Hospitality Law Blog : Hospitality Lawyer & Attorney : Davis Wright Tremaine Law Firm : Hotel & Restaurant Law, Employment Issues

Under the proposed amendments, the net worth standards for a natural person qualifying as an “accredited investor” continues to be net worth greater than $1 million, but the rule now excludes the value of the primary residence of the natural person when making the calculation. As a result, an investor whose net worth derives substantially from the value of his or her primary residence may no longer qualify as an accredited investor.

Further, especially relevant after the decline in home values following the recent economic downturn, if the amount of debt secured by the investor’s property exceeds the estimated fair-market value of the property (i.e., the case of an underwater mortgage), the debt in excess of the value of the property is to be considered a liability and deducted from the investor’s net worth.

As a result, regardless of whether one interprets the new rules favorably or unfavorably, the change to the natural person accredited investor standard means fewer individuals will qualify as accredited investors, which will reduce available private capital to entrepreneurs and restaurant businesses.

More information regarding the proposed amendments can be obtained here.

1. Governance and voting
   Investors will often negotiate for the right to appoint a member (or members) of the company’s board of directors or other governing body. If granting such a right is not appropriate, due to the small size of an investment or otherwise, it is common for investors to request board observer rights, information rights and/or inspection rights. Voting rights are typically equivalent with the rights of common equity holders, meaning that investors will vote their preferred equity on an as-converted to common basis. Unless investors acquire a majority interest, they will not control the vote. Therefore, many investors negotiate for provisions requiring the consent of their equity class, voting as a separate class, in order to approve certain non-ordinary course transactions, such as liquidation transactions, amendments to governing documents, or distributions outside the ordinary course of business. Lastly, there may be situations where management rights should be bifurcated. For instance, it may make sense for a seasoned operator to have control over day to day operations, while the investment fund controls financial components of the enterprise.
   
   
2. Preferred distribution rights
   Investors will virtually always receive a preferential right to distributions. This means holders of junior equity will not receive distributions until each investor has received a specified return, usually equal to its capital contribution plus a percentage return. If the preferred equity is “participating”, it will continue to receive distributions after its preferred return is satisfied, usually on a pro rata basis with junior equity holders. Because granting such a participation right is investor-favorable, it is not uncommon to place a ceiling on the total return payable to an investor.
   
   
3. Regulatory considerations
   It is crucial to identify and address early on any regulatory concerns with the investment. For instance, under most state liquor laws, holders of a financial interest in entities that own or operate establishments serving alcohol must pass regulatory scrutiny. Regulators can condition or deny licensure if the investor (or a manager or significant owner of an entity holding the investment) fails to satisfy regulatory requirements geared toward criminal history and other relevant background factors. States can take time to work through licensing issues, so it is important to start the process early in order to avoid delays in closing.
   
   
4. Redemption rights
   In situations where an investor has leverage, it may negotiate a redemption right. A redemption right allows the investor to force the company to redeem its interest, often in periodic tranches with a specified rate of return. Companies will typically resist a redemption feature on the theory that the expected liquidity will be achieved when the company goes public or is acquired. Plus, it can place a significant amount of financial strain on a company. From the perspective of investors, they want the right to force the company to cash them out at some point if other liquidity events (namely, an IPO or acquisition) have not occurred.
   
   
5. Registration rights
   Investors will often negotiate for the right to compel the company to register their equity interests, thereby helping to create a path to liquidity in the public markets. These rights typically take two forms – “piggy-back” rights and “demand” rights. “Piggy-back” registration rights allow the investor to participate in, but not to compel, a registration by the company, subject to customary cutback provisions. “Demand” registration rights permit a specified percentage of the preferred equity to vote to compel the company to file a registration statement covering the equity interests. Demand rights are typically not exercisable for a specified period of time, usually at least two years after issuance of the securities (or earlier if an IPO has occurred).
   
   
6.  IPO participation right
   An IPO participation right is an investor-favorable term that allows an investor to purchase a preallocated amount in an IPO. Because of underwriter concerns in marketing the IPO, as well as the need to ensure compliance with federal and state securities laws, care should be taken in granting an IPO participation right.
   
   
7. Preemptive rights
   Investors are commonly granted preemptive rights, meaning they can participate in future equity financings on a pro rata basis and therefore avoid dilution. These rights are usually granted by contract. However, many state statutes address preemptive rights, and it is important to review the default rules under the applicable statutes.
   
   
8.  Antidilution protection
   Generally speaking, antidilution protection prevents dilution in the event the company issues additional equity at a price that is less than the price paid by the investor. This is achieved by adjusting the amount of common equity into which the preferred equity will be converted. Certain types of issuances typically do not trigger antidilution protection, such as issuances under equity incentive plans, and securities issued in an acquisition transaction.
   
   
9. Co-sale rights
   Co-sale rights permit investors to participate on a pro rata basis in a sale by other interest holders (such as founders or other holders of common equity). This helps to ensure that investors are not “left behind” in a liquidation event involving the other interest holders. It is important to clearly define the respective rights and obligations of the parties, so as to not unduly impact the ability of equity holders to sell their interests.
   
   
10. Drag-along rights
    Majority owners want to avoid a situation where minority interest holders can hold up a sale of the company. Drag-along rights achieve this by requiring minority interest holders to participate in and vote for a liquidation transaction in the event a specified percentage of interest holders are in favor of the transaction. Without this right, investors get a fair amount of leverage due to their ability to potentially hold up a transaction. This is especially true when a purchaser is not willing to acquire a target with equity interest holders surviving the transaction.