NEW YORK An old technology developed by the buyout firms in the 80’s may have new applications in the venture capital industry, particularly for portfolio companies with complicated balance sheets and those facing severely rationalized valuations. The squeeze-out merger resets the capitalization structure and cleans out uncooperative minority shareholders.
Joseph Bartlett, partner at Morrison & Foerster LLP, completed a squeeze-out merger at the end of October and said this transaction works great for companies with otherwise good operating potential.
Follow-on deals at increased valuations have not been common in 2001, and in addition to the unpleasantness of down-rounds, the situation also brings technical complications and questions.
For example, how do you replace the management’s equity incentives? How do you untangle increasingly irrational liquidation preferences from previous funding rounds?
Many companies have cascading liquidation preferences at different levels, requiring the company to return unlikely gains before all the liquidation preferences are honored. Most new investors probably don’t want to invest in that structure and require a restructuring before they invest.
Previous investors don’t often like that idea, said Michael Littenberg, corporate partner at Schulte Roth & Zabel LLP. “If it’s restructuring versus writing off the whole investment, the answer is often, yes.'”
If minority shareholders cause the negotiations to fall apart, the squeeze-out merger becomes useful.
The new investors and faithful previous investors establish a new entity, “NewCo,” with agreeable terms and merge the complicated portfolio company back into NewCo, removing the complications and washing out the minority investors.
NewCo makes some sort of consideration to the target’s minority shareholders. The consideration might be cash, a note or common stock. Cash, in this case, might be favorable just to get the disgruntled minority out of the picture.
As a result, the portfolio company can continue to operate. Complications on the balance sheet have been removed and management incentives can be reset.
“They [the minority investors] don’t like it, but they’ve got their appraisal rights,” said Bartlett. The appraisal rights give the minority investors protection against a total rip-off.
James Warnot, partner at Shearman & Sterling Partners, has litigated a statutory appraisal proceeding in Delaware Chancery Court on behalf of a minority shareholder.
“If the minority shareholder is unhappy, they have the right to have the court decide what their appropriate consideration should be,” he said. Judges on these hearings have decided that minority shareholders deserved a greater consideration or even deserved less.
Warnot called it a, “flat-out battle of experts to decide what the price should have been.”
Bartlett said minority shareholders find this litigation expensive, and if appropriate attention is paid to the terms of the squeeze-out, the litigation would rarely return more than the original consideration.
The squeeze-out merger is one option among several arising to address the down-round situation.
“In this context, there is no one-size-fits-all remedy,” said Littenberg.
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