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Covenants in the purchase of companies: 2 types of clauses

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Covenants in the purchase of companies: 2 types of clauses

There are several covenants in the purchase of companies very common. When carrying out this type of operation, there are certain aspects that can be fundamental to the success of the operation: price, suitability of the buyer/seller, protection clausesetc.

Normally, the vast majority of investors and sellers tend to focus on the first two points, however, forgetting about protective clauses or conditions in the contract can be a big problem in the long run.

In this post we will discuss the different types of share and management clauses and offer some tips for planning future investments or partial divestments.

Clauses related to share mechanisms

Tag Along Rights

The first of the most relevant covenants in the purchase of companies establishes that the entrepreneur or the management team will can only sell its shares to a potential buyer if the purchaser also extends its offer to purchase the existing investor's shares on the same terms and conditions.

This clause is of paramount importance in situations where the entrepreneur or the management team be one of the most important intangible assets or difficult to replace, thus reducing investment risk.

2. Drag Along Rights

It establishes in certain circumstances the right to force all shareholders to sell their shares if there is a potential buyer willing to pay an acceptable price for the whole company.

This clause helps to avoid possible blockages of minority shareholders who do not want to sell their shares and could restrict or sabotage a sale.

For more information about Drag Along Rights you can visit this link in which it is explained in detail. 

3. Full Ratchet Clause

It guarantees the conversion of preference shares at the price at which new ordinary shares of the company are issued in a capital increase. capital increase.

An example of this type of covenant in the purchase of companies could be that the investor buys 10 preference shares for €6 per share and after a year there is an increase in the value of each share to €3. In this case, thanks to the clause signed, he would have the right to double the number of shares he owns by being able to exchange the preference share for 2 ordinary shares.

4. Weighted Ratchet

It serves to provide intermediate protection, reducing the impact of a fall in the share price, but without providing full protection.

An example of this could be seen if the investor bought 3M shares for €3/share and within the stipulated period, an additional 3M shares are issued at €1.5/share, the holders of preference or convertible shares could convert the share to the value of €2.25/share. Value to be calculated by taking out the average of the new and old share prices.

5. Call Option

Call option is one of the most common company purchase agreements.

Economic targets are set, which are based on projections. If they are not met, compensation can be obtained by increasing its shareholding at the expense of the management team. It is a punishment that seeks to give management power to the investor if things go wrong.

This type of option is often used to prevent entrepreneurs or managers from presenting unrealistic projections and to reduce operational risk.

6. Mandatory redemption of shares

It is a pre-fixed right that allows the investor to sell his shares to the company itself, at a time of his choosing, at the nominal liquidation price.

This clause allows the investor to force the liquidation or merger of the company in case the entrepreneur of the company does not respect his recommendations regarding the management of the company, or to exit the company in case he does not find a buyer.

7. Issue of new shares

This is a clause that gives it a pre-emptive right in future capital increases in the event of positive results.

It is a particularly interesting clause to make in a company that may have great growth potential. It serves as a first step without the need for a large upfront outlayWe are waiting to see how it performs to see if it merits a capital increase to further accelerate growth.

Clauses related to management mechanisms

Transfer of control of the company

Covenants in the purchase of companies: 2 types of clauses

This is a clause that allows the investor to guarantee the continuity of the management team or entrepreneurs of the companies after the purchase of the company.

Due to the sensitivity of change of control, the expertise of the business and the contacts or relationships already built up, the company could undergo a change of management team, and therefore by this clause the team is intended to be maintained for a certain period of time.


2. Control and veto over key areas

Typically the most common clause is one that allows the investor to control purchases or sales of assets. It restricts the sale or purchase of any of the company's assets by setting a limit (value or % of book assets) above which the investor can buy or sell any of the company's assets. no sale or purchase is possible without the approval of the company.

In addition to the control over purchases and sales of assets, the following items are usually controlled by the investor through covenants:

  • Covenants in the purchase of companies: 2 types of clausesTransfer of shares.
  • Issuance of additional equity shares.
  • Employment status of senior managers.
  • Extraordinary capital expenditure or investments.
  • New indebtedness of the company.
  • Appointment of new directors.
  • Licensing of intellectual property rights.
  • Changes to the company's articles of association.
  • Setting or modifying the company's pension plans.


3. Vesting Rights

This pact, which is common in the purchase of companies, "ties" the entrepreneurs by making part of the management team's remuneration deferred over three or four years.

In addition, it may include a share dilution plan of the managers or entrepreneurs in the event of poor performance of the company, being able to demand a lower price per share in order to continue injecting resources into the company.

It serves to dissuade entrepreneurs from leaving the company when they see a new opportunity and invest all the proceeds from the sale of their shares and salary.

Other common conditions that are set as incentives or disincentives for entrepreneurs and managers are:

  • Base remuneration of key persons.
  • Possible bonuses.
  • Non-competition clauses.

They are particularly useful incentives in companies in stages where people are more than just an important asset for the business and the right one.

Conditions can also be set out in clauses stipulating which objectives have to be met before the entrepreneur or manager can leave the company and leave.


4. Critical company information

It is a clause which gives the investor the right to right of access to financial statements. As obvious as it may seem, the lack of such a clause can jeopardise an investment in the event of clashes of interest between managers and investors.

This is why this clause helps to reduce investment risk by ensuring access to financial statements, ensuring that management does not deviate from the agreed strategy and being able to anticipate financial problems.

The clause can be arranged either to have access to them at will or even to have the exclusive right to approve the annual budget, gaining full control of the company.