I. Exit Scenarios for Investors
The scenarios of an exit can be manifold. Shares in a publicly traded company may be sold on the stock exchange or by way of a bulk sale. Shares in a privately held company can typically be sold by way of a private agreement subject to certain limitations of the articles of association and/or a shareholders’ agreement of the company.
Potential alternatives to a sale may be a true merger of a company by way of general legal succession, typically in exchange for the issuance of new shares.
An exit from an investment basically triggers capital gains tax at seller level. The tax consequences are described in D. above.
The following outlines certain provisions of typically privately held companies dealing with exit scenarios in the articles of association and/or a shareholders’ agreement.
II. Management of the Exit Process
A lead investor usually wishes to agree with minority shareholders in an investment or shareholders’ agreement that the majority shareholder is in control of the exit process. An important feature is, inter alia, the decision on which advisors of the shareholders shall be retained in the exit process, in particular investment banks, corporate finance advisors, lawyers, accountants, etc. The majority shareholder typically desires that his advisors take the lead in the process.
III. Initial Public Offering (IPO)
In times of efficient capital markets, the IPO may be a preferred exit device and the parties may contractually agree on this preference. The IPO allows the investors to behave differently with regard to their respective shareholding. Whereas certain investors seek to dispose of their investment within a certain time frame (e.g. private equity investors), their strategic partners may be interested in a long-term ongoing shareholder relationship with the joint target company.
It is common that the parties agree on a time horizon with regard to an intended IPO. The parties may also pursue the exit by way of a trade sale (dual track; see IV. below) simultaneously with the preparation of the IPO.
If the IPO takes place, the shareholders are commonly subject to certain lock-up obligations, e.g. for a period of 6 to 12 months, vis-à-vis the issuing banks and/or the stock exchange. The shareholders may internally also agree on certain rules on how they may limit and prioritize any sales, if any, if they are not being made by way of a bulk sale, but rather through the stock exchange. Obviously, the main concern of all parties is to protect the stock purchase price in case of substantial disposal pressure.
IV. Trade Sale
The standard alternative to the IPO is the so-called trade sale, i.e. a sale of all or almost all outstanding shares in the target company, typically by way of an organized sales/auction process. Alternatively, the assets of such company and/or its subsidiaries may be sold in a third party transaction. A further exit alternative may be a recapitalization, by which shareholders seek a return on their investment through one or more jumbo dividends that may be financed by the assumption of further debt by the target company. (For tax consequences, see D.)
In a privately held company, it is common that the shares are not freely transferable but rather that share transfers are subject to consent requirements of the management, the board or the shareholder assembly, respectively, and to preemptive rights or rights of first refusal of the other shareholders.
In case of a trade sale, the minority shareholder will typically request a tag-along right vis-à-vis the majority shareholder, which allows the minority shareholder to co-sell its shareholding together with the majority shareholder.
The other side of the tag-along right is the drag-along right. The drag-along right secures the majority shareholders’ position to sell 100 % of the target company shares, thereby generally achieving a higher purchase price. The drag-along right is typically an undertaking of the minority shareholder vis-à-vis the majority shareholder. The majority shareholder may possibly seek to protect his drag-along right by obtaining a proxy from the minority shareholder in order to smoothly effectuate the trade sales process.
The minority shareholder may seek to obtain protection regarding the drag-along rights by the majority shareholder by agreeing that the disposal
- is being made according to the same conditions for the minority shareholder as the conditions agreed upon by the majority shareholder;
- (in certain scenarios) contains a minimum price (e.g. EBIT or EBITDA-related); and
- may not be an intra-group transaction of the majority shareholder.
V. VC Transactions
In VC transactions, it is common that investors obtain a liquidation preference upon exit that secures a prioritized return allocation to financial sponsors (waterfall). Typically, the most recent financing has priority over prior financing by other financial sponsors or the original investment of the founders of the company. In detail, these provisions may be rather complex (see H.I.2.e)).