Top 10 Considerations When Negotiating a Minority Interest Investment in a Hospitality Enterprise
With valuations for hospitality enterprises becoming more attractive to investors, many expect private equity investments to increase in 2010. Many of these transactions will result in investors holding a minority interest. Summarized in this post are some of the more important considerations for these types of investments, including:
- Governance and voting
- Preferred distribution rights
- Regulatory considerations
- Redemption rights
- Registration rights
- IPO participation right
- Preemptive rights
- Antidilution protection
- Co-sale rights
- Drag-along rights
- 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.
- 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.
- 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.
- 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.
- 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).
- 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.
- 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.
- 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.
- 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.
- 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.
