Miranda Tang

miranda.tang@apifs.org

“They are exercising the put option! Business is down the drain. I have no cash to repay. They are really pulling the life line!!” cried one of my recent clients amidst the pandemic.

At challenging times, investee companies often fall short of the pre-determined operation milestones and trigger the redemption / put provision(s) in the investment agreement.

To those who are not familiar with the normal terms of venture capital (VC) and private equity (PE) deals, this is one of the worst-case scenarios. The redemption or put option is a common feature for minority investors.

The internal rate of return (IRR) on the investment amount can go as high as 20%+ under a redemption clause. It is unthinkable to many owners who receive VC or PE money.

The investment agreement is in fact a prenuptial arrangement (“prenup” in short)!

One of my fund’s investor was laughing so hard when I told him this logic years ago and there were literally tears in his eyes.

In Asia, prenup is rare. It is primarily an agreement between two people before marrying that establishes rights to their possessions and support in the event of divorce or death.

This type of agreement is more common in the Western world and popular amongst the rich and the famous. But as time goes by, prenup becomes more common for various reasons:

• Pass separate properties to children from prior marriages. A marrying couple with children from prior marriages may use a prenup to spell out what will happen to their properties when they die, so that they can pass on separate properties to their children, if necessary. Without a prenup, a surviving spouse might have the right to claim a large portion of the other spouse's properties, leaving much less for the kids.
• Avoid arguments in case of divorce. By specifying in advance how their properties will be divided, and whether or not either spouse will receive alimony.
• Get protection from debts. Prenups can also be used to protect spouses from each other's debts, and they may address a multitude of other issues as well.

So why the association with investments?

If I use the analogy of the traditional dating as the investment cycle, maybe it is easier to understand.

1. The initial meeting with the company and management is the first date.
2. If both sides like what they hear and see, the due diligence will continue. That is when the dating starts.
3. There will be “love-at-first-sight” and there will be further understanding required before serious commitment.
4. The negotiation on investment terms and structure is the proposal. Once accepted, then the exclusivity period is almost equivalent to an “engagement”.
5. The marriage vow is the investment agreement. It comes into play with a lot of blessings and usually after a certain degree of due diligence, understanding, compromising and satisfaction.
6. The marriage begins when the money is invested and the post investment period is the marriage life. Then the “real” relationship starts.
7. Upon exit, it can be an amicable departure or it can turn out to be terrible at the other extreme.

At the point of divestment, this is also where most of the references are drawn upon the investment agreement.

Of course, the deal can fall apart at any given stage. But so is dating and marriage.

Investees need to understand that the biggest money to be made is at the point in time when the investors exit / divest and realize the return on their investments. The investors have so much skin in the game that they would need to protect their positions. It is the rationale behind to have preferred or convertible instruments where possible. Things change and not every investment can be rosy.

In Points 4 and 5 above, it is highly recommended that business owners understand thoroughly all major terms and conditions within the investment agreement before they sign on the dotted line. If they are not sure how certain clauses will be exercised, it is best to talk to the investors and ask them to cite examples or cases to know the impact and the consequences.

Some suggested solutions that we used in the past at the fund level to ensure the portfolio company continues to survive after the exercise of the redemption clause:

• Extend the payment period and often times by getting the money back by installment to give breathing space to the portfolio company
• Lower the total redemption amount to make it less severe and match with the incoming cashflow from operation
• Extend credit line or increase borrowing to cover all or part of the repayment
• Find another investor to cover the exiting investor’s position. This is not the ideal situation as terms may get even tougher
• Major shareholder to cover some or all of the repayment
• Any combination of the above

The case at the very beginning of this article is still under negotiation. The outcome is as yet to define itself but in various correspondences, the investor starts to accept counter proposals including a longer timetable with some partial repayments.

As an investor it is not the best interest of any fund to write off or write down any investment; particularly if the investment is sizeable within the portfolio. There will always be compromises which can come in many forms.

This is particularly true when the underperformance of the portfolio company is primarily due to macro factors like this pandemic. Investors will understand and usually be more lenient in handling redemption rights.

Under a normal prenup, it may or may not be exercised. Under the investment agreement, it is certain that the terms will be exercised as the fund has a definitive timetable to exit. It is only a matter of time and which clause it will trigger. Caveat emptor!

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