It is rare in life to have the benefit of 20/20 hindsight. “If only I’d known then what I know now” is a common lament, but generally the lessons of experience cannot be used to reshape the past. In many private equity transactions, however, performance-oriented capital structures provide an exception to this rule.
Performance deals in the private equity context are transactions in which the investor’s initial ownership interest can change based on future events, such as enterprise value at the time of a liquidity event or operating performance during a specified period1. Performance deals are not new, and have been used for years to bridge valuation gaps between investors and entrepreneurs.
In the current market, the gaps between the price expectations of buyers and sellers have widened, and it has become increasingly difficult to value companies with confidence. The reasons for these developments vary from situation to situation but generally reflect increased uncertainty over companies’ ability to achieve their financial and strategic objectives, lack of visibility regarding future results of operation, concerns about future market conditions, and investors’ reluctance to invest at high valuations, particularly in the wake of the often exorbitant valuation levels that prevailed during the recent bull market. Investors have also sought to devise structures that will help achieve target IRRs amid volatile and uncertain markets. Performance deal structures are used with increasing frequency by private equity investors seeking to close financings in this difficult environment.
Performance Deal Structures
The terms of private equity performance deals vary widely. In general, they permit an investor to obtain a relatively greater level of equity ownership and/or preferential participation if a company’s performance fails to meet prescribed benchmarks, or a relatively smaller ownership position and/or preferential participation if a company’s performance exceeds these benchmarks. The adjustment in the investor’s initial ownership generally occurs through a modification of the rate at which the preferred stock held by the investor converts into common stock, an adjustment to the amount of the preferential payment the investor receives in addition to its common stock interest, or both. The mechanics and terms of performance adjustments are tailored to meet the particular circumstances of each investment. Typically, they reflect specific risks which the investor seeks to hedge, such as the issuer’s future operating performance or the future condition of relevant financial markets.
A performance-oriented structure is often implemented by resetting the investor’s conversion price at the time of a sale or IPO, based on the common equity price per share at that time. Consider the following example: An investor contemplates making a $20 million investment in a company and the investor believes that a $120 million valuation (post-money) is reasonable based upon its forecast of future earnings and assumptions concerning market multiples at the time of a future liquidity event. The company’s founder, by contrast, may believe that the company can achieve a higher level of earnings, justifying a $140 million valuation (post-money) at the time of the investment. The investor would be happy to invest at a $140 million valuation (representing a 14.3% interest in our example) rather than a $120 million valuation (representing a 16.7% interest in our example) if the investor reasonably believed that the company was likely to achieve an exit valuation of $490 million or more. At these exit values, the investor would realize a return of 3.5x or more (i.e., $70 million or 14.3% of $490 million). Unfortunately, the investor in our example believes that an exit valuation of $300 million to $350 million is more likely. The parties are at loggerheads concerning the company’s valuation because they have differing views of how the future is likely to unfold.
To bridge the valuation gap, the investor may agree to acquire convertible preferred stock representing a 16.7% interest for a purchase price of $20 million, or $11.98 per share assuming 10 million fully diluted shares outstanding as of closing. This implies a post-money valuation of $120 million and gives the investor the right to acquire 1.67 million common shares upon conversion, assuming 10 million fully diluted shares outstanding as of closing. (For purposes of simplicity, this example does not include a preferential participation on sale or other liquidity events in addition to the underlying equity stake or conversion price adjustments based upon the time to a liquidity event, and assumes that the company’s initial capital structure does not change.) The terms of the preferred stock will provide, however, that the stock will convert into fewer common shares if the company completes a liquidity event at a price per share in excess of a specified level-say, $36 per share. At this price, the company will have a value of $360 million and the investor’s 1.67 million shares will have a value equal to three times the original purchase price. As valuation upon a liquidity event increases above $36 per share, the conversion rate will begin to decrease until an upper limit is reached-in our example, $49 per share. At this upper limit, and at exit valuations in excess of that amount, the investor will receive 1.43 million common shares upon conversion. At $49 per share, the investor’s shares will have a value of $70 million at the time of the liquidity event, representing a return of 3.5x the initial investment. At values above $49 per share, the investor’s shares have a value in excess of $70 million. The conversion price adjustment formula will also typically call for linear interpolation at per share exit values between $36 and $49. As a result of these provisions, the investor’s initial $120 million valuation is effectively reset at the time of the liquidity event if and to the extent that the company’s common stock price per share exceeds $36 per share, until an initial valuation cap of $140 million is reached at exit valuations of $49 per share or above. At these levels, the company’s performance has validated the entrepreneur’s initial optimism and the investor has achieved a favorable return.
There are many variations on this basic concept. For example, some convertible preferred stocks provide for a preferential participation (typically 1x the investment but sometimes less or more) at the time of a liquidity event in addition to the residual common equity interest. In a performance deal, this preference may begin to decline as valuation at the time of a liquidity event exceeds benchmark levels, phasing out completely at certain preset levels of valuation. In some cases, the investor is entitled to an adjustment both to its preference and its common equity stake, usually with reference to the same set of performance criteria. An investor will generally use these preference based performance structures to hedge downside risk, particularly if the investment is being made at a high value. The preference assures that the investor will receive a return of its investment cost in a relatively low value exit scenario through a sale and in many cases provides a return of some or all of its cost at the time of an IPO as well. In exchange, the investor usually trades off upside potential, facilitating investments at higher initial valuations than would be possible under a structure without a preference. From an entrepreneur’s perspective, the higher valuation and fixed ownership percentage of the investor are attractive.
Some performance deals include not only per share and/or preference-based valuation benchmarks, but also (or alternatively) performance criteria that relate to time to the liquidity event. For an investor, IRR is critical. The earlier a liquidity event or other return of capital occurs, the higher the IRR. Providing a company with an incentive to effect a liquidity event early by providing for conversion into a relatively smaller equity stake than would result from a later transaction at the same value can result in a favorable IRR, while enabling the entrepreneur to retain more equity. This type of structure also addresses concerns that an entrepreneur may not be inclined to seek a liquidity transaction at all. Time-related performance deals typically target high IRR benchmarks in the early years following an investment and successively higher, multiple-based exit values in later years. As access to the public markets has dramatically constricted, concerns about IRR and time to a liquidity event have become greatly amplified.
Performance deals that include a time element usually involve a matrix or series of performance benchmarks. Some incorporate a cliff approach-i.e., if the company achieves a liquidity event by one or more specified dates and/or at or above specified values, the conversion rate and/or preference changes, but the conversion rate remains fixed if the company misses the relevant benchmark by one day or one dollar. More commonly, time-based performance deal structures provide for partial adjustments to the conversion rate and/or preference amount in the event performance falls between relevant benchmarks. These adjustments usually are based on linear interpolation of per share values and involve quarterly, monthly or daily pro-ration. As a technical matter, a linear set of per share exit values or multiples in a performance deal will produce a non-linear curve of related ownership percentages. For example, company performance that falls at the midpoint of per share values in a performance deal typically will not result in an adjustment to the investor’s ownership percentage that is at the midpoint of the ownership range.
While most performance-based preferred stock adjustments specify the number of common shares the investor will receive upon conversion, some also assure that the investor will receive a specified minimum value. In such a structure, the investor receives as many common shares as are required at the time of a liquidity event to provide a return of, for example, 3x the original investment cost, effectively constituting a floor on its return. If the company’s value at the time of the liquidity event results in the investor holding shares with a value in excess of the threshold return under the original conversion rate, the investor receives the original fixed number of shares without limit on their value. This approach may facilitate a liquidity transaction because it avoids the need for negotiation over the size of the investor’s stake in a situation that would not constitute a qualifying public offering or a qualifying sale requiring a forced conversion into common stock under traditional preferred stock terms. However, performance deals do not typically guarantee the investor a fixed percentage interest in the company.
Investors and companies sometimes use benchmarks other than equity value per share and time to the liquidity event when structuring performance deals. For example, if a company has a revenue plan which an investor considers overly ambitious, and if revenues are a useful indicator of value in the company’s sector, the parties may specify revenue hurdles to reset the investor’s equity stake. Similarly, Ebitda or performance criteria such as attainment of specific corporate objectives sometimes are used to measure performance. Performance adjustments also are used occasionally as a mechanism to remedy breaches of representations and warranties or to reflect resolution of contingencies, such as the settlement of a pending piece of litigation. Provisions of this nature typically take into account the reduction in the investor’s value caused by the breach or resolution. Once the amount of this reduction is determined, the investor’s initial valuation and ownership stake are reset in lieu of cash damages. Some performance-oriented structures also incorporate warrant coverage in addition to or in lieu of the techniques described above.
The possible combinations of performance criteria are essentially limitless. Regardless of the specific terms, however, the underlying concept in each performance deal is that the price at which the investor initially invests is reset as future events unfold. The reset occurs when the future events become known, but looks back to the time of the original investment, effectively building in the benefits of 20/20 hindsight from the start. These performance deal structures need to be based on the fully diluted capital structure in place at the time of the original investment and the performance metrics need to be expressed on a per common equivalent share basis. This approach protects the investor from dilutive acquisitions and gives the founders the benefit of accretive acquisitions, because the company must achieve a higher overall enterprise valuation to meet the investor’s per share performance hurdles (and thereby clawback equity from the investor) if the company has issued shares in dilutive financings. A sophisticated performance deal structure also could incorporate adjustments that reflect dilutive issuances occurring after the initial investment, as if the reset valuation had been in place from the start.
Strategic Objectives, Pitfalls and Opportunities
While simple in concept, performance deal structures can result in problems if they are not used with deliberation and care. As an initial matter, it is important to note that performance deals involving formula-based adjustments to equity ownership are rare in earlier stage venture capital transactions. Valuations in earlier stage transactions usually are not based on earnings multiples and relative simplicity generally prevails. Recent trends in this sector have included increasing use of staged capital contributions tied to attainment of objectives such as new product introductions, full ratchet anti-dilution protection and tough covenants, but not performance adjustments. In financings involving later-stage companies, by contrast, revenue and earnings are more relevant to valuation negotiations and pricing structures typically are more finely calibrated. Investors and companies considering a performance deal for this type of company must be mindful of several strategic objectives and potential pitfalls.
First, an investor needs to design its performance deal to address the specific risk or risks that concern it. If an investor is concerned that market multiples for comparable companies may not be sustainable through the time of exit, a performance adjustment tied to per share value in a liquidity transaction is likely the appropriate approach. In the current market environment, where multiples have already tumbled, an investor may be more concerned that a company’s revenue or profit plan is overly ambitious. Here, a revenue or Ebitda-based performance structure may be more useful. If the investor is being asked to invest at a high valuation and downside protection is a concern, a preference-based performance structure that declines and falls away at prescribed valuation levels may be helpful. On the other hand, if the investor’s key concerns involve risks such as management retention, competition, technology or scalability of the company’s business, a performance deal will not be an effective solution. At the end of the day, a performance deal structure cannot change a poor investment into a good investment.
A second important objective in designing a performance deal structure is to ensure that performance adjustments correctly correlate IRR and return multiples. In the early years of an investment, a high IRR target is required in order to generate minimum target returns on a multiple basis for the investor’s portfolio. As time goes by, however, multiple targets must increase to support IRR but IRR can decline to a more typical target return level. For example, a 100% IRR on an annual basis for an investment sold six months after the initial return will yield a 1.5x multiple, falling below an investor’s target multiple return of three to five times because the capital cannot be reinvested. However, a 35% IRR over a five-year investment horizon will produce a 4.5x investment return. The establishment of correlated IRR and multiple-based performance benchmarks also may take into account the differences between an exit through an IPO and an exit through a sale.
A third key objective is to align the interests of the investor and its entrepreneur partner. Revenue or Ebitda-oriented tests are particularly apt to cause the interests of the investor and the entrepreneur to diverge. Management of a company with revenue-based performance hurdles may embark on a growth at all costs strategy in order to meet specified revenue objectives and thus capture a larger share of ownership.
Similarly, a company may reduce or forego needed spending in order to satisfy shorter-term Ebitda targets. Thus, performance structures based on operating results often combine both revenue and Ebitda tests. They also tend to track performance over a relatively short period (such as several quarters), as the number of variables potentially affecting operating performance expands exponentially as the time horizon lengthens.
The interests of investors and founders also can diverge when performance adjustments focus on per share equity value and/or time to liquidity event. For example, if a performance deal calls for a different adjustment upon a sale of the company (which may or may not give the investor future upside and risk, depending on the type of consideration involved) as contrasted with an IPO (which will give the investor future upside and risk), management and the investor may favor differing exit strategies. Similarly, if a performance structure contains a cliff-based adjustment, such as a significant change in the investor’s equity stake if a liquidity event does not occur by a specified date, management or the investor may seek to accelerate or forestall a transaction which may otherwise be in the company’s interest. It is thus generally preferable to design a performance deal along a curve of outcomes rather than constructing a stair step or cliff-based model. As a practical matter, factors other than the capital structure tend to dominate a company’s decision to sell or go public, but it is best to design a capital structure that does not artificially influence this decision.
A fourth objective in designing a performance deal, related to alignment of interests, is to ensure that there is an upward tilt to the investor’s return as the company’s valuation increases. The entrepreneur should want the investor to be better off as valuation increases, particularly if the investor can veto a liquidity transaction. The investor, in turn, will seek to avoid caps on returns. The investor and entrepreneur accordingly assess company valuations at points along an upward sloping curve and agree upon fair allocations of value at key points along this curve, with the investor’s return sometimes flattening in exchange for downside protection. Modeling performance structures to confirm that the investor’s and entrepreneur’s interests are in fact aligned along the range of possible outcomes is an important practical step as the parties proceed to closing.
Legal and tax issues comprise a fifth area of focus for investors considering a performance deal. For example, if an investor does not give careful consideration to the technical implementation of the agreed-upon business deal, the application of Section 16 of the Securities Exchange Act of 1934 could impose unexpected limitations on the investor’s liquidity options. An investor’s liquidity options could be limited if an adjustment to the conversion price at the time of an IPO is deemed to be a Section 16 purchase by a 10% beneficial owner of the company’s shares and this purchase is matched against a sale occurring within the six-month period following the IPO, such as in a hot secondary offering. (A careful analysis of the Section 16 deputization issues facing a private equity investor who sits on the board of directors is also important in avoiding limitations on liquidity.) Some performance adjustments similarly can trigger Hart-Scott-Rodino filing requirements. It is important to structure the original investment in a manner which anticipates and avoids these limitations. The tax issues associated with performance structures can be equally subtle. For example, if an investor’s equity stake increases rather than declining at the time of adjustment, a taxable dividend to the investor could result. As a result (and also in light of Section 16 considerations), it is preferable from the investor’s standpoint to draft performance adjustment provisions in a manner that results in a reduction rather than an increase in the size of the equity position as future performance is determined, although entrepreneurs often want the reverse.
Performance-oriented structures also must be crafted in a way that will avoid preferred stock original issue discount upon issuance and avoid dividend treatment on the payment of a preference amount at the time of an IPO. In addition, certain types of performance structures can result in charges against earnings or earnings per share under applicable accounting rules.
Performance deals can complicate later financings. If a company’s charter includes a complex performance adjustment, subsequent investors may have difficulty establishing the capitalization table and/or may need to build in their own adjustment provisions that are tied to those of the original investor. This can result in re-negotiation or removal of the original performance terms. The presence of performance adjustment provisions in a company’s charter can similarly complicate hiring or the consummation of a liquidity transaction. It may be difficult for prospective new hires in a company with a performance-oriented capital structure to determine how much of the company they will own-the answer to this question necessarily must be it depends. Further, if a charter has an Ebitda test under which an investor’s interest is reduced if Ebitda reaches a specified level by year two, management may oppose a sale in year one on the basis that there has not been sufficient time to meet the test.
Beyond legal and tax considerations, performance-oriented transaction structures can raise other potential issues. Challenges can arise, for example, when performance adjustment terms are combined with liquidity for the founding stockholders. If the sellers in a private equity recapitalization sell on a pro rata basis, any subsequent adjustment will affect all sellers equally. However, if non-pro rata selling occurs and there is a subsequent repricing, the selling and non-selling founders will have been disproportionately affected. In this circumstance, the documentation often provides for intra-seller adjustments, or adjustments between the selling founders and the investor at the time the investor’s equity position is adjusted. These adjustments are intended to put the parties in the positions they would have held had the reset valuation been in effect at the time of the original transaction.
It is important to remember that most performance deal structures do not look beyond a liquidity event. The investor therefore retains the risk that a steep decline in market value following an IPO or stock-for-stock sale will erode or destroy the additional value obtained through the performance structure. Investors who have suffered through the market conditions of the last 18 months are acutely aware of this risk. To address it, investors sometimes enhance performance deal terms by incorporating hedging strategies such as the use of cashless collars, preferential registration rights, guaranteed liquidity programs, and the like.
Finally, performance adjustment provisions in any transaction must be drafted with precision. Performance hurdles should have standards that can be objectively measured and determined. Often these provisions contemplate resolution of disputes by third party accountants or arbitrators and by reference to objective and verifiable criteria. Investors should negotiate for the ability to monitor performance on an ongoing basis in order to anticipate and head-off potential disagreements.
Performance structures can become unnecessarily complex. Simplicity is almost always preferable and clarity is a must when crafting a performance deal, as with all financial transactions.
A performance deal is not the right solution for every investment situation. Indeed a performance deal is not right for many situations. If the gap between the price expectations of the investor and the company is too wide, a performance structure will not bridge it and will create a company that essentially has no readily determinable value. If the performance terms become overly complex, negotiations may grind to a halt. If a performance structure is not tailored to address particular risks that concern the investor, the structure probably will not achieve the investor’s objectives. And if a private equity firm relies too heavily on performance deal structures across its entire portfolio to protect against downside risk or lock in targeted returns, it may trade away too much upside potential in the process. This can significantly reduce the potential for the breakaway returns on several investments that often drive a fund’s overall performance.
Despite the potential negatives, performance deals are being used with increasing frequency in a private equity marketplace characterized by volatility, lack of visibility regarding future results, downward pressure on prices, and gaps between the price expectations of buyers and sellers. Performance deals enable investors and entrepreneurs who have differing views about valuation to bridge their differences and proceed to closing. If properly structured, a performance deal can motivate management to build equity value while protecting the investors’ interest. The structures of performance deals vary widely, but in all cases they must be crafted in a way that aligns the interests of management and private equity investors while avoiding unforeseen legal and structural difficulties. Performance that meet these objectives often provide the difference between a failed bid or a broken deal and a tombstone on the shelf. t
John LeClaire is a partner at Goodwin Proctor, and serves as co-chair of the law firm’s Private Equity Group.
Jeff Haddan is a partner at Goodwin Proctor’s Corporate Department and a member of its Private Equity Group.
Kurt Jaggers is a managing director with TA Associates focusing on technology and Internet investments.