Brian Lucareli, Director of Foley Private Client Services (PCS) and co-chair of the Family Offices group, sits down with Glenn Singleton, Partner and leader of the firm’s Transaction Practice Group in Dallas, for a 10-minute interview to discuss minority direct investments. Glenn spoke on the distinguishing characteristics of minority investments, key terms and their negotiations, common structures of minority investments, and techniques to mitigate associated risks.
Lucareli: Hello, I’m Brian Lucareli, Director of our Private Client Services (PCS) group and co-chair of our Family Offices team at Foley and Lardner, and today I’m here with Glenn Singleton, a partner and leader of our Transactions Practice Group in our Dallas office. Today we’re going to discuss minority direct investments. First of all, I want to say welcome Glenn.
Singleton: Hey, good afternoon.
Lucareli: And before we get started though, would you mind just sharing a little bit of your professional background for our audience before we get rolling?
Singleton: Sure yeah, I’m a corporate lawyer, my practice consists probably of about 50% company side and 50% investor side, practice of both sides of the practice representing family offices, private equity funds, venture funds, other strategic investors as well as the companies themselves. So all the different sides of the transaction.
Lucareli: That’s perfect, you are the guy for the role today. So, developed a few questions with your assistance so I’m going to kick it off right now and say so, again on the topic of minority direct investments, what makes minority investment different from other investments that family offices may be more familiar with, such as public markets, control companies or control investments, real estate, etcetera?
Singleton: Right yeah, I think there’s a couple of common themes that really differentiate it from the asset class that they may be, you know most comfortable with or whether the original you know wealth was developed. And that really is that within these minority deals it’s a lack of control is the number one difference. And you’re usually going to get there via, you know minority protections or other covenants. There’s limited information on a lot of these companies assuming that we’re talking about early stage or you know high growth companies, they’re relatively young, they may not have audited financials and they just may not have that much operating history. Another distinguishing characteristic is usually the check size is smaller, these are smaller investments, it may not make as much you know sense to marshal the resources…
Singleton: …you typically would. And then also these assets are generally illiquid so you need to plan for that as well.
Lucareli: So then moving on to the next one. So, how are these sorts of investments typically structured? If there’s smaller deals, less information, how do you usually see the structure on that?
Singleton: Right well, every once in a while a handshake, but hopefully not and they’re coming to talk to us to do it right. So, typically the way we see them is they’re done either as a convertible note or a safe, or a kind of priced you know preferred stock investment. So, with the convertible note, largely what you’re doing is punting the valuation. You’re making an investment, loaning it to the company with the intent that eventually it will turn into equity in the future. With the priced round it’s exactly that, you’re picking evaluation of the company, your investment gets a certain percentage of ownership of the company, and then there’s a lot of nuance kind of further within those. But those are the two largest structures that you will see.
Lucareli: Very helpful. So, again from a deal perspective then, what are the most material terms that family office deal makers should be thinking about at the outset then?
Singleton: Yeah it’s a little different depending on which of those two types of investments you’re talking about. With the convertible notes, again remember this is a loan that is intended to turn into equity so it won’t have all the same features, but because it is debt you’ll have some debt-like concepts that you need to think about. So generally what you’re looking for is you know the principal amount, obviously everybody wants to make sure they’re clear about that. I would note that these are unsecured notes because usually these are asset-like companies so this is a general kind of unsecured debt temporarily.
Lucareli: Good point.
Singleton: Then really what you’re looking for is the term, how long is this going to be out there as debt? And then really the nuance here is the conversion mechanics. And this is really where a lot of the focus is and convertible notes is how will they convert and when will they convert into equity in the future? So, effectively what the investor and company are doing is saying, I will give you say a million dollars but we don’t know how much of the company it should be worth yet. Instead we are going to wait until your next round of financing which will be larger, it will have a better, you know more information to for the investors to dig into to come up with the valuation, and I will convert my note into that future round. Now because I came in a little earlier I would like a premium and so I’ll certainly you know get some sort of discount to that next priced round. And also to protect me from you know the valuation the company really getting away from me and locking in you know an idea of how much I should get we’ll also negotiate a cap. So the cap and the discounts those are really what you hear a lot of folks talk about. The other terms are what will convert me? If I’ve given you money I don’t want to convert the next time you raise $50,000 because whatever equity you gave that $50,000 investor, may not be indicative of the company or something that I kind of want to convert into. So typically this is defined as a qualified financing, and what that means is that an investment of a certain size that gives me comfort that a sophisticated investor has set the valuation that we kind of punted, once that trigger is met then I will automatically convert. There’s other scenarios about you know can I convert at my option, and well can I convert with the agreement of the company, and then also you will look at what happens if the company doesn’t raise that next round, and then you talk in you know a couple of other scenarios of either it just stays as debt, you convert into a hypothetical yet to be determined security, or you may even convert into common. So those are really kind of the main features with the last one being what happens at the company sells before that happens, and at that point we may get some sort of premium on our investment. But those are the main kind of levers in a convertible note round.
Lucareli: So a lot of moving parts going on here. So you did mention control and protective provisions. Since the investor won’t own a majority of the company, hence the minority discussion today, how do they get those protections and what are some of the protections investors should be focusing on?
Singleton: Right, so with the convertible notes you can have in your note purchase agreement, your note or a side letter certain covenants, just like you would see with you know a bank loan that says that the company won’t do certain things without getting the Investor’s approval.
Singleton: With the priced round those terms will typically be included in the certificate, a shareholders agreement, some other investment documents with a company’s organizational documents. And now with the priced round I’m actually a shareholder, so I’ve invested into the company and so I will sign documents that say either give me a board seat, at which I’ve got kind of the seat at the table and that’s all I can exercise my you know my opinion. Now my vote may or may not be necessary for certain things, that’s also negotiated term, or I can get a list of kind of minority or protective provisions that will apply to me as a shareholder, and I may need to focus on if I’m the only shareholder that’s whose consent would be needed to take those actions. If I’m part of a larger round the investor needs to be cognizant of how much of that round they make up and you know what it takes to exercise that blocking right or that consent right, because they may not be, their vote may not really be required. So that’s really kind of how you fold all of those protections into the stock purchase documents. Now of those provisions some of them matter more than others and these are really heavily negotiated. I think you see the NDCA forms have you know big long lists, but typically you know what you’re really looking for, economic protections and then you know other government’s protections. The economic protection usually comes in the form of a liquidation preference. So in bad scenarios the investor will get their money back first and then participate in the upside or get the better of their money back or participate in the upside. The other ones are other things like preemptive rights, that sort of thing they want to worry about. But then the list starts getting really granular. Do I want the company to have to check with me before they make certain amendments to the documents, before they raise money, before they sell company, before they incur debt? And so this list goes from kind of major issues that most people get all the way down to more you know minor issues that really depend on the party’s leverage and how much the investor cares.
Another way to manage these controls, and even if you don’t control the company or have a majority stake, is by budget approval. So I like this when I’m the investor I can kind of have this as a back door way to protect my investment, is to say ‘you know you have to check with me to do anything that goes with outside, goes beyond the budget that we’ve you know negotiated or approved each year.’ And then that way management doesn’t have to come to you every day, but you also have a protection that you know this is still the company and it’s the path you know that you invested in. So those are sort of the main issues that I focus on.
Lucareli: So just changing the lens or focus a little bit different, what are the most important areas of diligence then? Because you talked about protections what about on the diligent side?
Singleton: Right, on the diligent side you know it will obviously depend on the specific company but if these are younger companies they’re high growth it’s really, they probably have some technology some sort of competitive advantage that’s intrigued the investor to begin with…
Singleton: …I really like to focus on the team. So I really want to diligence the key personnel, make sure they’re full-time, understand how they’re compensated, understand that alignment, so the people actually becomes a very first level of diligence. After that obviously you want to look at the revenue model, make sure that it’s sustainable, see how much more money they will need in the future, is your investment enough to get them to profitability or not, and really understanding you know the total addressable market and the growth opportunities there. As I noted earlier you can, if you’re buying a mature company, obviously the financial statements can have a wealth of information…
Singleton: …In an emerging company they may not. So sometimes that’s helpful sometimes it’s not. Obviously the organizational documents that I talked about earlier, the shareholders agreements, that sort of thing will let you know you don’t control this company, you’re sliding into an existing structure with all of its different control mechanisms. So you need to understand what shares you’re getting, what their rights are, what the other you know kind of power dynamics are within the company? Finally you want to understand the capitalization. Young companies will often, it won’t entirely be clear who owns what…
Singleton: …there may be promises, handshakes, option plans, that sort of thing, founders that may no longer be with the company. So you really want to understand the capitalization. And then finally depending on what type of company it is, IP ownership is critical in these early companies, because a lot of times that hasn’t necessarily been done the right way from the start.
Lucareli: Wow, a lot, again lots of moving parts that you’re working on in your area. So lastly and I want to keep us on task with time, what are some ways investors can mitigate the risk associated with this asset class right?
Singleton: Well first of all, and obviously a shameless plug, is to get an attorney involved who has experience with these specific sorts of transactions. Because these are very specific types of deals and you have a limited budget, you need somebody who’s done a lot of them and understands what are the material issues and where to really focus and is used to the creative solutions to some of the items you may find in a company that is young and hasn’t been following best practices necessarily. Part of your investment may be to help get them there, so you need to recognize you might be finding something with a little bit of hair on it. But the mechanics that anybody can do, are to put investments in in stages, and set milestones for the company. So you see this a lot of times with biotech companies where you say when you get FDA approval, we will fund this amount, whenever you sign up your first customers we will fund this amount, whenever you release a certain version of your app we’ll release another amount, and so that’s a good way for you to have your investment lock it in but then not actually fund it until certain milestones that de-risk your investment are met. Another thing you can ask for is a very detailed use of proceeds, and not just throw money you know into the working capital bucket for them to set on fire for growth, but to really understand what they plan to do with it. How much is going to product, how much is going to talent, that sort of thing.
Another thing that you can do is get an option to invest later. Say you want to invest a million dollars now, but you like the company you can negotiate the right to say I can put in another million dollars at that same valuation but a year or two from now. So now you’ve built in a little bit of value that way. Another thing that I tell families or strategics who haven’t done a lot of minority investing, is to pull the resources and get together with other families or other groups who they can kind of share the burden of the diligence or learn from more sophisticated investors. You see that a lot with syndicates and you know that sort of thing, I think that’s a really good way to do it. And then you also because these are iliquid Investments you really got to be thinking about where are the exits at all times. And so with an illiquid investment like this, you’re typically waiting for this company to transact and sell, or IPO, which could be you know years and years in the future if ever, so sometimes investors will also negotiate you know redemption rights which says if the company does not sell or transact with a certain period of time they can either force the cell or they can put their equity back to the company. That’s tougher for the companies to take on but it you know that is a route and sometimes you can even force the sale. Registration rights allowing you to kind of force a registration of your security so you can sell them in the public markets, harder to get, but you definitely need to be thinking about you know those other ways out of the deal and ways to de-risk it.
Lucareli: Wow, I have to tell you, very impressive. So Glenn I want to thank you for your time and your professional insight today. I know that I clearly learned a lot it was very helpful for me. I hope it was for our audience as well and I want to thank all of you that were watching the presentation. For more information please visit us at Foley.com, under Family Offices. Thank you again.