New Terms for Business Lawyers
Even during a pandemic, business lawyers need to be prepared for questions they may be asked by their clients about current trends and recent developments. Business lawyers who have been isolated from recent developments while exiled from their office during the COVID-19 pandemic may not have heard much about a number of terms that have started being used with more frequency. This article will take a brief look at four of such terms: SPACs; ESG; Growth Equity; and Continuation Funds.
SPACs, or Special Purpose Acquisition Companies, have been in existence for a long time (mostly under the name “blank-check companies”). In recent years, however, SPACs have exploded in popularity, success and prestige as they have become more mainstream. A key element in this mainstreaming has been the fact that reputable business executives or managers, with demonstrable track records, are now founding SPACs, and are often raising money from reputable institutional investors before going to the public markets. A SPAC then raises money in the public securities markets through an initial public offering (IPO) of its securities, often in conjunction with a PIPE (a private investment in public equity made by institutional investors in the same securities that are being sold in the IPO). The SPAC then has two years to use the money it raised in its IPO by acquiring an existing company, or it has to return the money raised in the IPO to its investors (and the funds are held in a segregated trust account during this period). If the SPAC is able to negotiate for the purchase of an existing business, and if its shareholders approve the transaction, each individual investor has the right to get his or her money back in exchange for their stock in the SPAC, or to own their share of the “de-SPACed” company. The target corporation benefits from this arrangement in a number of ways: it becomes public in a process that is usually quicker and less costly than a traditional IPO; its business has access to the SPAC’s cash (which is often supplemented with another PIPE at the time of the closing), which can be used to cash out investors of the target and/or as growth capital for the target; and it can benefit from both the ongoing advice of the SPAC principals, and the relationship with the PIPE investors. In some SPAC transactions the SPAC founders take control of the day-to-day management of the target business, and in others the executives of the target retain their positions. SPACs have exploded in frequency in the last few years, but as of the date of this writing there are questions about how successful they will be going forward arising primarily from some SEC accounting interpretations, the availability of PIPE financing (which is becoming increasingly essential to get deals done) and the fear that the number of SPACs that has been formed exceeds the number of targets that are there to pursue and will make acquiring targets for favorable prices very difficult.
ESG is an acronym for environmental, social and corporate governance. The term is used in the context of corporations and other business entities paying attention not just to their bottom lines but to how the operation of their business effects the environment and climate change, the society around them (including diversity in their workforce and pursuing human rights initiatives around the globe) and responsibly governing the business entity for the benefit of not just shareholders, but also other stakeholders in the business like employees and the local community. The push toward ESG performance is partially caused by literature concluding that businesses make themselves more, and not less, profitable when they pay attention to ESG. Whether or not a particular business believes that it can improve its profitability by focusing on ESG, and whether or not improved ESG performance would improve productivity, all businesses are coming under pressure to both improve and publicize their ESG performances. The pressure is more acute with larger and public companies, to be sure, but the pressure is rapidly moving to smaller and private companies as well. Pressure for more ESG performance comes from the government, which is considering expanding ESG disclosure requirements for public companies and also considering if the forgiveness of PPP loans can be used to make sure borrowers were fair to their workforce during the pandemic. But pressure is also coming from investors (many of which are reporting to their investors or governments as to what they are doing for ESG), employees (who are freer to publicize their mistreatments, real or perceived, as well as the mistreatments of their communities in this “Me Too” era), and even from customers and suppliers who are happy to boost their own ESG performance by pressuring their customers and suppliers for better ESG performance. If your clients have not yet been forced to focus on ESG, you will be doing them a favor by helping them focus on it before external forces impose it upon them.
Growth Equity is a term without a legal definition, and therefore even those who use the term all the time don’t agree upon its exact meaning. That having been said, “Growth Equity” normally refers to a non-controlling investment made by an institutional investor in a business that is used, at least in part, to provide the business with equity capital (although in some instances a portion of the proceeds may be used to make a special distribution to the existing equity holders). It usually differs from a venture capital investment in the following manner: it is normally made into a later stage enterprise, normally one with positive EBITDA; it is normally made by private equity funds, rather than venture capital funds; and it is usually made into a limited liability company rather than a corporation. In terms of the substance of the deal and documentation, growth equity deals look very much like private equity deals. However, since limited liability companies are pass through entities for federal and state income tax purposes, investors need to insure that the company will make periodic tax distributions to allow its investors to pay taxes. Also, as managers of a limited liability company do not have the statutory fiduciary obligations to minority investors that directors of a corporation have, attorneys for investors need to consider whether and how to insure that the entity is managed with the goals of their client in mind.
With the continued growth of private equity, and more private equity dollars and funds chasing investment opportunities, private equity funds find themselves ever more frequently owning a company that has to be sold because the life of the private equity fund is about to expire, but where the company has favorable growth prospects and the private equity principals would like to continue to manage and grow the investment. Hence, the creation of “Continuation Funds” – new private equity funds formed for the purpose of moving a portfolio company from one fund controlled by the private equity group to another, newer fund, thus providing an exit for investors in the first fund but with the principals still controlling the company on behalf of a newer or “continuation” fund with a longer remaining life span. Often, investors who indirectly own a portion of the portfolio company will be allowed to exchange their interest in the particular portfolio company for an interest in the new continuation fund, often on a tax-deferred basis. The primary legal issue with a sale to a continuation fund is providing comfort to the investors in both the old fund and the continuation fund that they are being treated fairly when the same individuals – the principals of the private equity group – are on both sides of the transaction. Often, the procedures for handling this type of conflict are dealt with in the documents of the two funds. For example, some funds may require that, when the private equity group is selling an entity to an affiliate, the outside investors get to either consent to or run the sale process (if the deal is large enough sometimes with their own investment bankers and/or counsel). But even where the fund documents don’t limit the private equity group from selling a portfolio company to another entity that they control, for purposes of both institutional reputation and protection from lawsuits by disgruntled investors, the principals of the fund have to wrestle with how to make both the process and the result fair. This is in order to be able to defend claims by the investors in the first fund that they did not get a high enough price, and claims by investors in the new continuation fund that they paid too high a price.