Introduction

The market dynamics have further increased the appeal of minority investing this year: many founders have businesses in need of capital but do not want to sell a majority interest in a softer market, while sponsors have capital to deploy but are not able to access debt financing on the same basis as previously.

The other benefits for founders associated with partnering with a minority investor are:

  • it provides a way to access capital and business expertise (e.g. to accelerate M&A and/or international expansion) without ceding control;
  • it allows founders to diversify their personal investments by receiving some "cash out" (so the majority of their personal wealth is not tied up in a single illiquid investment) whilst also retaining the benefit of the future growth of the business; and
  • it can assist with succession planning, enabling a more systematic transition plan and enabling other members of the management team to receive equity to incentivise them as part of the next phase of growth.

In approaching minority investments, sponsors should take care to understand the rights that may and may not be available to them. One of the primary challenges that often arises is balancing the founders'/majority shareholders' desire to retain control with the sponsor's need to protect its investment throughout the lifecycle and control (to an extent) the exit process.

The legal terms will always be influenced by jurisdictional norms and the structural and economic terms of the transaction (e.g. the size of the minority investor's stake in the business, the size of any sweet equity pot, any third-party debt, and the founder and sponsor's exit expectations). As a result, there are fewer "rules of thumb" as to what constitutes standard market practice than on a buy-out and a carefully considered approach to the legal terms will be essential.

Key strategic/operational controls

Board control and management team

As a minority shareholder, the sponsor will have less control over the composition of the board and will not generally have the same ability to change the management team. However, minority investors can often exert influence over the management of the business in more subtle ways – for example:

  • depending on the size of the sponsor's stake in the business, it will often have the right to appoint one or more investor directors to the board (and speak and vote on key decisions);
  • investor directors will often have the right to be appointed to the remuneration and/or audit committees (and thus influence incentive and compensation structures); and
  • sponsors may have the right to appoint and/or influence the appointment of an independent chair or non-executive director.

Veto rights

In addition to its right to influence decisions made by the board and its committees, a minority investor should ensure it has a contractual veto right over key operational decisions and matters which could materially affect the business and therefore the minority investor's investment. The extent and content of those veto rights is often specific to the sponsor's requirements and based on the commercial context of the investment, though examples can include:

  • material amendments to constitutional documents or share capital;
  • distributions or returns of capital;
  • borrowings outside of the existing debt finance arrangements/in excess of a leverage test;
  • changes in the nature of the business;
  • adoption of / changes to the annual budget / business plan;
  • material acquisitions and disposals of assets;
  • related party transactions between the majority shareholders and the group; and
  • changes to the senior management team and/or incentive schemes.

In addition to the rights a founder will automatically have as a majority shareholder, they will often seek equivalent veto rights to the sponsor, especially where a founder shareholder is no longer actively involved in the operation of the business. Any concessions should be carefully considered, particularly where rights continue to apply following a default event (see further below).

Step-in rights

A fundamental right for a financial sponsor is the ability to "step-in" and protect its investment in a downside scenario. Most commonly, these enhanced rights are triggered by a breach (or anticipated breach) of the financial covenants in the debt finance documents, though other triggers can include defaulting on shareholder debt payments, underperformance against the agreed business plan and/or other operational matters which are vital to the business.

Following the occurrence of a default event, the "step-in" rights that are available to the minority investor may include:

  • Appointing third party advisers: the ability to appoint third party advisers to advise on strategic options and the obligation of the board to consider and/or implement them in good faith;
  • Emergency funding: the ability to provide emergency funding on a non-pre-emptive basis (typically subject to a catch-up right for other shareholders);
  • Voting rights: increased voting rights;
  • Board control: the right to take control of the board through appointing additional directors and/or removing existing directors; and/or
  • Rotating management: the right to dismiss and replace certain senior managers.

Key mechanisms to influence an exit

Agreed exit timeline

As is typical for sponsors, the timing and form of its exit will be one of its foremost priorities – how that fits with the founders' desire to retain control of the business is often one of the most fundamental points to agree commercially.

In order to set expectations, it is helpful for the sponsor and founder to agree a general timeline and plan to achieve an exit for the sponsor at the outset. The legal documentation may therefore include provisions requiring the parties to work together to achieve that exit by a certain date, and rights for the investor to appoint third party advisers to advise on an exit.

Transfer/drag rights

In addition to setting expectations, a minority investor will want some form of backstop in the event an exit has not been achieved in the agreed timeline, so as to have certainty that it will be able to satisfy its obligation to return capital to its investors.

A sponsor may have the right to market and sell its minority investment to a third-party (often after a lock-up period). A majority shareholder may request the ability to first make an offer to buy the minority investor's securities and, if declined by the minority investor, they may only sell to third-parties if the terms are more favourable than those offered by the majority shareholder (known as a right of first offer or ROFO). An alternative construct is where the minority investor finds a buyer but the majority shareholder has a last look right to accept those terms (known as a right of first refusal or ROFR). Given the inherent risk of their offer being gazumped, ROFRs in particular can make marketing a minority investment difficult and so can be difficult for minority investors to accept.

However structured, a sale of the sponsor's minority stake will likely limit the number of interested parties and require the incoming investor to adopt terms it hasn’t had the ability to negotiate, often resulting in the application of  a "minority discount". As such, the minority investor will, if possible, seek to be able to require a full sale by all shareholders to maximise valuations. Whilst a sponsor may not be able to negotiate a traditional “drag-along” provision as it would expect on a buy-out, the other shareholders may be willing to accept the minority investor having drag-along rights if subject to certain limitations. For example:

  • Delay: the drag-along right may only become operable after a specified date following completion (usually aligned to a period after the agreed exit timeline); or
  • Value floor: where a minimum return must be achieved by dragged shareholders as a condition precedent to the operation of the drag-along mechanism.

Conversely, majority shareholders may seek the ability to drag the sponsor. Careful consideration should be given before accepting founder drag rights, as the sponsor would want to ensure that, if it is dragged into a sale, the sale occurs on acceptable arms-length terms. Typical limitations include a value floor, a moratorium on exercise of the drag and/or a minimum shareholder approval threshold before the founder drag provisions can be triggered.

Other mechanisms to influence an exit

Where the sponsor is not able to negotiate drag-along rights, it may be able to negotiate alternative means to influence an exit.

For example, an investor may be able to negotiate the right to enhanced returns on its securities after a certain period, creating an additional incentive for the majority shareholders to instigate an exit process. This could be achieved by providing for “exploding” or “stepped” coupons on the investor’s debt securities or by requiring that some or all of the sponsor's securities can be redeemed (or receive a guaranteed dividend) in each case after a specified date following completion.

Practical tips

In addition to the legal protections minority investors will seek, there are a number of practical hurdles to overcome in making an investment alongside founder shareholders.

The first and often most challenging of those is convincing the founder to accept that sponsors require the ability to protect their investment and ultimately achieve returns for their investors. Unlike majority investments where the investor's control rights are presumed, absent a well-informed process, the abovementioned protections could be viewed as attempts by the investor to chip away at the founder's control of the business. It is therefore critical to ensure there is clarity at the outset regarding not only the nature of protections that will be required by the minority investor, but also the rationale and limited circumstances in which those protections are required. Proceeding without that alignment increases the risk that the parties reach an impasse in negotiations and/or that the relationship between the sponsor and founder is soured during the deal process.

Furthermore, sponsors should accept that there will be practical limitations given their position as a minority shareholder. They normally won't (outside a default event scenario) control board decisions or have the same ability to change management, influence operations or "professionalise" the business as they may be used to on a buyout. Instead, the sponsor should ensure it has appropriate information rights and utilise its board seats to influence and guide the strategic direction of the business.

Ultimately, as with a majority buyout, if the relationship between the sponsor and the other key stakeholders remains positive and collaborative the path to value creation is more straightforward. In these circumstances, the legal protections are used only as a guiderail to steer discussions, and are in place if needed where the relationship becomes more complicated.

A willingness to make minority investment alongside a founder can unlock new opportunities for financial sponsors. However, to be successful in doing so both sponsors and founders will need to work together to agree a compromise that satisfies their differing aims.