Think of this as part two of my prior posting on legal documents ...
In two transactions recently, I’ve had the following experience. (In each case, it was an investor and an operator, but it could just as well have been lender and investor, or lender and operator.) As the parties drew near to the final signing of documents and transferring of funds, an attorney raised a question regarding an old, innocuous agreement or governance document which no one thought applied or mattered to the business at hand.
In one instance, it was a no-longer-active development agreement which had never been properly cancelled; in the other, it was a document related to the fund’s governance which appeared to prohibit it making certain types of investments (my client’s deal among them!). In both cases, the “opposing” counsel identified the language, brought it to their clients’ attention, and -- in the overly sensitive attitude which always prevails during the final days of any pending deal -- what should have been a minor issue became at least a momentary firestorm. In both cases, the issue was cleared up, and all parties proceeded to fund, but neither issue need ever have appeared.
Let’s take the operator first: while she was properly focused on running her business, she’d been lax at times in reviewing old -- but still outstanding -- contracts to be certain that they didn’t interfere with current plans. In recent months, her counsel and internal staff had caught a few such issues, as they prepared for a new partnership with an investor, but this agreement had slipped through the cracks. Quite understandably, the new investor needed to be assured that a prior agreement wouldn’t jeopardize his ability to work with the operator and develop new units.
Now the investor: while the seemingly endless number of funds which have appeared over the past twenty-five years may seem indistinguishable to operators, some have very specific governance wrinkles, either because of their limited partners’ requirements or because they have access to state or federal funds (development agencies, SBA). Sometimes these restrictions don’t get fleshed out in term sheets and proposals -- as in the case I cited above -- and cause last-minute reconfiguration of the investment instrument. Is it preferred stock? Does it have voting rights on board matters? Are partnership instruments permitted? Somewhat surprisingly, the investor’s requirement for additional warrants actually threatened its ability to hold voting stock, as the exercise of the warrants would have elevated its ownership beyond what its charter permitted. The operator’s counsel caught the inconsistency, and at the (next-to-) last minute the equity investment was reconfigured in order to address the issue.
These things always happen, and there’s no way to avoid them entirely, but I draw three lessons. First, it’s worthwhile for operators (and their boards, and their counsel) to periodically clean out the cupboard, making sure that old agreements aren’t adversely affecting new plans. Second, it’s worthwhile for investors, lenders, and operators to focus attention on innocuous bits of language in term sheets early on, so they don’t become unintentional problems at the last minute. Finally, for both “sides” it’s worth having all documents, contracts, governance agreements, and the like in good enough order that they can be supplied to the potential lender or partner early in the process, so that any potential glitches get discovered early and addressed before everyone’s nerves are frayed.