Many of our fashion clients who are keen to grow their businesses often ask us about the merits of seeking investment from the private equity community. This is a well-trodden path – fashion brands which have recently received private equity investment include Sweaty Betty, the parent company of Cotswold Outdoor, and New Look.
A note of interpretation – whilst we refer to private equity investors in this article, there are, of course, other types of equity investors – such as venture capital funds and angel investors – as well as private equity houses. For shorthand, we have used the term ‘private equity investors’ as an umbrella term and includes other such funds and investors.
In this article we focus on some of the commercial implications of a brand receiving investment from a private equity investor, and how this will impact on the equity held by the company’s founders.
Our experience is that the following “value” factors (amongst others) play heavily on the minds of founders when considering whether or not to accept private equity investment:
- How much equity to relinquish – this is obviously a key negotiation point, and goes straight to the heart of the commercial agreement. If the private equity investor is looking to make a strategic investment, generally speaking it will wish to own between 15%-30% of the brand’s enlarged share capital. Their stake needs to be large enough for them to justify making the investment, and their continual involvement in the company. However, they recognise that their stake should not be so great that they dilute the shareholding of the founders to such a level that they are not sufficiently incentivised to work for the company’s success. Therefore a balance is to be struck. If on the other hand the private equity fund wishes to buy out the founders, then they will end up owning the majority of the company’s shares.
- Form of investment – it should also be considered how the private equity fund intends to invest. For instance, some private equity investors will wish to be issued with preference shares, as opposed to ordinary shares. Preference shares give their holders certain rights not enjoyed by holders of ordinary shares (for instance a guaranteed dividend payment, priority on an exit/liquidation of the company). Further, some private equity funds may wish to take a mixture of equity and debt in the brand. Convertible loan notes are a typical form of debt finance – pursuant to these, the company pays a coupon (interest) to the note holder, and the note may convert into equity upon the occurrence of certain specified events (e.g. upon the share/asset sale of the fashion brand). When considering such debt finance instruments, the brand should be comfortable that it can meet the payments which are required to be made under such loan notes, without adversely affecting the company’s future cash flow, as well as with the conversion terms.
- Ratchet mechanism – a performance ratchet is designed as an incentive for the brand’s founders. Its effect is to vary the percentage of the brand’s equity held by its founders/management according to the performance of the company after the investment is made, rising if the company performs well and falling if it does not. A ratchet is often introduced into negotiations between the founders and the private equity fund if a sticking point between them is the future financial performance of the company – typically founders/management will be more bullish about the company’s growth and profitability than the private equity fund.
- Investor’s fees – it is common practice that the private equity fund will ask the brand to pay various fees to it, and/or on its behalf. For instance, the brand will be expected to pay the private equity fund’s legal fees which it incurred when making the investment. In addition, the private equity fund will appoint one of their officers to be a director of the brand. This person will be entitled to attend and vote at directors’ meetings, and is to be provided with the same information that is given to all of the company’s directors. The private equity fund will typically charge an annual fee for this director’s services. It may also charge a commitment or arrangement fee. Therefore, when considering the financials of receiving investment from a private equity fund, these amounts should be considered (and potentially negotiated) as they effectively constitute cash leaving the business.
- Likely exit routes and timing – once a private equity firm has invested in a brand, they will be aiming to sell their investment within a specified time period (usually within 3-5 years from the date of making the investment). Such a sale is usually effected by either a trade buyer purchasing the company, the private equity fund selling their investment to another private equity company, or (less often) by the brand going public and listing its shares on a stock exchange. Brands not keen to embark on such a journey in the medium term should therefore reconsider seeking investment from a private equity fund.
- Leaver provisions – the private equity fund will usually request that the constitutional documents of the brand be amended to contain provisions requiring departing employees (which would normally include the brand’s founders) who are shareholders to offer their shares for sale, to the other continuing shareholders and, sometimes, to the company itself. These so-called “leaver provisions” usually differentiate between a “good leaver” and a “bad leaver”, depending on the circumstances of their departure. Although there are many variables, usually employees who leave in breach of their contracts of employment or who are lawfully dismissed by the brand are categorised as “bad leavers”. The important differentiator is that “good leavers” are usually entitled to receive market value for their shares. In contrast, “bad leavers” may only receive the face or par value of their shares or the amount they paid for them when they were acquired.
Before entering into negotiations with a private equity fund, it is worth the brand considering the above points, and reaching a conclusion as to how much ground they are willing to cede. If the answer is very little, then investment from a private equity fund may not be for them.