Emergency funding provisions in post-COVID shareholders agreements – some ideas
Posted on: 29 April, 2020 at 6:23 PM
By John Bellew, Head of Private Equity, Bowmans
As many fund managers are buried deep in their portfolio companies, a number may be wishing that they had a greater ability under their shareholders agreements to take pro-active steps to address the consequences of the crisis that we find ourselves in, and in particular that they were in a position to unilaterally inject fresh capital into struggling businesses.
Although funds holding controlling stakes are likely to be better off than those with minority shareholdings, there are likely to be negotiated provisions in existing shareholders agreements regulating the raising of fresh capital, and potentially minority protections (or reserved matters) dealing both with this issue and with other key decisions affecting the business. Many of these minority provisions are likely to chafe on a majority shareholder in the current environment.
Most shareholders agreements prescribe a process to be followed where a company needs to raise money, with shareholders standing at the back of the queue and being given time to consider whether or not to fund. There are also typically provisions conferring on shareholders the right to participate in fresh share issues pro rata to shareholdings.
Whilst equitable and reasonable, these provisions are not always appropriate in situations where emergency funding is required. Going forward, and learning from this experience, we expect many shareholders agreements to make express provision for emergency funding.
How might an emergency funding clause look?
The first issue to be addressed is when an emergency will exist.
If you are a controlling shareholder, it is better to retain as much flexibility as possible over what will constitute an emergency rather than to limit yourself to a defined list of matters. In a control scenario a provision allowing the Board to determine in good faith that it is in the best interest of company that emergency funding is needed is optimal, bearing in mind that with shareholder control also comes the right to control the appointment of the majority of directors. Also, if an emergency does exist, the operation of certain reserved matters effectively requiring minority shareholder approval should be suspended for the duration of the emergency. These must include the raising of fresh funding from shareholders and the restructuring of bank debt, but could also be extended to key business decisions such as appointing and removing key employees, shutting business lines and selling assets.
If you are not a controlling shareholder then a list of indicators of an emergency that will individually or collectively compel the board to consider whether an emergency exists (and therefore whether to activate the emergency funding provisions) is desirable. Your nominated director must be able to convene a board meeting to consider the issue. Indicators could include cash or liquidity requirements (including, but not limited to, a prospective breach of a liquidity covenant), defaulting on loan repayments, financial distress (as contemplated in business rescue legislation), sudden precipitous drops in turnover or refusals by key suppliers to continue supplying the business without payment guarantees. Your minority protections must remain in force and could potentially increase, so that you don’t fund into a situation where you have no voice on key decisions.
To be effective, the emergency funding provisions need to cut through the usual capital raising process. They need to balance the needs of the business for an urgent cash injection with the existing rights of shareholders and they need to allow funding shareholders the right to determine the mix of emergency funding. The right to determine the mix of emergency funding is important for the following reasons:-
– Whilst a funding shareholder would most likely want to advance the emergency funding as a loan, this may not be permitted by the terms of existing bank debt, and it may be necessary to inject the funding as preferred or ordinary equity;
– If the ordinary equity has no value, the substantial dilution of existing shareholders arising from a fairly priced share issue may result in key shareholders (especially key management) becoming disincentivised, or in a loss of black ownership (relevant especially in the South African context);
– Preferred equity or shareholder loans allow a fund to prescribe return parameters on the emergency funding that must be met before ordinary shareholders earn a return, and offer some priority on liquidation. They are therefore lower risk and also provide compensation for taking additional risk;
– Some additional ordinary equity may be reasonable as a de facto equity kicker on loan or preference share funding; and
– Certain types of equity funding may necessitate regulatory approval. This is especially true where the issue will result in a change of control of the portfolio company, needing competition approval.
The typical emergency funding provision allows a specific shareholder to provide the required funding urgently, whilst allowing the other shareholders a period of time within which to ‘claw back’ their pro rata participation in the emergency funding from the funding shareholder, on the same terms.
Concerns may be raised by non-funding shareholders, especially those who are not in a position to fund. It is important to stress that emergency funding procedures do not override the fiduciary duties of directors or deprive shareholders of their remedies if they are being oppressed. Under South African law, directors may only issue shares for ‘adequate consideration’ (which is not necessarily the same as market value), and if they fail to do so they may attract personal liability. Also, issuing shares at a substantial discount could constitute conduct that is unfairly prejudicial to the other shareholders, and aggrieved shareholders could apply to court for relief. The court has extremely wide-ranging powers to put an end to the oppression. Note though that the mere fact that a shareholder does not participate in a share issue and suffers dilution does not in and of itself constitute unfairly prejudicial conduct.
Finally, linked to the ability to inject equity into the business is the ability to provide guarantees, for example to creditors needing security to continue supplying. Ideally guarantees should be provided pro rata to shareholding. Disproportionate guarantees should come with a market-related fee, which also incentivises all shareholders to participate.
Bowmans is a leading corporate law firm with a highly skilled team, track record and geographical footprint to provide both upstream and downstream services to the private equity sector in Africa. www.bowmanslaw.com/service/private-equity