Key Governance Considerations in PIPE Transactions

Private investment in public equity (PIPE) transactions can be a fast and cost-effective way for companies to raise capital relative to other options—and can present an attractive investment opportunity for private equity funds. However, sponsor-backed PIPEs can raise a number of key governance issues that need to be carefully negotiated. The governance rights afforded to the sponsor typically reflect the anticipated length and nature of the relationship between the sponsor and the issuer, as well as the size of the sponsor’s investment in the issuer, and may implicate SEC regulations, stock exchange rules and state laws. Below are nine key governance issues that regularly arise in sponsor-backed PIPEs.

1. Is the Issuance of Securities Authorized Under the Charter? At the outset of a PIPE transaction, the sponsor should confirm with the issuer that it has sufficient authorized but unissued common stock to consummate the transaction or, if it is issuing a different type of security (such as preferred stock), that such security is authorized to be issued under the issuer’s certificate of incorporation. Where the charter includes “blank check” preferred, the board may designate a new series by resolution, and sponsors should confirm whether a separate class vote is required if terms could adversely affect existing classes and that the share reserve covers the full as-converted amount. If sufficient shares are not available, or the type of security being contemplated is not authorized, the issuer would need to seek stockholder approval to amend its charter, which can have significant timing and structural implications for the transaction.
2. Are There Contractual Limitations to Be Considered? The structuring of the PIPE transaction must take into account limitations under the issuer’s existing debt and other senior securities, such as restricted payments limitations, incurrence tests and change-of-control definitions tied to voting power that a PIPE could inadvertently trigger. There may also be other contractual agreements that place limitations on the terms of the PIPE, including by restricting dividend rights, redemption provisions or conversion features. The sponsor should confirm with the issuer that the structure of the PIPE is permitted under the agreements to which the issuer is a party. Where the investor or its upstream owner is a non-U.S. person, and the investment includes a board/observer or broad information rights, the parties should also consider whether CFIUS review is advisable.
3. Are Board Representation Rights Desired? In many cases, the sponsor will negotiate the right to minority or proportional board representation. Board observer rights may also be granted, either in addition to or instead of board representation. Typically, board representation rights fall away if the sponsor’s ownership interest falls below a certain negotiated level. Depending on the issuer’s charter, a sponsor-appointed director may be directly appointed to the board by a resolution of the board at closing, or that person may need to be nominated and approved by the issuer’s stockholders at the next annual stockholder meeting. Board representation can provide sponsors with greater access to information and the ability to influence the strategic direction of the issuer, but representation also brings with it fiduciary duties and potential liability for the director. Sponsors and issuers should also align on committee participation, observer NDAs and MNPI management/cleansing processes. If the sponsor has portfolio companies that arguably compete with the issuer, Section 8 of the Clayton Act regarding overlapping directors should also be considered.
4. What Voting and Consent Rights Are Required? Sponsors are sometimes granted consent or veto rights over certain corporate actions. In the context of PIPE transactions, these rights are typically limited to protecting the economic and structural position of the investment. For example, sponsors may have the right to veto amendments to organizational documents that would adversely affect their preferred equity or violate the certificate of designations, or to veto the issuance of new preferred equity that is senior to or pari passu with their own.
5. Is the Issuer Requesting a Standstill or a Lockup? Nearly all PIPE transactions include a “standstill” period during which the sponsor and its affiliates are prohibited from making unsolicited bids and open-market purchases of the issuer’s securities. The standstill period is often the longer of (i) a fixed period following the closing and (ii) a period following the expiration of board nomination or observer rights. The issuer typically negotiates a “lockup” period during which the sponsor is prohibited from transferring the issuer’s securities for a specified period following the closing of the PIPE transaction. The lockup is designed to protect the market price of the issuer’s stock and ensure alignment on a longer-term investment. Lockup periods generally range from 12 to 24 months but may vary depending on deal terms. In some cases, the lockup may permit the staggered release of securities for resale over time.
6. What Information Rights Does the Sponsor Require? The issuer may grant the sponsor certain information rights, the scope of which can vary depending on the size of the sponsor’s investment and whether it has board representation. Because the sponsor is acquiring securities in a public company, the information rights granted in a PIPE transaction are generally narrower than those in private company financings since much of the issuer’s information is already publicly disclosed through SEC filings.
7. Is Stockholder Approval Required? A key question to be answered in connection with structuring a PIPE transaction is whether stockholder approval under stock exchange rules is needed for the issuance. Two rules in particular warrant close attention: The 20% Rule: Under stock exchange rules, stockholder approval is required for any issuance of 20% or more of the common stock (or securities convertible into or exercisable for common stock) or voting power outstanding prior to the issuance, in any transaction other than a public offering, that is for less than the lower of: (i) the closing price of the common stock immediately preceding the transaction or (ii) the average closing price of the common stock for the five trading days immediately preceding the transaction. If the PIPE is being issued in connection with an acquisition, and the potential issuance size exceeds the 20% pre-issuance threshold, stockholder approval is required even where the issuance price exceeds the minimum price threshold. If a PIPE meets the exchange’s standard for a public offering for cash, the 20% rule will not apply. However, where a single sponsor or a small group of sponsors provides the funding, the transaction will typically not qualify as a public offering for cash and thus will remain subject to the 20% approval requirement. If the purpose of the funding allows, sponsors may structure their investment in two steps: a 19.9% or less tranche that can close immediately, and the balance contingent upon obtaining stockholder approval. Alternatively, sponsors making a convertible preferred stock investment that would otherwise require a stockholder vote may agree to cap conversion and as-converted voting of the preferred stock at 19.9% until the stockholder vote is obtained. However, utilization of a conversion cap to avoid shareholder approval must be structured in a manner that complies with stock exchange listing rules and doesn’t run afoul of state corporate law requirements. Counsel should be consulted if a conversion cap is being considered to avoid the need for a shareholder vote prior to the closing of a PIPE investment. Change of Control: Stockholder approval will be required if the transaction is of sufficient size to constitute a “change of control” under stock exchange rules—even in situations where a sponsor may not view the investment as a traditional control transaction. When determining whether a change of control will occur, the exchanges will look to all facts and circumstances surrounding the transaction. NYSE guidance suggests that change of control is typically a concern when the transaction results in an investor or group reaching 35-40% ownership. Nasdaq, on the other hand, considers a change of control to occur when, as a result of the issuance, an investor or a group would own, or have the right to acquire, 20% or more of the outstanding shares of common stock or voting power, and such ownership or voting power would be the largest ownership position.In addition, certain related party transactions may require stockholder approval under the stock exchange rules.
8. What Is the Path to Liquidity and Exit? A critical consideration for the sponsor is how to secure liquidity and how, in time, an exit will be effectuated. A sponsor will often seek registration rights in the form of (i) demand registration rights requiring the company to register the sale of acquired shares pursuant to a resale registration statement and (ii) piggyback registration rights that allow the sponsor to join in a registered primary offering by the company or a secondary offering by other company stockholders. In the absence of registration, the most commonly used exemption for the resale of securities by investors is Section 4(a)(1) of the Securities Act of 1933, as amended. To ensure the availability of the Section 4(a)(1) exemption, an investor selling “restricted” securities (i.e., securities acquired in unregistered transactions) or “control” securities (i.e., securities held by an affiliate of the issuer) will typically seek to comply with the relevant provisions of Rule 144 of the Securities Act. However, it is important to remember that Rule 144 precludes the sale of restricted securities during the applicable holding period (which is either six months or one year, depending on the relevant facts) and subjects the sale of control securities to volume and manner of sale limitations. Restricted or control securities may be resold pursuant to a different exemption from the registration requirements of the Securities Act. However, reliance on any such exemption limits the pool of potential investors to institutional and certain sophisticated investors and frequently causes purchasers to demand a “liquidity discount” on the purchase price since the securities will remain restricted in the hands of the purchaser.
9. What Are the SEC Filing Obligations? Sponsors should be prepared to comply with SEC disclosure requirements following the closing of a PIPE transaction. If the sponsor acquires beneficial ownership of more than 5% of a class of the issuer’s registered equity securities, it will become subject to ongoing reporting requirements under Section 13 of the Securities Exchange Act of 1934, as amended, and the sponsor must file a Schedule 13D or, in certain limited circumstances, a Schedule 13G. Recent amendments have accelerated certain 13D/13G timelines and clarified amendment timing. Coordination between investor and issuer counsel is important where voting/support agreements, derivatives or cooperation terms could affect “group” analysis or the choice between a Schedule 13D and a Schedule 13G.If the sponsor acquires beneficial ownership of more than 10% of a class of the issuer’s registered equity securities, it will also become subject to Section 16 of the Exchange Act. Section 16 imposes ongoing reporting obligations, including the filing of an initial Form 3 and subsequent Form 4s to report changes in ownership, as well as liability for the disgorgement of any “short swing” profits within a six-month period. Finally, the election of a director to the issuer’s board may trigger separate SEC disclosure obligations for the issuer and for the director. The sponsor should confirm with the issuer that all such director filings will be handled by the issuer.