Exits in private equity transactions in France: the legal negotiations
Renee Kaddouch
Squair AARPI, Paris
Exit strategies play a crucial role in private equity transactions, encompassing both venture capital and leveraged buyouts (LBOs). The exit phase represents the culmination of the business' founders’ efforts and sacrifices, while investors realise the anticipated value appreciation from their initial investment. Various exit routes can be considered, including an initial public offering (IPO), a sale to an industry player or a secondary LBO where another fund invests alongside management in a holding company, facilitated by substantial debt financing.
Investment in private equity is inherently temporary, and the duration of the investment is stipulated in the investment legal documentation. The treatment of the exit assumes central importance during the investment process, constituting a critical aspect of the related legal documentation. Prior to making a final investment decision, investors must diligently evaluate prospective exit opportunities and remain vigilant regarding any factors that could jeopardise a satisfactory exit.
In the legal documents, particularly the shareholders’ agreement (which may incorporate certain provisions into the company’s articles of association (statuts)), exit considerations are primarily addressed through two approaches:
- granting preferred shares (actions de préférence) to investors, entailing a preferential liquidation right; and
- providing exit clauses in the shareholders’ agreement.
Granting preferential liquidation right through preferred shares (actions de préférence)
First introduced in French law in 2004, preferred shares confer special rights upon their holders, distinguishing them from ordinary shareholders. In private equity transactions, investors – especially venture capital or private equity funds – typically subscribe to preferred shares, while founders subscribe to ordinary shares upon incorporation of the company. The rights associated with preferred shares, negotiated in conjunction with the shareholders’ agreement, are delineated in the company’s articles of association (statuts).
Frequently, a preferential liquidation right is attached to preferred shares subscribed to by the investors, entitling them to a higher proportion of the liquidation proceeds compared to ordinary shareholders. This right serves to offset the premium paid for their shares relative to those held by founders, thereby mitigating the inherent risk associated with investing in the company.
The negotiation process between the parties assumes utmost significance for several reasons. Firstly, the extent of the granted preferential liquidation right must be discussed. Broadly speaking, two types of preferential liquidation rights prevail. The first type, known as ‘participating’, offers the most favourable terms to the investors, ensuring not only the return of the invested capital but also a proportional share of the remaining proceeds based on their ownership percentage in the company. The second type, known as ‘non-participating’, guarantees solely the return of the invested capital, with the residual proceeds allocated to ordinary shareholders. If the strictly proportional distribution of the liquidation proceeds exceeds the investment amount, the investors can simply waive the application of the clause, as usually contractually provided. In practice, to preserve the motivation of founders, whose commitment is indispensable for the project’s success, investors often opt for a ‘non-participating’ right or, at least, a ‘hybrid’ right that combines both types based on prior financial simulations.
Secondly, the parties need to negotiate the triggering events for the liquidation preference right, encompassing all potential exit scenarios. These typically include proper liquidation (to recoup the majority of the liquidation surplus), change of control (ensuring priority payment over the sale price) and the sale of the company’s assets, including intangible assets. The inclusion of a greater number of liquidity events enhances the favourability of the clause for investors.
To prevent the bypassing of the preferential liquidation right, investors should also ensure that the triggering events defined apply to the company’s subsidiaries. For instance, if a subsidiary’s assets are sold, the investors can exercise their preference over the price of the sale of such assets.
Investors may also request a veto right within the board of commissioners (such board being a consultative committee, unlike the board of directors existing in common law legal systems), of which they are typically members (if provided for in the shareholders’ agreement), granting them the right to vet a liquidity event by the company or its subsidiaries. This provision enables them to prevent founders, for instance, from transferring control of the company under conditions unsatisfactory to the investors, without prior discussion of the liquidity event.
In addition to the preferential liquidation right granted to them through preferred shares, investors must negotiate exit clauses in the shareholders’ agreement.
Exit clauses in the shareholders’ agreement
The shareholders’ agreement, serving as the legal centrepiece of the transaction, governs the relationship between founders and investors after fundraising. Consequently, it is natural for the agreement to address exit considerations. Alongside regulations relating to share transfers, exit-related matters are primarily addressed through two clauses: the drag-along clause and the liquidity clause.
The drag-along clause
The drag-along clause (also known as a forced exit clause or mandatory sale clause) mandates minority shareholders to sell their shares if a supermajority of shareholders decides to sell the company to a third party. In practice, if an acquisition proposal covering almost all the company’s capital (typically over 95 per cent) is accepted by one or more shareholders representing a highly reinforced majority of the capital, all shareholders are compelled to sell their shares to the third party.
Once again, negotiation assumes paramount importance and should commence even before the drafting of legal documentation, during the preliminary agreements (term sheet or letter of intent) stage.
Investors can negotiate the inclusion of their shares in the acceptance threshold for the acquisition proposal. Consequently, the offer must be accepted by a supermajority of the capital, necessitating the inclusion of the investors’ shares to trigger the drag-along right. In this manner, investors are assured that they will never be compelled to sell their shares. Instead, they can facilitate the exit of all shareholders, even those who may be initially reluctant, provided that the conditions of the third-party offer are favourable to them.
If investors fail to have their shares included in the supermajority acceptance threshold mentioned earlier, the primary risk is being compelled to sell their shares to a third party. To mitigate this risk, the shareholders’ agreement can provide that the drag-along provision can only be implemented if the company’s valuation, on which the third-party offer price is based, exceeds the valuation utilised for the investors’ initial entry. In this way, through the mechanism of the aforementioned preferential liquidation right, investors are ensured of receiving a share at least equal to the amount of their investment.
Investors can also initiate the exit themselves through a liquidity clause.
The liquidity clause
As commonly understood, investment in a startup is inherently temporary, and parties typically establish an investment timeline, typically ranging from five to seven years. The liquidity clause empowers the investors to initiate an exit process following this predefined timeframe.
Depending on negotiations between the parties, the favourable terms of this clause can vary. At a minimum, the investors will be granted the right to appoint an investment bank to seek a buyer for all the company’s shares or explore the feasibility of an IPO. Additionally, the investors may secure the right to have their shares repurchased by the founders or a third party.
In conclusion, the negotiation of exit conditions assumes critical significance in private equity transactions, constituting a substantial portion of the discussions between founders and investors. Parties must remain vigilant for any factors that may compromise a satisfactory exit, thereby ensuring that they do not demotivate the founders – whose commitment is vital throughout the company’s lifecycle – nor impede investors in their holdings or force any party to exit under unsatisfactory conditions.