Over the last several years, private equity sponsors have increasingly been looking to the public markets to exit portfolio company investments. Although there is nothing new about sponsors exiting through an initial public offering, stockholders agreements entered into by sponsors at the time of the original investment have not always anticipated properly the various nuances of owning interests in a public company and the expectations of a sponsor (and management and its co-investors) with respect to the sell-down of that investment and post-IPO governance arrangements. Below are some considerations that sponsors should be mindful of when making an investment in a company where an exit through an initial public offering could be in the cards.
- Structure. Particularly where a sponsor makes an investment in a flow through entity, the deal structure in place at the time of the initial investment may be very different from the structure in place at the time of the entity’s public offering. Whether through the use of an “Up-C” structure or otherwise, sponsors should ensure that their stockholders agreement provides maximum flexibility to restructure their investment to allow for a tax efficient exit. This includes cooperation and other similar covenants ensuring that the company, management and co-investors take all actions reasonably requested to implement an efficient structure.
- Governance. It is important to plan in advance for the governance of a public company following an IPO. Immediately following the IPO, the sponsor (and its co-investors) will likely have a sufficient ownership of the company’s voting stock to ensure that it will be able to elect a majority of the board of directors. However, as the sponsor sells down equity following the IPO, it may quickly lose that ability, and therefore should ensure that it has negotiated in the stockholders agreement for the right to nominate one or more directors based upon its voting interests (with proxies from other stockholders to vote for those directors) with appropriate step-downs based upon relevant thresholds.
- Sell-Down. In deals with multiple sponsors, we advise that sponsors (and management) be clear as to when and how shares may and will be sold once the company is public. In most cases, registered underwritten offerings effectuated through registration rights will be the primary mechanism through which sponsors sell their shares into the market. However, there will inevitably be other means through which a sponsor sells shares (e.g., block trades and 144 sales) and careful planning needs to be done at the outset to ensure that the initial stockholders are on the same page as to notice periods, tag rights, etc. We have increasingly seen the use of coordination committees, which are helpful in ensuring that sponsors continue to communicate post-IPO with respect to sales (particularly after a substantial portion of their shares have been sold). It is important to realize that incentives which were aligned initially may become misaligned as co-investors and management make disparate selling decisions following an IPO.
- Springing Rights. Just as a sponsor’s relationship with a company will vary greatly between the time of its initial investment and the company’s initial public offering, its relationship with the company will also vary greatly between the initial public offering and the time that a sponsor has sold a majority of its initial ownership. There may be certain rights that a sponsor wants to implement from a good governance perspective once it no longer controls the company. For example, a sponsor should consider whether anti-takeover provisions should apply once it has sold down a material portion of its initial shares.
- Other Protections. Historically, many sponsors have taken an approach that is contrary to that which is implied in this note; i.e., their stockholders agreement simply terminates upon an IPO, at which point they negotiate the post-IPO arrangements. We don’t advise doing this. Instead, we encourage sponsors to think ahead and be thoughtful not only about the substantive issues outlined above but also to think critically about other legal protections that are regularly included in stockholders agreements. For example, an indemnity may come in very handy if there are issues that arise following the IPO that are not otherwise indemnified through D&O or other indemnities. In addition, there may be sponsor-specific provisions (e.g., use of name, those relating to regulatory considerations) that a sponsor would like to survive an IPO. On this point specifically, and more generally, sponsors should keep in mind that they ordinarily will have maximum leverage at the time of their initial investment, and it may be difficult to recut the deal on the eve of a public offering.