Fairness Considerations in a Downturn
Fairness Considerations in a Downturn
Economic downturns often impact the available strategic alternatives of investment funds and companies looking to exit an investment or raise capital. When markets recede in a downturn, valuations contract, capital costs rise, and financing and exit alternatives become more limited. This article will discuss several types of transactions that tend to become more prevalent in this environment and address a number of the fairness considerations that come along with them.
Down-Round Financing Transaction
A “down-round” financing transaction occurs when a company sells shares of stock at a valuation below those of prior financing rounds. Often times, the company is in financial distress and is running out of liquidity but needs to raise additional capital to finance its continuing operations or refinance existing debt. However, in a downturn (when the business’ revenue and profits may be receding further) other, less expensive financing options may be inaccessible.
Since shares are sold at a valuation that is lower than prior financing rounds, the transaction can be highly dilutive to existing investors that are either unwilling or unable to participate in the financing. Moreover, because companies often have an urgent need for new financing, the company may not have time to hire an investment banker and conduct a market-clearing process to raise the capital. Conflicts of interest could also arise if the board of directors of the business is controlled by the party leading the down-round financing (such as a private equity sponsor). In this case, the board’s decisions and recommendations on the capital injection are likely not protected by the Business Judgment Rule due to these conflicts, and may be reviewed under the more demanding standard of Entire Fairness (which requires both fair price and fair process).
In addition, there may be more ambiguity than usual regarding the value of the company than in prior financing rounds. This is not only because the company typically has not gone to market to raise the capital (i.e., there has been no market check), but also due to the fact that the economic downturn (and the associated volatility and impact on profits) may increase uncertainty regarding the financial outlook of the business. The lack of visibility on when the economy will return to normal may make it more difficult for management to prepare a financial projection for the business with the same level of confidence it otherwise may have.
Each of these considerations bear on the potential fairness of the transaction to unaffiliated and non-participating shareholders and creates a higher hurdle with respect to the board of directors’ review and approval of the transaction than would otherwise exist absent these factors.
A going-private transaction occurs when a publicly traded company is acquired in a deal that involves a related party and which also results in the company being delisted from the public exchange on which its shares were trading, thereby extinguishing its periodic financial reporting requirements to shareholders. Going-private transactions tend to become more prevalent in an economic downturn for a number of reasons.
First, reduced public market valuations may result in an acquisition at a more reasonable valuation for the buyer of the business. In other words, the lower the valuation as a multiple of earnings or cash flow, the more attractive the target company becomes as an acquisition candidate, all else held constant.
Second, from the public company’s point of view, when share prices are down, the company’s shares become less valuable as consideration in a potential acquisition of, or merger with, another business. If the public company wanted to use its shares as consideration to acquire another business or to raise capital, it would have to issue more shares to do so. The resulting transaction would be more dilutive (and therefore more expensive) to existing shareholders. In this way, the company has less of an incentive to remain public and continue to incur the additional costs (such as increased auditor fees, legal expenses, expenses associated with SEC reporting requirements, etc.) that result from being public.
As noted above, a going-private transaction is by definition initiated by an affiliate of the company, such as a controlling shareholder, members of the board of directors, or the executive management team that have significant influence over the affairs of the business and are also shareholders. As a result, there are clear conflicts of interest in the transaction given that these shareholders are participating on both sides of the deal. Because of these conflicts of interest, there are enhanced disclosure requirements in connection with a going-private transaction and greater SEC scrutiny of these transactions. Moreover, much like a down-round transaction with a related party, the board’s actions and decisions in connection with a going-private transaction will be subject to Entire Fairness review rather than the more forgiving protections offered by the Business Judgment Rule.
The Value of a Fairness Opinion
In both cases, the board of directors of the target company may seek to commission a fairness opinion from an investment bank or valuation firm qualified to provide such opinions. Fairness opinions play a crucial role in assisting the board in its review of a transaction and help to establish that the transaction is fair from a financial point of view.
A fairness opinion from a qualified financial advisor can buttress the record that a board has satisfied its fiduciary duty of care in considering a proposed transaction, thereby helping to protect the directors from second guessing and hindsight bias in any future litigation that may result. The ideal fairness opinion provider will be independent and have deep industry experience, credentialed and experienced professionals, and a proven track record of providing opinions in a timely manner and on a range of complex transactions.
Amid increased scrutiny of transactions and risks of litigation, board members need qualified, objective advisors who can stand by and support their opinions during both the critical phase of deal execution and after a transaction has been consummated.