Why is Multi-entity Equity Management Important in Complex Corporate Restructuring Cases?
Corporate restructuring can help companies streamline operations, reduce expenditure, and ultimately, create more value for investors. This is especially true for companies that expanded operations by establishing multiple entities to ensure compliance with region-specific regulatory requirements.
For example, the European Union is moving to simplify its tech laws. These laws have focused on ensuring data privacy and promoting healthy competition. If the EU continues down this path, US tech companies with operations in the region could unlock significant cost savings through strategic corporate restructuring.
This article will examine how effective multi-entity equity management can help mitigate these challenges and enhance the likelihood of successful restructuring.
Why is multi-entity equity management needed in complex corporate restructuring cases?
In corporate restructuring cases, multi-entity equity management can prove essential for the following purposes:
Designing new employee stock option plans
While there are certain norms about stock-based compensation, two related companies might not necessarily have identical stock-based compensation plans. For instance, one party might offer stock options at a 20% discount to the share price, while the other might offer options without any discount.
Similarly, there could be differences in the type of stock-based compensation and the vesting conditions.
One solution to this issue would involve the following steps:
- Buying back all stocks owned by employees and service providers
- Facilitating the net exercise of all vested stock options
- Issuing fresh grants that provide value comparable to the stock options that would have vested in the original grant’s remaining period had the restructuring not occurred
However, this solution can deplete the cash reserves of the resulting entities and, hence, is not desirable.
An approach that places less strain on the cash reserves would involve swapping the employee stocks and stock options with stocks and stock options of their respective employers post-restructuring. Then, you could issue fresh grants in the same manner as the previously discussed solution.
In some cases, applying a combination of these two approaches might be ideal. An example of this would be when numerous employees must be let go to remove redundancies. In this case, buybacks and net exercises would be needed for a certain set of employees, and for others, you could execute swaps of stocks and stock options.
Regardless of the stock option plan amendments you choose to implement, they must comply with the regulatory requirements of all relevant jurisdictions, as well as the terms outlined in the employee stock option agreements of the pre-restructuring entities.
Conversions of complex securities
Companies may issue various types of complex securities, such as warrants, Simple Agreements for Future Equity (SAFEs), convertible debt, and preferred stock. After a corporate restructure, the management may prefer not to retain such securities, as they can complicate dilution analysis and ownership structures.
In some cases, these securities automatically convert into common stock upon a change in control, such as a merger or acquisition, as per the terms in their original agreements. In other situations, these securities must either be settled in cash or swapped for common stock of the resulting entities.
As discussed earlier, cash settlements are not desirable since they deplete cash reserves. If this is a major concern for you, swapping the complex securities for the common stock of the resulting entities is a better alternative.
However, a direct swap can be challenging to execute. Valuation of complex securities often requires sophisticated financial modeling with many assumptions and variables, which increases the potential for valuation disputes.
A more practical approach would be to convert the complex securities into common stock of the pre-merger entities and then swap those stocks for the common stock of the merged entity.
To confidently execute such transactions, you must carefully review the original funding agreements. Failure to adhere to the provisions in these agreements may lead to disputes with investors.
Example
Suppose Forge Metal and Titan Steel have agreed to merge and form TitanForge. Since this is a merger of equals, shareholders of both companies will receive shares in TitanForge at a 1:1 swap ratio. Each share in the pre-merger companies will be exchanged for one share in the new entity.
The details of the existing convertible bonds of these two entities are as follows:
| Bond | Per unit value | Total value | Units issued | Interest rate | Conversion ratio | Maturity date | Credit rating |
|---|---|---|---|---|---|---|---|
| Forge Metal | $1,000 | $100,000,000 | 100,000 | 9% | 5:1 | March 2027 | AAA |
| Titan Steelworks | $1,000 | $150,000,000 | 150,000 | 12% | 4:1 | December 2026 | AAA |
If you were to swap these bonds directly for TitanForge’s common shares, you would need to establish their value first. This would involve using complex techniques such as the Black-Scholes option pricing model, Monte Carlo simulations, and the lattice-based option pricing models.
You can view how convertible bonds are valued using the mentioned techniques in this article.
A simpler alternative would be to convert the bonds and then execute share swaps as per the merger agreement. This approach would play out in the following manner:
| Step 1: Convert the convertible debt | |
|---|---|
| Forge Metal common shares received by Forge Metal’s convertible bondholders = Number of convertible bond units × Conversion rate = 100,000 × 5 = 500,000 common shares | Titan Steel common shares received by Titan Steel’s convertible bondholders = Number of convertible bond units × Conversion rate = 150,000 × 4 = 600,000 common shares |
| Step 2: Apply a share swap ratio of 1:1 | |
| Forge Metal’s convertible bondholders receive 500,000 TitanForge common shares. | Titan Steel’s convertible bondholders receive 600,000 TitanForge common shares. |
This method avoids the complexities of the direct swap while honoring the original conversion terms and the merger agreement.
Restructuring entities from different regulatory jurisdictions
If your corporate restructuring involves entities operating under different regulatory jurisdictions, you may encounter significant differences in shareholder rights across the pre-restructuring entities.
Some examples of differences in shareholder rights in the US and Europe are as follows;
- In the US, only the board can propose changes to corporate charters or articles of association. However, in some European countries, these changes can be proposed by shareholders as well. In Germany, even supervisory boards can suggest these changes.
- In France, shareholders can propose a binding resolution to remove directors at any point in time. However, in the US, binding resolutions to remove directors can be passed only at annual general meetings or meetings convened by shareholders owning at least 10% of the voting capital.
- In the US, supermajority requirements are becoming less common. Only 35% of S&P 500 companies require supermajority votes to amend charters and bylaws. In contrast, a 3/4th majority is required to pass certain major decisions of the management board in Germany. Similar provisions are found in the UK, France, and Italy.
- In the US, the board decides the dividend distribution, but in the UK, France, and Italy, the dividend distribution is decided through binding votes from shareholders.
- Approvals for transactions where there is a conflict of interest are not required in the US. But such approvals are needed in the UK and France. In Germany, such approvals are needed for decisions related to the compensation received by the supervisory board members.
When you are restructuring the corporate structure of entities in different countries, you must devise shareholder agreements that meet the norms and regulatory requirements in each jurisdiction.
Prevention of disputes over the share swap ratio
Suppose you are tasked with restructuring a group where the parent company has demonstrated stable but low growth, and subsidiaries carry high risk but have the potential to deliver high growth. The expectations of those who invested in the parent company will be extremely different than those who invested in the subsidiaries.
In such cases, you must calculate the share swap ratio based on the expected valuation of the merged entity and the valuations of subsidiaries. This ensures that the differences in growth expectations are incorporated in the share swap ratios.
Let us understand this process with an example.
Suppose a parent company is worth $95 million, excluding its ownership in a subsidiary valued at $5 million.
When these entities are merged, the subsidiary’s contribution to the combined valuation is = Subsidiaryy’s valuation/Subsidiaryy’s valuation + Parent companyy’s valuation independent of the subsidiary
= $5 million/$5 million+$95 million
=$5 million/$100 million
= 5%
Let us assume that the parent company has 1 million outstanding shares.
To give subsidiary shareholders a 5% stake in the combined entity, the parent company must issue new shares = Outstanding shares × 5%/100%-5%
≈ 1,000,000 × 5.26%
≈ 52,600
Suppose that the subsidiary has 100,000 outstanding shares.
Then, the share swap ratio will be = 52,600/100,000
= 0.526
So, the investors of the subsidiary will receive 0.526 shares for every share of the subsidiary.
This ensures that subsidiary investors are fairly compensated for contributing a higher-growth business to a larger, slower-growing merged entity.
You must note that successfully executing such a transaction requires consensus on the valuation of all involved entities, which is something that can be achieved with prudent and transparent equity management.
Eqvista- Streamlining equity management!
The success of complex corporate restructuring efforts depends on a thorough understanding of regulatory differences across jurisdictions and the ability to address the diverse needs, rights, and expectations of all stakeholders involved.
Hence, such efforts require extensive compliance support and clear visibility into ownership structures. You can be assured of both these necessities when you manage your equity on Eqvista. Contact us to know more!
