LEGAL STEPS OF A DEAL STRUCTURE

Signing a contract with an investor is demanding. Obtaining professional legal support during investment processes is essential; otherwise, you risk losing your shares, even when everything seems to be going well. In this article, we will explore how investment processes are conducted.

First Stage: Verbal Meetings

The initial contact between the investor and the shareholders occurs through preliminary meetings facilitated by a merger and acquisition consultancy representing one of the parties. At this stage, founders should be careful not to make overly binding statements or commitments, as these should be reserved for the next stage: the Term Sheet.

Before the investor begins the Due Diligence process, shareholders need to analyze potential issues and devise solutions. During this stage, a Non-Disclosure Agreement (NDA) may be signed with the investor to protect sensitive information.

Second Stage: Term Sheet (Letter of Intent) and Valuation

Following the initial contact, a Letter of Intent (LOI) is signed between the parties to outline the framework of the investment. Although referred to as a “Letter of Intent” or a “Term Sheet,” this document serves as a preliminary agreement that establishes the main points of the Articles of Association, which will be signed later. Preparing this document meticulously with legal supervision is vital to prevent misunderstandings or loss of rights down the line.

While the final value and terms will be determined during the third stage, the Due Diligence Stage, initial company valuation figures are usually discussed during this preliminary agreement process. Valuation determines the company’s worth, which influences the investor’s stake. Financial indicators are primary considerations, but factors such as the characteristics of entrepreneurs or key employees can also be important.

In these discussions, two types of valuation are typically addressed:?

1. Pre-money valuation, which refers to the company's value before the investment.

2. Post-money valuation, which reflects the company's value after the investment.

For example, if the agreed-upon value of Company X is $10,000,000, and Investor Y injects $2,000,000 into the company, Y will own 16.67% of the company according to the post-money valuation. This results in a 16.67% share dilution for the current shareholders, as they did not participate in the capital increase.

Third Stage: Due Diligence

The Due Diligence (DD) process involves teams specializing in legal, tax, finance, and commercial matters, in addition to a specialized team (e.g., IT) depending on the company’s activities. These teams will address questions related to their fields and request relevant documents. Companies may either provide a space for the investor to review documents or send them electronically. The area where documents are organized and reviewed is known as the “data room,” and if documents are provided in a secure virtual location, it is termed a “virtual data room.”?

The due diligence process typically examines records for the past three to five years and concludes after two or more rounds of questions and answers, after which the teams compile reports for the investor.

This stage is crucial, as the investor will base their investment decision on the findings from the due diligence. Therefore, it is imperative to prepare detailed responses and documents meticulously, as they serve as an important signal for the continuation of the investment process. While the investor usually covers the costs of the due diligence studies, the company being invested in may occasionally bear these expenses. Specifying who will cover the costs in the Term Sheet is essential.

Meticulously preparing the details in the Due Diligence Checklist, which is provided by the buyer at the beginning of the due diligence process, is vital for completing this stage promptly and creating a positive first impression for the buyer.

Fourth Stage: Agreements

Share Purchase Agreement (SPA)??

When the agreement between the parties involves the acquisition of some shares of the company by the investor, a Share Purchase Agreement (SPA) is drafted between the investor and the current shareholders.

Typically, the SPA is prepared by the investors' lawyers, although, in some cases, it can also be drafted by lawyers representing both parties. The content of the agreement is based on the previously mentioned due diligence (DD) reports. Any issues identified in these reports are listed in the Conditions Precedent (CP) document, which must be resolved before a specified date. The Representations and Warranties (R&W) document outlines that the responsibility for any problems arising from these issues rests with the company founders. For instance, it is common practice for the founders to be held solely responsible for tax-related matters prior to the investment for a period of 3 to 5 years from the signing date of the final agreement, referred to as the Closure Date. Additionally, information about the company's brand, domain name, real estate, vehicles, insurance policies, and employees is provided in various annexes to the agreement.

As seen, due diligence acts like an X-ray of the company. Subsequent studies build upon the findings of the due diligence.

Shareholders Agreement (SHA)??

Regardless of the investment type, a Shareholders Agreement (SHA) is signed between the investor and all or some of the current shareholders who will remain with the company. This agreement governs the relationship between shareholders and investors post-investment. The most important topics addressed in this agreement include:

- Share Groups: Status of preference shares.

- Executive Board Structure: Number of board members and how many are appointed by each party.

- Board of Directors: Decision quorum for meetings.

- Minority Rights: This is crucial for parties retaining minority rights within the company post-investment. The SHA delineates what actions cannot be taken without the approval of this minority party, including capital increases, taking on debt above a certain threshold, and asset sales.

- Dilution: This refers to the reduction of shares held by shareholders. Dilution can result from share sales and lack of participation in capital increases, which can significantly impact economically weaker parties. For example, some early shareholders in Facebook experienced substantial share reductions when they could not participate in later capital increases. To safeguard against the economic power of future investors, an Anti-Dilution clause is often requested by the investor, typically protected under minority rights clauses.

- Non-Competition: Investors usually require company entrepreneurs not to engage in competing businesses. The non-competition clause may specify that the entrepreneur dedicates a certain percentage of their time to the company's business.

- Limitations on Share Transfer: This issue is particularly sensitive in SHAs, often involving:

??- Preemptive Right: If new shares are issued, existing shareholders have the first option to acquire these shares.

??- Right of First Refusal (ROFR): A shareholder must offer their shares to existing shareholders on the same terms before selling them to outsiders. Shares may only be sold to third parties if no current shareholders are interested in buying them.

??- Drag-Along/Tag-Along Rights:?

????- Drag-Along: If a shareholder wishes to sell their shares, they can compel other shareholders to sell theirs as well. For instance, if an investor aims to acquire the entire company, this right facilitates selling the company as a block. This provision typically favors the investor or majority shareholders.

????- Tag-Along: This grants other shareholders the right to participate in the sale if a shareholder decides to sell their shares. For example, if an investor intends to sell their shares, other shareholders have the option to sell theirs as well and exit. This clause generally benefits minority shareholders.

Call Option / Put Option: Put Option refers to the right of one or a group of shareholders to sell their shares to other shareholders under certain conditions (price, etc.) and/or within a certain period. On the other hand, Call Option refers to the vice versa, i.e. the right of shareholders or group of shareholders to buy other shareholders' shares. In this context, the buyers do not have the right to waiver from the Put Option right while the sellers do not have the right to waiver from the Call Option right.

M&A Investment as an Alternative to Starting a New Company

Entrepreneurship typically involves starting from scratch and incorporating a new company. However, many entrepreneurs prefer mergers and acquisitions (M&A) as a less risky alternative. This approach allows involved parties to reap benefits more quickly. With M&A, the current operations of a business are taken over, which eliminates the need to establish a customer base, build reputations, recruit new employees, and design new procedures, processes, systems, and infrastructure. M&A can take place in two forms: merger or acquisition.

a) Merger: A merger involves the economic and legal integration of two or more legally independent companies. In a merger, both the transferee and transferor companies lose their previous legal entities, becoming part of a new company.

b) Acquisition: In an acquisition, the acquiring company retains its title and legal identity while obtaining all the assets and resources of the acquired company, which is then legally terminated.

Types of M&A:??

Mergers can occur in three main ways based on the sectors in which the involved companies operate:

1. Horizontal Mergers: This type occurs when companies in the same sector engage in an M&A process. Horizontal mergers can accelerate monopolization in the market by reducing the number of competing firms in that sector. An example is the acquisition of 75.5% of Tekstilbank’s shares by the Industrial & Commercial Bank of China for USD 313.8 million in 2014.

2. Vertical Mergers: These mergers involve companies operating at different stages of the production process. They may occur when there is a buyer-seller relationship between the companies, such as when a company merges with its supplier. The primary aim of vertical mergers is to minimize potential disruptions in production and to reduce inventory costs and overall expenses. For example, in 2014, Toyota Tsusho acquired Plasmar Plastic Company.

3. Conglomerate Mergers: This type involves companies that operate in different sectors or geographical regions. Conglomerate mergers have become increasingly common over the past 50 years. A notable example is Fiba Group’s acquisition of 50% of Florence Nightingale Hospitals in 2014, marking a move into a different sector.

Conglomerate mergers can happen in three ways:

a) Market-Extension Merger: The merging of two companies that sell the same product in different markets.

b) Product-Extension Merger: The merging of two companies that sell different but related products in the same market.

c) Other Conglomerate Mergers.

Benefits of M&As for Involved Parties:??

Mergers and acquisitions offer numerous advantages to both transferee and transferor parties. Some of these benefits include:

- Acquiring technology and know-how

- Accessing new markets by completing product ranges and gaining industry experience

- Gaining working capital

- Accessing new distribution channels and expanding distribution networks

- Reducing competition in the market

- Providing a source of liquidity for investors and shareholders

- The potential for quick returns on investment

- Achieving economies of scale

- Quickly accessing a wider customer portfolio

- Attaining sustainable growth

- Increasing production capacity

- Guaranteeing raw material supply

- Raising earnings per share

When M&A decisions are well-founded and the processes are effectively managed, they can be faster, more effective, and more efficient investment methods compared to the uncertainties of starting a new company.