Recent events have left many businesses in a position where they face an uncertain financial future. The forced shutdown of businesses and self-isolation controls mean businesses of all different sizes are in a position where they may find it challenging to service their loans or are generally short of working capital. One option in seeking to re-finance or restructure is to offer lenders an opportunity to obtain an equity upside in the financing arrangements (also known as equity kickers). This can allow businesses to generate the capital they need whilst providing appealing returns on investments and lending risk.
From a business perspective, offering an equity upside to a lender is an attractive option for both the business itself and for the lender. Such offers incentivise lenders to invest in both businesses that are struggling financially but have foreseeable recovery options and also businesses that are in their early stages and need a ‘kick-start’, due to the higher potential returns. Such arrangements can be a great way to achieve alignment of interests between the lender and the owners of the business.
What is “equity upside” and how can it be utilised?
An equity upside is a feature which provides a lender with exposure to the potential increase in value of the borrower itself (rather than only a right to receive interest payments). In other words, lenders may agree to a debt structure with less onerous payment obligations on the borrower or lower rates of return where they have the opportunity to benefit from an equity investment in the longer term.
The magnitude of the upside will inevitably depend primarily on the risk associated with that investment. For example, companies that are struggling financially will likely have to offer a higher upside than those in a more stable financial position, as their future is less certain and the investment comes with more risk. However, the higher risk brings about higher returns.
For lenders who are considering taking advantage of equity upside and for companies considering offering them, there are a number of considerations. We set out some of the key considerations below.
Type of instrument:
In structuring the equity upside, the type of instrument will often be a warrant over issued shares or a right to purchase or convert securities into shares in the future (by way of convertible notes, redeemable preference shares or similar). It may also be a contractual right to co-invest alongside a major shareholder at the same price. It is in each party’s interest to ensure that the terms of any such arrangement are carefully negotiated on a case-by-case basis to ensure they are fit for purpose. Both parties need to ensure that the ownership percentage ultimately on offer is commercially acceptable in relation to the size of the loan and degree of risk.
In negotiating the terms of financing, a well-advised lender will seek to obtain as many protections for their investment as possible. In particular, lenders will seek anti-dilution protections to ensure equity rights retain their value. Anti-dilution protections may take the form of price protection against future capital raises at a lesser price, restrictions on capital reconstructions (such as share sub-divisions) and potentially a right to obtain a fixed percentage of equity at the time of exercise. Note that the latter right of a fixed percentage is very favourable to lenders and can hinder the business if it has a need to raise capital in the interim. At a minimum, financiers are likely to seek pre-emptive rights over the issue of any further shares or securities in the business to give the lender the right to participate in such offers to prevent further dilution.
In addition to the above, lenders may also see to be granted pre-emptive rights for share transfers involving existing shareholders. Having the right to take up the shares of any selling shareholder provides the lender with the opportunity to prevent both competing financial investors and shareholders with a controlling interest in the business from increasing their control without involving the lender.
Lenders may also seek minority consent rights to have negative control (veto) over certain corporate actions such as share buy-backs and related party transactions.
Both parties should also keep an eye on the long term and consider what options the lender will have if it wishes to exit the investment at any time. Businesses may wish for lenders with equity rights to be subject to usual shareholder agreement provisions (such as a prohibition on shares transfers without consent or an obligation to offer shares to existing shareholders first). Lenders may seek tag-along rights so that they can participate in any realisation of value when a controlling shareholder exits the business, by selling their shares to the purchaser on the same terms and at the same price.
There are additional regulatory considerations that lenders need to look out for. In any investment, lenders should be asking themselves key questions such as:
- Has the business obtained all necessary consents and approvals to issue these securities?
- Is it possible that this transaction may be unwound if the business is liquidated?
- Is there an existing shareholders’ agreement that might contain restrictive or unfavourable terms for shareholders?
We also strongly recommend that lenders and businesses seek tax and accounting advice before finalising any investment. Without such advice, the parties may expose themselves to unintended consequences – such as whether the investment is accounted for as either equity or debt.
It is important to remember that every transaction is different. Whilst the above list contains many of the key considerations, there will likely be specific issues that need to be taken into consideration in any investment.
If you would like to know more about structuring an equity upside arrangement, please get in touch with our Business Law Team.