Private Equity Investment in Latin America

Transcription

1 Private Equity Investment in Latin America November 2007 Peter V. Darrow Randall R. Gibeau

2 Mayer Brown LLP is among the 10 largest law firms in the world, with more than 1,500 lawyers practicing in 14 cities around the globe. In addition, Mayer Brown has an independent correspondent relationship with Jáuregui, Navarrete y Nader, a prominent law firm in Mexico City. Mayer Brown offers a broad range of services to clients conducting business in Latin America. We have extensive experience in private equity investments, joint ventures and mergers and acquisitions, debt and equity security offerings in the international capital markets, acquisition financing, advice concerning disclosure obligations under the U.S. federal securities laws, securitization and structured financing, corporate and project finance, and real estate investments and financing. The attorneys in our Latin America practice work with local counsel to find innovative, cost-effective solutions to various investment objectives when advising private equity funds, portfolio companies, management teams and financial institutions in connection with fund formation, investment/ exit transactions and related financing activities. In private equity, Mayer Brown acts for traditional private equity funds, captive funds, venture capital funds, portfolio companies, management teams and financial institutions in connection with private equity transactions. We are experienced in representing private equity clients in management and leveraged buyouts, follow-on acquisitions, public-to-private transactions, private investments in public companies, seed and venture capital investments and all forms of exit transactions, including auction sales, recapitalizations and IPOs. Our firm-wide team provides corporate, securities, tax, employment, antitrust, environment and other regulatory skills to efficiently structure and close the most complex transactions. For more information, please contact: Peter V. Darrow pdarrow@mayerbrown.com Randall R. Gibeau rgibeau@mayerbrown.com Mayer Brown LLP 1675 Broadway New York, New York Tel: Fax: Copyright 2007 Mayer Brown LLP. This Mayer Brown publication provides information and comments on legal issues and developments of interest to our clients and friends. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

3 Private Equity Investment in Latin America Introduction There has been an exponential growth in private equity investment in the United States over the last decade, and private equity investors both private equity funds and hedge funds attracted by the prospect of high returns, have started to increase their investment activity in Latin America, especially in Brazil and Mexico, the two largest and most mature markets in the region. In addition, a number of private equity funds have been organized throughout the region in response to the longstanding demand for, and inadequate supply of, capital. These developments, together with the perception that asset values in Latin America generally are low in relation to asset values in the U.S. and Europe, have led to an acceleration in the growth of private equity investments in Latin America. Latin buyout funds generated one-year gross returns of 31% in the year to June, 2006, according to the Emerging Market Private Equity Association. According to Venture Equity Latin America, during the period over $4 billion in private equity investments were made in Latin America, while over $4.5 billion in private equity funds was raised for investment in the region. Latin buyout funds generated one-year gross returns of 31% in the year to June, 2006, according to the Emerging Markets Private Equity Association. In addition, Dealogic reports that leveraged buyouts more than doubled in Latin America in 2006, with 36 deals worth $2.4 billion, compared with three deals in 2003 worth $363.5 million. The relative economic stability of the region, combined with strong economic growth and increasingly sophisticated capital markets, has also made Latin America an attractive market for private equity investment. The types of Latin American companies that may be in search of private equity vary widely. For example, there are many companies in the region that have grown and matured in their respective industries that need to recapitalize their balance sheets in order to obtain debt financing upon competitive terms to either consolidate their position in the local market or meet the competitive challenges arising from increasing economic globalization. In addition, there are a large number of less mature companies in the region that are investing in growth sectors, such as housing, commercial real estate, and consumer goods and services. These companies are capital intensive, and require significant ongoing capital infusions in order to continue their growth and expansion. Successful venture capital and private equity investments in the region can prove to be very beneficial for the companies in which the investments are made, as well as the economies in which the companies operate. A successful private equity investment in a target company will reward the investor with an attractive rate of return while allowing the target company access to the capital, skills and technology it needs in order to sustain growth and profitability. Furthermore, Latin American economies benefit from an influx of private equity which aims to achieve profits through the long-term growth of target companies, as opposed to more traditional investments in local capital markets which have proven all too often to be speculative and short-term in nature.

4 Characteristics of Private Equity Investments in Latin America Broadly, private equity investments often share the following characteristics: (i) the investment is made in a company (the Company ), the equity securities of which are either held by a small group of shareholders (the Original Shareholders ) who founded the company or are publicly listed in a capital market that, because of liquidity or pricing issues, is unable to support the Company s access to public capital; (ii) the investment is often made by professional venture capitalists, strategic investors, or by funds organized for the purpose of making private equity investments ( Investors ) who are likely to assume that their participation in the investment will add value to the Company, and will, therefore, expect to be granted some degree of participation in the management or, at a minimum, oversight of the Company; and (iii) such investments are not intended to be held indefinitely, but for a limited period of time (usually 3-6 years). Due to their limited time horizon, Investors generally seek Companies that are perceived to enjoy high-growth potential over the long term, whether because they are industries with long-term, high-growth potential, because they are developing new products or services that when introduced are likely to garner a significant market share, because they are an active force in a rapidly consolidating industry, or because of any combination of these characteristics. Many Latin American Original Shareholders are family members who have historically opposed selling any equity in their company and who are, as a rule, unwilling to surrender control. These general characteristics must, however, be viewed in a Latin American context. For example, many Latin American Original Shareholders are family members who have historically opposed selling any equity in their company and who are, as a rule, unwilling to surrender control. As a result, private equity investments in Latin America often involve the acquisition of lesser percentages of the equity of the Company than is common in the United States. Furthermore, depending on the sector and the local jurisdiction, there may be legal restrictions on the percentage of foreign ownership allowed in the Company. For the reasons discussed below, the Company s capital structure will customarily include both common and preferred stock. Private equity investors normally expect their investment to be in the form of preferred stock, which will enjoy certain important preferences in relation to the common stock, will be convertible into common stock, and may (depending upon the bargaining power of the Investor and the Company s need for capital) be redeemable at the option of the holder. Risks of Private Equity Investments Private equity investments pose risks for both the Original Shareholders and the Investors, in addition to the business and valuation risks that all companies face. Past experience has shown that the more significant factors which have given rise to problems in private equity investments in Latin America have included, among others (i) disagreements on the value of the Company, the sales price of the Investors participation and the appropriate valuation procedures; (ii) disagreements on exit formulae; (iii) the conflicting objectives of the Original Shareholders and the Investors; (iv) the resistance of the Original Shareholders to permitting the Investors to exercise significant influence over the management and direction of the Company; and (v) where the investment is made in a Company incorporated in Latin America 2

5 (as opposed to an offshore jurisdiction), the potential lack of a clear and reliable legal framework to enforce minority rights, and the potential inability of the local judiciary system to resolve controversies efficiently. As in any direct investment, there is the risk of changes in or disagreements with regard to either the goals of the Company or the interests and expectations of the Original Shareholders and Investors. Therefore, it is important that the parties negotiate clear and effective mechanisms to regulate the relationship among all shareholders, especially the terms and conditions dealing with governance, financial decisions, day-to-day management, dispute resolution, and exit strategies. With respect to the Original Shareholders, a private equity investment will often involve having to learn to manage the Company with certain restrictions on decision-making. Investors frequently request representation on the board of directors and rights to veto actions relative to certain key management and operating issues. In some cases, the Investors will even seek direct participation in the day-today management of the Company. While these restrictions may seem burdensome and restrictive to the Original Shareholders accustomed to exercising unfettered control of the Company, they are nevertheless important to protection of the interests of minority shareholders. An additional risk faced by the Original Shareholders is the potential for dilution of their interests. Private equity investment is often attracted to businesses and industries with strong prospects for growth. As a result, Investors often make an investment in a Company in anticipation of the pursuit of an aggressive growth strategy, which may impose significant and continuing capital needs on a Company. Depending on their resources, the Original Shareholders may experience dilution as Investors or other capital sources make contributions in excess of their ratable interest. As a result, Original Shareholders should seek to include antidilution provisions in the agreements documenting the private equity investment. With respect to the Investor, the relative illiquidity of the Company s shares (the Shares ) purchased by the Investor generally represents one of the most significant risks in any private equity investment. Accordingly, in order for the Investor to be able to realize an acceptable return on its investment, the Investor will insist upon negotiating an acceptable exit strategy at the outset of the investment. Such strategies, discussed in greater detail below, may include taking the Company public, selling the Company to a third party, selling the Shares back to the Company (pursuant to a put provision in the agreements documenting the private equity investment) or selling the Shares to a third party. Engaging Legal Advisors Prior to entering into negotiations with private equity investors, the Original Shareholders will need to engage a law firm that is experienced in advising companies in connection with private equity investments. The law firm will have responsibility for reviewing and negotiating with private equity investors the terms and conditions of any investment, while seeking to protect the interests of the Original Shareholders. The Original Shareholders may be unfamiliar with this 3

6 process and are often more focused on obtaining adequate private equity financing. As a result, the Original Shareholders may not take (or have) the time to fully understand and properly evaluate the significance of investment terms proposed by private equity investors, and may make concessions that have the consequence of reducing their future rights and equity interest in the Company. Support from knowledgeable counsel can be important to the Original Shareholders in leveling the playing field, elevating their awareness about the implications of proposed investment terms and preventing them from making significant and avoidable concessions. The Process of Obtaining a Private Equity Investment Formulating a Business Plan Once the Company has decided to seek private equity, the first step will be the preparation of a detailed business plan that describes the Company s business and operations, summarizes its business strategy, describes the relevant market, includes financial statements, if available, and includes detailed financial projections. If the Company is a development stage entity, the Original Shareholders will be more likely to prepare the business plan, since there is no significant role for investment bankers to play in early stage financing. If the Company is a more mature business, it may be desirable to engage an investment banker to assist in preparing the business plan, identify prospective investors and assist in implementing the investment. In either case, before entering into the various stages of negotiation, the Company should obtain the services of a law firm with experience in private equity investments to negotiate and document the terms and conditions of the investments and to advise the Company on legal issues arising from the search for private equity. Confidentiality and Due Diligence Through contact with the Company s management or investment bankers (if they have been retained) and review of the business plan, Investors with interest in the Company will identify themselves and ask to undertake an in-depth due diligence review of the Company. The due diligence review is essential to formulating a valuation by potential investors and for verifying the assets, liabilities and contractual obligations (including any existing or potential contingent liabilities) and financial condition of the Company. Before further discussion is held with prospective Investors or additional material is distributed or made available to them, a Company ordinarily requires that a confidentiality agreement be executed. In order to prepare for the due diligence to be carried out by interested Investors, the Company, with advice from its legal counsel, will be responsible for selecting, organizing, and making available for review all relevant documents. In addition, the Company will typically arrange for Investors to meet at length with management and tour the Company s facilities. 4

7 Term Sheets and Letters of Intent Typically, after a potential Investor has performed its due diligence and has indicated a serious interest in making an investment, the parties will want to negotiate a term sheet or equivalent letter of intent which sets forth, in detail, the principal terms and conditions on which the investment will be made. (However, it is not uncommon for a term sheet to be negotiated prior to the performance of due diligence by a potential investor.) Those terms and conditions will be influenced by the amount to be invested, the level of ownership the investment represents, the type of business the Company operates, the Company s financial situation, and the type of investment (development stage, strategic investment in an ongoing business, recapitalization, or troubled company turnaround). The shareholders agreement should be drafted in such a way so as to protect all shareholders, represent their interests, and anticipate any kind of controversy by providing an adequate mechanism for its resolution. The single most important issue to be addressed in the term sheet is determining the value of the Company. This issue is the most sensitive matter at the initial negotiation stage, and the Investors will generally not go forward with a proposed investment upon the failure to reach agreement. Other important issues relating to the financial terms of the investment, including the schedule on which capital is to be invested and the nature of the investment (convertible debt, debt with warrants, common stock, preferred stock, etc.), are resolved at this term sheet stage. In most cases, the term sheet also addresses issues relating to Company governance and the relationship between the Investors and the Original Shareholders. The amount of negotiation on these issues and the extent of the detail included in the term sheet or letter of intent will influence, in an important fashion, the negotiation of the relevant agreements. To the extent the parties are able to reach a detailed agreement at the term sheet stage concerning these issues, there will be a corresponding reduction in the amount of time required to negotiate the documentation of the investment. Typically, there is significant negotiation between the principals that occurs at the term sheet stage. Once the terms and conditions have been agreed to by all the parties, legal counsel will incorporate the terms into draft documentation. This generally includes both a securities purchase agreement (containing the price, the nature and terms of the Shares, the conditions to closing the investment, the representations of the parties and any indemnity obligations), and a shareholders agreement, which regulates all aspects of the relationship among the Company s shareholders, including the resolution of any controversies that may arise among the parties. Therefore, because of the pivotal role it plays in the success of the investment, the shareholders agreement should be drafted in such a way so as to protect all shareholders, represent their interests, and anticipate any kind of controversy by providing an adequate mechanism for its resolution. Where registration rights are contemplated, they will either be incorporated in the shareholders agreement, or contained in a separate registration rights agreement. It will be the lawyers responsibility to produce documents that set forth, in a clear manner, all the terms and conditions negotiated by the parties and provide a workable arrangement for the management of the Company. 5

8 What Form of Capital Structure Should be Used? The Original Shareholders will want the Company to have a capital structure that allows them flexibility in financing, recognizing that not all Investors will receive the same rights, and that different classes of Investors will have different investment expectations. Private equity investors will typically expect to receive preferred stock, convertible into common stock, that enjoys preferential treatment in any liquidation of the Company. Private equity investors will typically expect to receive preferred stock, convertible into common stock, that enjoys preferential treatment in any liquidation of the Company, and may enjoy other preferences, including the right to receive dividends. Private equity investors may also expect to receive warrants. Typical Preferred Stock Provisions Preferred stock issued to private equity investors will generally have some or all of the following features: The preferred stock will be convertible at any time, at the option of the holder, into common stock of the Company, at a specified price per share. The conversion ratio will generally be on a one-for-one basis, adjusted for stock splits, stock dividends, recapitalizations and similar events. Also typically included would be antidilution rights discussed below. In addition, the preferred stock will automatically convert into Shares of common stock, at the then applicable price per share, upon the completion of a Qualified Public Offering that meets certain specified criteria, which typically include a minimum of proceeds and a per share price which is a specified multiple of the original purchase price. The preferred stock will customarily vote with the common stock on an as converted basis (i.e., as if it has already been converted). The preferred stock will vote as a class (separately from the common stock) on certain issues of importance to the holders of the preferred stock, including (i) changes in the capital structure, (ii) the issuance of additional preferred stock which is pari passu with or senior to the existing preferred stock, (iii) mergers and business combinations, (iv) changes of control, (v) the adoption of any stock option plan and (vi) any IPO. Preferred stock will often carry a fixed dividend payable at regular intervals, which may or may not cumulate in favor of the holder if not declared for any reason. Cumulated dividends must be paid to holders of preferred stock before any dividend may be paid to holders of common stock. However, since many companies either lack the cash with which to pay dividends, or are in industries where the practice is generally to pay no dividends, holders of preferred stock will 6

9 customarily be entitled only to dividends and distributions equivalent to those paid on the Shares of the common stock, based upon the number of Shares of common stock into which the preferred stock could have been converted on the record date for the declaration of dividends. The preferred stock will enjoy a liquidation preference, so that upon any liquidation, dissolution, merger, or sale, the holders of preferred stock will be entitled to receive an amount equal to the purchase price, plus any declared but unpaid dividends, before any payment is made to holders of the common stock. The amount payable to holders of preferred stock upon liquidation or sale may also include some form of return on invested capital or participation in the increased value of the Company. Often, a liquidation is deemed to occur upon a change of control entitling the preferred stockholders to a purchase price at least equal to the liquidation preference and, possibly, higher than the price paid to common stockholders. In order to provide themselves with an exit strategy (which is discussed generally below), Investors receiving convertible preferred stock will often negotiate for a right of redemption at the option of the holder, which typically will be exercisable after the lapse of a specified period of time in which no initial public offering has been successfully implemented. Like the liquidation price, the redemption price will be the purchase price, plus any declared but unpaid dividends, and may include some form of return on invested capital. Antidilution Protection As mentioned above, the Original Shareholders will expect to experience dilution as new Investors are brought in, but will nevertheless hope to retain control of the Company. The Original Shareholders may negotiate for preemptive rights, giving them the right to purchase their pro rata share of any new Shares issued by the Company, before Shares may be offered outside of the existing group of shareholders. However, since the Original Shareholders may lack the financial resources to exercise their preemptive rights but will need additional capital they may expect to be diluted. Investors will expect to be protected against dilution arising from the future issuance by the Company of Shares at a price below the price which they paid for their Shares. There are two common antidilution formulas: a weighted average antidilution formula, and a full ratchet antidilution provision. Under full ratchet provisions, the conversion price of existing convertible preferred stock automatically decreases if one share of stock is issued at a price lower than the existing conversion price. In that event, the conversion price of the preferred stock automatically ratchets down to the lower price, entitling the holders of the preferred stock to receive a higher (and possibly much higher) percentage of the common stock upon conversion, even though the Company may have only raised a nominal amount of additional financing. Obviously, this type of antidilution is much more Investor-friendly. 7

10 In contrast, a weighted average antidilution provision moderates the rate at which existing shareholders suffer dilution. Under this approach, where the Company issues new Shares at a price below the conversion price of existing convertible preferred stock, the conversion price is reduced, but to a number that takes into account how many new Shares are being issued by the Company. Thus, where only a limited number of new Shares are issued by the Company at a price below the existing conversion price, the conversion price of the existing convertible preferred stock will be reduced (entitling the holders thereof to acquire more Shares of common stock) only slightly. Corporate Governance Rights Minority Investors will generally expect to have a right of approval in relation to a variety of matters that are important to the capitalization, growth, financing and management of the Company. Set forth below is a description of the principal issues that will arise in any negotiation with potential Investors. Board Representation and Observer Rights Investors will expect representation on the Company s board of directors, typically at a level proportionate to their investment. Board representation allows an Investor to review all important managerial decisions relating to the Company and to participate in all decision-making that occurs at the board level. Typically, the board representative selected by an Investor will have experience in the industry in which the Company is involved, or will be experienced with companies at a similar stage of development. By having one or more appropriate representatives on the board of directors, together with the veto rights referred to below, the Investor feels that it has the ability to influence the Company s business and to protect its investment. If a private equity investor is unable to obtain a seat on the Company s board, it may request observer rights, which give the Investor the right to receive all materials sent to the Board and to participate (though not vote) at board meetings. Veto Rights of Minority Investors Minority Investors will, dependent upon the level of their investment, generally expect to have a right of approval in relation to a variety of matters that are important to the capitalization, growth, financing and management of the Company. In the case of actions requiring shareholder approval, veto rights in favor of a minority Investor are created either by explicitly granting an Investor these rights in the organization documents of the Company (including by creating a separate class of securities held only by the Investor and requiring the approval of holders of that class of securities, voting as a separate class), or by requiring the approval of a supermajority of the stockholders that cannot be obtained without the participation of the Investor. If the organizational mechanisms are unavailable or impractical, the Investor may seek from the Company a covenant (to be contained in the shareholders agreement) that such actions will not be taken without the prior consent of the Investor. 8

11 The nature of the Company will also have an effect: generally, the more established the Company, the fewer of these issues require Investor approval, while in development-stage companies, Investors generally seek approval of a broader segment of these issues. Issues requiring approval by a minority Investor are often divided between those actions that require approval at the level of the board of directors, and those actions requiring shareholder approval. However, while there is no prevailing convention for allocating in any particular fashion those actions that are taken at the board level and those actions that are taken by the shareholders, in practice these actions are often divided along certain logical lines. Minority Investors will usually request that most fundamental changes of the Company, its business and direction, and its organic and capital structure be subject to a favorable vote by such Investors. Minority Investors will usually request that most fundamental changes of the Company, its business and direction, and its organic and capital structure, which normally require the approval of shareholders, be subject to a favorable vote by such Investors. These matters typically include the following: issuance of additional stock, bonds, debentures, Shares or any options or warrants to purchase stock, the reclassification of stock, or an initial public offering; redemption of stock; amendments to the charter and bylaws of the Company; increases or reductions of the capital stock of the Company; extension of the duration of the Company; change of the corporate purpose of the Company; effecting a merger, spinoff, consolidation or business combination of the Company or a sale or conveyance of all or substantially all of the Company s assets; liquidation or dissolution of the Company or filing for bankruptcy or insolvency proceedings; and changing the number and composition of the board of directors or of any special committee of the board. The issues that minority Investors typically identify as requiring their approval generally include changes to the capital structure of the Company and, particularly in the case of development-stage companies, changes in the management or operations of the Company s business. Board actions commonly requiring the Investor s approval include, among others, the following: appointment and removal of the CEO of the Company; approval and amendment of the Company s business plan; 9

12 approval and amendment of the Company s annual operation and capital investment budgets; incurrence of debt; creation of liens and encumbrances; sale, lease, conveyance or purchase of assets outside the ordinary course of the Company s business; entering into any merger, consolidation or business combination; payment of dividends; appointment and removal of the Company s external auditors and statutory examiners; entering into agreements involving expenditures or commitments in excess of a determined amount or outside the ordinary course of business; approval of any agreement with related parties to the shareholders or directors or officers or their respective relatives; initiation of any litigation or consent to the settlement or admission of liability with respect to any litigation; approval of employment contracts and severance agreements with key management; and any of the above-mentioned issues with respect to any of the Company s subsidiaries. Management The Investor may require that certain changes be made in the management of the Company, and may seek involvement in the day-to-day management of the Company, especially where the Investor has acquired at least a majority of the Company s voting securities. The resolution of this issue will depend on the financial situation of the Company, the level of the investment, and the degree of expertise of the existing management to meet projected goals, and other factors. 10

13 General Transfer Restrictions on the Company s Shares Preemptive Rights Preemptive rights give shareholders the right to purchase, out of new securities to be issued by the Company, their pro rata share of such securities. This provides to each shareholder a right to maintain its proportionate interest in the Company and thereby avoid the dilution that will occur upon the Company s issuance of securities to other shareholders or to third parties. Investors will typically insist on having preemptive rights to protect themselves against any possible dilution. Right of First Refusal Investors will typically insist on having preemptive rights to protect themselves against any possible dilution. Shareholders agreements typically include rights of first refusal, allowing shareholders to purchase their pro rata portion of Shares that are offered by any selling shareholder to a third party, at the price and on the terms that have been offered by the third party. If any shareholders elect not to purchase their ratable portion of Shares to be sold, the remaining shareholders have a subsequent opportunity to acquire their pro rata portion of the unpurchased Shares. Once all shareholders have exhausted their right of first refusal, the original selling shareholder is free to sell the remainder of its Shares to the third party, at the tendered price, for a specified period of time. Tag-Along Rights In the situation where the shareholders have successfully negotiated to sell their Shares to a third party, tag-along rights require, as a condition of the sale, that the other shareholders be permitted to sell their Shares to the purchaser (i.e., to tag along with the majority shareholders) on the same terms and under the same conditions of the offer. This provision discourages competition among shareholders to sell their Shares to a potential buyer. Often, tag-along rights apply only to sales of a majority of the outstanding Shares, in which circumstance the tag-along right prevents a third party from offering to purchase from the majority shareholders at a premium price only that number of Shares sufficient to obtain a majority of the board of directors. Drag-Along Rights Drag-along rights, which are common in shareholders agreements, permit majority shareholders to negotiate the sale of the Company to a third party, and then compel (or drag along ) the minority shareholders to sell their Shares to the third party on the same terms and conditions that have been negotiated by the majority shareholders. Drag-along rights allow majority shareholders to force uncooperative or complacent minority shareholders to participate in an exit strategy. Drag-along rights can be very coercive to minority shareholders, compelling them to sell their 11

14 Shares in an entire sale of the Company in circumstances where they would prefer to remain as minority investors. Exit Strategies One of the most important issues to be negotiated between the Original Shareholders and any minority Investor(s) is the exit strategy. A private equity Investor does not make an investment with the intention of retaining its investment for an indefinite period of time. As a result, exit strategies play a key role when an investment has matured (or the Investor believes the Company has achieved a sufficient level of growth or profitability) and the Investor wishes to exit the Company by selling its Shares. The exit procedure set forth in the shareholders agreement will depend on, among other factors, the size of the Company and its business, as well as market conditions. The shareholders agreement will usually anticipate that the Company will be taken public through an initial public offering (an IPO ). However, it is possible that at the desired time the international markets may prove inaccessible for an IPO by a Latin American company, so an Investor is likely to require that an alternate exit mechanism is provided. An alternative would be for the Investor to be able to cause the Company to be sold to a strategic buyer, such as a larger local company wishing to expand or a foreign company interested in entering the local market. The shareholders agreement may also provide the Investor with the option to put its Shares back to the Original Shareholders or to a third party (i.e., require that they purchase the Investor s Shares) that is acceptable to the Original Shareholders either at the then market price of the Company or at a price intended to provide the Investor with an acceptable rate of return on its investment. If an exit provision such as a put has been triggered, the valuation procedures set forth in the shareholders agreement will be of critical importance in determining the value of the Company. Therefore, a detailed procedure should be negotiated and documented in order to avoid any conflict or complications among the shareholders. This provision should be carefully structured so as to complement, and not conflict with, the exit strategies and dispute resolution measures also provided for in the shareholders agreement. Initial Public Offering and Demand Registration Rights To many Investors, registration rights are an important issue in making their initial investment decision. The Company can engage in a public offering only with the support of the Company s board of directors and its management, meaning that a minority Investor in a nonpublic Company is effectively subject to decisions made by the majority shareholders. Therefore, negotiating in advance the circumstances 12

15 under which the Company will cooperate in a public offering of its Shares is critical to a minority Investor. * In order to insure their ability to sell their Shares publicly, minority Investors secure in advance the consent of the majority shareholders to cooperate and to cause the Company to cooperate in the preparation and filing of a registration statement that will comply with all of the SEC s requirements (referred to as registration rights ). As a practical matter, an IPO is only likely to be successful where the Company itself is issuing Shares, although at the discretion of the underwriters the IPO may also include all, or some portion, of shareholders Shares among those Shares that are to be registered with the SEC. Accordingly, minority Investors will negotiate for registration rights that will permit them to include their Shares in any future public offering by the Company. An IPO is only likely to be successful where the Company itself is issuing Shares. There are two types of registration rights; demand rights and piggyback rights. Piggyback registration rights allow shareholders to have their Shares included in any suitable registration statement that the Company is planning to prepare and file with the SEC on behalf of itself or other shareholders. Demand registration rights, on the other hand, require that the Company initiate and follow through with a registered offering (and pay the costs associated with preparing and filing a registration statement) and include in that offering Shares held by the Investor making the demand. Typically, Investors will seek the right to make up to a negotiated number of demand registration rights within an agreed-upon period. Dispute Resolution There will be many issues throughout the existence of the investment that may give rise to conflict between the Original Shareholders and the Investor. These issues will generally encompass key financial or managerial decisions such as capital contributions, dividends, budgets, business plans, acquisitions, sales of assets, indebtedness and appointment of key officers. Since disagreements among the parties will inevitably arise, it is essential to the existence of the Company and for the protection of the Investor s investment to have a clear and effective procedure pursuant to which any type of controversy may be addressed and resolved fairly and efficiently. Controversies involving issues to be addressed at the board of directors level may be resolved in a variety of ways. One alternative involves giving the President-ofthe-board the decisive vote and having the Presidency change among the shareholders from year to year. This procedure guarantees that the President, knowing that the following year another shareholder will have the power to elect a successor, shall make a careful and conscientious decision. Another alternative for resolving disputes among the members of the board is to present the issue to the board on two separate occasions. If the board is unable to resolve the dispute during * For a useful discussion of registration rights, see Equity Finance Venture Capital, Buyouts, Restructurings and Reorganizations, Joseph W. Bartlett (John Wiley & Sons, Inc., Second Edition, 1995). 13

16 that time, the issue will be presented to the shareholders for resolution at a meeting convened precisely for that purpose. If any issue to be addressed at the shareholder level, including any disputes originating at the board of directors level, cannot be resolved in two consecutive shareholder meetings, the dispute may be resolved through an arbitration procedure with as much formality and procedural specificity as the parties may agree. The shareholders agreement normally sets forth the scope of this arbitration procedure, which may range from a mini-arbitration procedure set forth in the shareholders agreement to a more formal procedure conducted under the rules of an arbitration organization, such as the American Arbitration Association or the International Chamber of Commerce. When disputes arise among the shareholders, certain unrelated events may be triggered under the shareholders agreement. For example, put and call rights embedded in the shareholders agreement may be triggered which would force the shareholder in disagreement to either sell all of its Shares to the remaining shareholders or to purchase the Shares of all the other shareholders. It is in such situations where a carefully structured valuation procedure would prove valuable in attempting to avoid any further controversies among the shareholders. Amendments to the Company s Charter and Bylaws In most circumstances, the Company s charter and bylaws will have to be amended to reflect the terms and conditions agreed to by the Investors, the Company and the Original Shareholders. The most significant changes affecting these documents will probably involve changes to the description of the economic and voting rights appurtenant to the Shares being purchased, the structure of the board of directors, the procedures for appointing and removing directors, key management and auditors, and the voting requirements for the board of directors and general and special shareholders meetings. Stock Purchase Agreement In addition to negotiating a shareholders agreement, the parties will also negotiate a detailed stock purchase agreement, which is generally prepared by counsel for the Investor. This agreement will, in addition to containing the terms regarding the purchase of the Shares, include extensive and detailed representations and warranties concerning the business, assets, liabilities and financial condition of the Company and its subsidiaries, their compliance with all applicable laws and regulations, and their possession of all required governmental permits, authorizations and licenses and may also include representations about the selling shareholders. It will also include covenants applicable to the Company and, in many cases, the selling shareholders, conditions to closing (including receipt of any required governmental authorizations or approvals), provisions allowing for termination of 14

17 the agreement, and a broad indemnification in favor of the Investor for any damages, losses or claims (including fees and expenses) arising from any breach by the Company or the selling shareholders of any representation or warranty or covenant contained in the stock purchase agreement. Inaccuracy of the representations and warranties by the Company will allow the Investor to assert a claim for postclosing indemnification against the Company (and typically the selling shareholders). In order to ensure adequate disclosure to the Investor concerning the condition of the business of the Company, the stock purchase agreement will typically include numerous disclosure schedules that require management of the Company and its counsel to furnish detailed, itemized information concerning all of the Company s assets, liabilities, material contracts, real estate owned and leased, information systems, insurance coverage, licenses and similar information. Inaccuracy of the representations and warranties by the Company will allow the Investor to assert a claim for postclosing indemnification against the Company (and typically the selling shareholders), and obtain a downward adjustment in the price paid by the Investor for the investment. Tax Considerations for Private Equity Investments in Latin America Tax considerations will typically have enormous importance to Investors, particularly U.S. Investors. For U.S. Investors, the primary goal is to reduce the aggregate of the taxes imposed by the local country and by the United States. A secondary goal is to defer the payment of U.S. taxes on the foreign income. As a general matter, the primary goal is achieved by reducing foreign taxes to the largest extent possible and maximizing the ability to take a credit against U.S. taxes for any foreign taxes paid. In many cases this requires that the foreign entity be eligible to be treated as a pass-through entity for U.S. federal income tax purposes or that the investment be made through a jurisdiction with which the foreign entity has a favorable tax treaty. In other instances, the investment is made in part with debt or provides that the U.S. Investor receives fees for providing services. In any event, the legal team assembled by the Company should include an experienced international tax lawyer familiar with the U.S. tax issues present in equity investments, and local counsel conversant with the local tax regime, and the availability of pass-through entities, such as limited liability companies and partnerships, which are likely to minimize potential tax liability. Conclusion For Latin American companies, private equity investment often represents an attractive source of capital. As the discussion above makes clear, there are a number of important considerations that require careful review and negotiation by the parties in relation to any private equity investment. The discussion set forth above relating to these issues is not intended to be comprehensive, but rather is designed to highlight certain matters to which Latin American companies, and their private equity investors, need to be sensitive when considering private equity as a source of financing. 15