Enhancing the value creation of the company is one aspect of managing and monitoring, but the other side of the story of managing and monitoring is represented by the need to protect the value the company has created. This is a dramatic need for the PEI because, you know, PEI only has a certain time and has to exit maximizing its capital gain. So protecting the value created within the company is very relevant. Protecting the value is not easy, and best practices of PEIs from all around the world suggest that the right way could be to negotiate, to insert, within the relationship between the PEI and the company, a certain number of covenants. Covenants are mechanisms regulating duties and rights of the PEI and the venture backed company itself. The list of covenants is made of nine different mechanisms we must have in mind to understand basically everything about the issue of protecting value. The first covenant is represented by lockup. What is lockup? Lockup is a mechanism where one of the shareholders can’t sell shares before a certain time. Why is it useful? It's useful, for example, within startup businesses. In a startup business, one of the risks for the PEI is that the entrepreneur is going to sell his or her shares immediately. That could be very dangerous because the PEI decided to invest because of the skill of the entrepreneur, and if the entrepreneur decides to leave and sell his or her shares, it's drama for the PEI. With the lockup mechanism, the PEI is able to stop, reduce, and mitigate this kind of risk. The second mechanism is represented by permitted transfer. What is a permitted transfer? A permitted transfer is a more sophisticated lockup, because with permitted transfer, one shareholder can sell its shares only with the approval of the other shareholder. Let's imagine again the case where a PEI decided to invest in a company. With the permitted transfer, the entrepreneur can sell a certain amount of shares or the entire amount of shares only with the approval of the PEI. As you can understand, it's a way, again, to mitigate the risk of the exit of the entrepreneur. The third mechanism is represented by the staging technique. The staging technique is very popular in the US, and it's very popular for startup businesses. What's the concept of staging technique? The concept of staging technique is that a PEI is going to deliver money in different tranches. and each tranche is delivered only if the company is able to be compliant to certain numbers at certain milestones. Well, what's the idea? Let's imagine again a startup. Startups are very risky activities as you know. One story could be the PEI will give the entire amount of money at time 0. Let's imagine 50 million euros. With the staging technique, the idea is to say okay, 50 million euros is the amount of money the PEI is going to give, but the 50 million euros will be split into 5 tranches of 10 million euros, and the conditions to receive the next tranche of 10 million euro is only that the company meets certain numbers written in the business plan. As you can imagine, the staging technique is a mix of a set of tools to reduce the amount of risk and to generate the right incentive for the company to get to specific results. Mechanism number four is represented by stock options. Stock options are very popular within the investment banking system, but also very popular within PE. What is the idea of stock options? Stock option is a covenant where a certain shareholder can buy new shares at a certain favorable price. Why’s it useful within PE? It's useful again, for example, in a startup in early growth, or in all the cases where the entrepreneur is very relevant. With a stock option mechanism, the PEI gives an incentive to the entrepreneur to work a lot in the company. Because if the entrepreneur is going to work a lot, he can buy shares at a very favorable price while the value of the share is bigger. It's very common, this kind of approach, in every moment where the PEI has the majority of shares and the entrepreneur has the minority. And the risk is that the entrepreneur doesn't have the right motivation to work in the company. Mechanism number five is represented by callable and puttable securities. Callable and puttable securities are shares with call and or put options embedded inside. The most common example is a puttable security. A puttable security means the private equity buys shares, but in the shares there is a put option. That means the private equity has the possibility to sell the shares to the entrepreneur. The shares could also be callable. Callable could mean that the entrepreneur has a call option. That means it has the possibility to buy the shares from the PEI and basically firing the PEI. Callable and puttable securities are very common within PE businesses to identify very different exit ways from the marriage between the entrepreneur, the company, and the PE. Covenant number six is represented by tag-along right. What is tag-along right? Tag-along right is a covenant for minority PEIs. With a tag-along, the private equity investor has the right to sell the shares to the entrepreneur at the same price the entrepreneur is going to sell. It's a very beautiful exit way, because in case the entrepreneur is going to sell shares to someone else, the PEI has the possibility to sell the shares at the same price. Covenant number seven is represented by drag-along right. What is drag-along right? With drag-along right, the PEI has the possibility to ask entrepreneur to sell its shares at the same price the PEI is going to sell. Why is the drag-along relevant? It's relevant because with drag-along, the PEI basically has the possibility to sell 100% of shares of the company without owning it 100%. Obviously when you can sell 100% of shares, you can negotiate a wonderful price. Covenant number eight is represented by the right of first refusal. Right of first refusal is where the PEI has the right to buy the shares from the entrepreneur at the same price the entrepreneur is going to sell it to someone else. Basically it’s a mechanism the PEI wants to have to protect the value of the amount of shares it has in its portfolio. The last mechanism, number nine, is represented by the exit ratchet. What is the exit ratchet? The exit ratchet is a covenant where in the moment in which one of the shareholders is going to sell shares to another one, the percentage of the capital gain is given back to the other shareholder. That's the case for example, in which the PEI is going to sell shares. The entrepreneur is very powerful, and he wants to receive a percentage of the capital gain of the PE. Or on the contrary, if the business is super good and the PEI gave a lot of money to the entrepreneur and the entrepreneur is going to exit together with the PEI, The PEI wants to have back a certain percentage of the capital gain of the entrepreneur as an endorsement of the big support that the PEI gave to the company.
