In our daily practice we see it often: owners of companies have high expectations of the future performance of their companies, arguing that their companies have a lot of unrealized potential. Investors / private equity funds on the other hand are willing to invest capital into the company, but not at the perceived valuation, which, to the liking of the investors, is too much staked on future, uncertain developments of the company.

In our previous article we discussed two ways to bridge this valuation gap by using 1) Staged Closings or 2) Warrants. In this article we deal with two other bridges we frequently use to structure the deal:

3. Preferred Stock Conversion Ratio’s; and

4. Protection on Liquidity Events.

Bridge 3: preferred stock conversion ratio’s

Generally, equity securities can be dived into two types of shares: ordinary shares and preferred shares. Preferred shares carry rights that go above the rights of the ordinary shares. Preferred shares, often used in venture capital financing, entitle their holders to receive a certain percentage of dividends and the liquidation proceeds ahead of the holders of ordinary shares (who are entitled to these dividends and proceeds pro rata their shareholdings). Other typical rights include redemption rights, anti-dilution rights, voting rights and drag-along provisions.

Preferred shares can be either convertible or non-convertible. Convertible shares entitle the investor to choose between a normal equity claim – by converting the preferred shares into ordinary shares – or debt claim prior to the moment of dividend distribution or liquidation – by retaining their preferential rights.

Example: let’s assume that an investor, in exchange for his investment of € 1,000,000, holds a certain number of convertible preferred shares, representing 20% of the outstanding share capital. In a “liquidation event”, like the sale of the company, the investor can choose to either convert his preferred shares or not. His decision will depend on the amount of the expected proceeds of the sale. If these proceeds are more than € 5,000,000 he will convert his preferred shares into common shares, because then he will join in the proceeds with the other holders of ordinary shares pro rata his interest in the company (20%). If the proceeds are less than EUR 5,000,000, he will not convert, since he will be in a better position with the liquidation preference he is entitled to (€ 1,000,000).

This brings us to our third bridge: preferred stock conversion ratio’s. We have seen that the conversion right permits the investors to convert their preferred shares into common shares. The exchange rate – in how many common shares each preferred share will be converted – is called the conversion ratio.

Now, to bridge the valuation gap, first preferred convertible shares may be issued to the investor against a certain initial valuation of the company the skeptical investor and optimistic founder can agree on. In case it turns out that the initial valuation of the company was too high – measured by certain milestones not being met – the investor has the right to convert (part of) its preferred shares into ordinary shares of the company at a pre-agreed conversion ratio >1.

Example: assume a founder believes his company should be valued at € 5,000,000 and the investor thinks the company is worth only € 4,000,000. So we’re dealing with a valuation gap of € 1,000,000. The investor is willing to invest € 500,000. At a € 5,000,000 (pre)money valuation the investor would be entitled to 10%. At a € 4,000,000 valuation 12,5%. The investor is willing to accept the € 5,000,000 valuation but only if the company’s monthly recurring revenue will increase with a certain percentage within two years, failing which the investor has the right to convert his preferred shares into such a number of ordinary shares to result in 12,5% shareholding.

Pro’s:

• it is a very flexible contractual mechanism.

Con’s:

• it is more abstract (than a warrant or second stage investment).
• leakage of share premium attached to be converted shares.
• you lose part of the classical preferred rights such as liquidation or dividend preference, full ratchet clauses (anti-dilution) and redemption features such as buy back (inkoop).

Bridge 4: protection on liquidity events

Our fourth and final bridge concerns the sale of the company or the redemption of the investor’s shares. In such a ‘Liquidity Event’ the parties can agree that the investor will be entitled to receive an amount which gives the investor a specific annualized IRR over the period of the investment. This mechanism is used pretty often. It basically boils down to a pre-agreed ‘waterfall’ between the shareholders of proceeds realized when a “liquidity event” occurs (sale of the company, IPO, etc). The waterfall gives a preference to the investor pre-dominantly based on a pre-fixed IRR (e.g. double money in 3 to 4 years).

Pro’s:

• Well known and also flexible ‘modus operandi’.

Con’s:

• does not necessarily give the investor the true value (as his return is capped to the pre-agreed waterfall).

Conclusion and recommendations

We have suggested four bridges that might help move deals forward when parties cannot agree on the value of the company. One thing all the bridges have in common is they are constructed around certain targets or milestones being met or not. To minimize discussions these milestones should be well documented, objective and measurable. For instance:

• use crystal clear definitions of the milestones (on EBITDA and synergies);
• insert a simple example of how the milestones will be calculated;
• have an accountant check the arrangement to see if it makes any sense to him.

Finally, it is imperative for investors to stipulate clauses to which they are in a position to check, control or influence the milestones.

How do we add value?

Our extensive expertise and experience in this field enables us to offer solutions to the most complex investments and participation agreements. Our team of qualified specialists delivers the highest quality of legal services and will be at your side from the first exploratory talks till closing the deal, while always considering your perspective and keeping course.

About Cleber

Cleber is a boutique law firm that specializes in private equity and M&A transactions, corporate restructuring and corporate litigation. We focus on only a limited number of closely related areas, to provide the best services to our clients. At the same time, we keep a broad view, in order to be able to make our clients aware of other aspects outside our expertise, which may be relevant to their businesses.