funding and capital matters
• Transfer restrictions
• The process for a future exit.

Investor protections are a normal feature of a PE-backed investment and are not inherently problematic. They reflect the investor’s role, capital commitment and responsibility for the wider investment. For founders and management holding a minority stake, the important point is to understand the practical effect of those protections and how they may affect day-to-day decision making and longer term flexibility.

A PE acquisition may use a newly incorporated investment holding company and a purchaser subsidiary, with management participating alongside the investor. That is a common approach, but there is no universal structure. The focus should be on the rights and obligations created by the particular transaction documents.

Management’s position: Several roles, one connected package

A founder or senior manager may have several roles in the same transaction: selling shareholder, continuing employee, director or consultant, reinvesting shareholder, incentive-plan participant and person subject to restrictive covenants. The documents relevant to those roles should not be considered in isolation.

Employment, service or consultancy arrangements, incentive documents, subscription or rollover documents, the shareholders’ agreement, articles of association and restrictive covenants can each affect the others. Looking at them together helps management understand how their future role, economic participation and contractual obligations fit together.

Management continuity is often important to a PE investor, just as continued clarity and fair treatment are important to management. Where the interests of management differ from those of other selling shareholders, separate legal advice may be appropriate.

Working constructively with a PE investor

Private equity investors will commonly be focused on growth, governance, performance and a future exit. They will usually expect clarity around strategy, operational priorities and the business plan, as well as an appropriate framework for oversight and decision-making after completion.

A successful process benefits from early clarity about the respective roles of the investor, board and management team. That does not mean that every issue needs to be negotiated at length. In particular, where an investor is applying an established buy-and-build model, some provisions may be fundamental to the framework and less likely to change.

The objective is to identify the points that materially affect value, control, risk and future flexibility, distinguish them from matters that can be resolved efficiently, and maintain momentum towards completion. An experienced legal team can help protect material interests while recognising legitimate buyer requirements and working constructively with the investor and its advisers.

Future exit: Understanding the route ahead

A PE investment will usually be made with a future exit in mind, although the timing, route and outcome will depend on the circumstances. As the exit arrangements are developed, it is sensible for continuing shareholders and management to understand how an exit may be initiated.

Drag-along provisions, for example, can enable a majority shareholder to require minority shareholders to sell in specified circumstances. Transfer and exit provisions may also interact with retained equity, incentive arrangements and good-leaver or bad-leaver provisions. Considering those arrangements early is not about anticipating a dispute; it is about ensuring that the parties are aligned on the framework for the next stage of the investment.

Warranty protection and a cleaner exit

Warranty and indemnity insurance may also be relevant in a suitable transaction. Buy-side W&I insurance can materially reduce a seller’s direct liability for insured general warranty claims and may help reduce or avoid escrow or retention arrangements for insured general warranty exposure.

It is not, however, a substitute for appropriate treatment of known or specific risks, or for ensuring that the sale agreement, disclosure process and insurance arrangements work together. The availability and terms of cover will depend on the particular transaction, the target business, diligence, disclosure and insurer appetite.

Looking beyond completion

Selling to private equity can be an attractive way to realise value while supporting the next stage of a business’s development. Where founders or management reinvest or continue in the business, the transaction also involves arrangements for their ongoing investment, role and participation after completion.

For founders and management teams selling to a private equity investor, or to a trade buyer backed by private equity, the most effective preparation is to understand the whole package: the sale, the continuing investment, the governance arrangements, management’s ongoing role and the route to a future exit.

How we can help

Thomson Snell & Passmore’s Corporate / M&A team advises sellers, founders and management teams on domestic, cross-border and private equity backed transactions, including business sales, acquisitions and buy-and-build strategies. We help clients understand and negotiate the interconnected sale, reinvestment, governance and management arrangements, with a focus on the issues that materially affect value, control, risk and future flexibility.