Click here for printer friendly page

Sweden's private equity industry

International investors entering the Swedish venture capital market will recognise many of the features of the region's deal-making process. Yet there are some important differences, as Fredrik von Baumgarten and Sara Bohman of law firm Vinge explain.

During the past few years, the Swedish private equity market (including both venture capital and buy-outs) has shown considerable strength. In 2001, Sweden topped the list prepared by the European Private Equity and Venture Capital Association (EVCA) showing a country's private equity investments compared to GDP. Swedish investments amounted to 0.87  per cent of the GDP followed by the UK (0.65 per cent) and the Netherlands (0.44 per cent). In the buy-out market, Industri Kapital, EQT and Nordic Capital have contributed to the country's prominent position. But even with buy-outs excluded from the figures, Sweden topped the list for 2001 with 0.43 per cent of GDP. Large Swedish firms in the venture capital market include HealthCap, Investor Growth, 3i and Startupfactory.

Considering the rapid development of the Swedish venture capital market since 1998, the gap between the Swedish and the Anglo-Saxon market has been reduced. International investors entering the Swedish market can generally expect to recognise most of the features of a Swedish venture capital deal, although certain matters will be dealt with differently. In this article, we will focus on problems that are approached differently in Sweden, which we believe are of particular interest to international venture capitalists looking to invest in Swedish target companies. These include:

• investment documentation; including the reliance on contractual obligations rather than on obligations in corporate documents;
• convertible preference shares and the mechanics for anti-dilution protection; and
• the format for representations and warranties.

Investment documentation
Swedish deals normally feature a shareholders' agreement and a subscription agreement, as well as articles of association for the target company. The terms and conditions typically included in Swedish investment documentation are not fundamentally different from those used in other countries, although the documentation tends to be less comprehensive than in, for instance, the US and the UK. The comparative brevity of the documentation is owed to a combination of tradition and the concepts of reasonableness and fairness, which apply to all Swedish transactions. In recent years, it would appear there has been a tendency to use longer agreements, which may indicate a move towards a more Anglo-Saxon style.

One special feature of Swedish investment documents is the format of Swedish articles of association - the short-form document often coming as a surprise to international investors entering the Swedish market for the first time.

The Swedish legislator distinguishes between provisions binding upon the company, on the one hand, and agreements among the shareholders, on the other, where normally the former but not the latter may be included in the articles of association. The articles would typically include provisions concerning preferential rights to dividends and to proceeds upon liquidation, and regulations concerning redemption and conversion - all of which are matters involving the company. Meanwhile, tag-along and drag-along provisions, and preferential rights in trade sales are all matters concerning only the shareholders, and thus not items that can be included in the articles.

The practical consequence of the restrictions on the contents of the articles is that the investors primarily will have to rely on the contractual obligations in the shareholders' and subscription agreements, without being able to extend any obligations to the company. For this reason, it is often necessary to ensure that all shareholders sign up to the agreements or at the least confirm the essential terms in separate undertakings. In a trade sale, for instance, the investors may not be able to force shareholders who are not bound by the agreements to sell their shares. Even if a buyer with more than 90 per cent acceptance may squeeze out any non-selling shareholders, such a procedure can be both costly and time-consuming. Furthermore, shareholders who are not bound by the agreements are not obliged to share their proceeds with the other investors pursuant to any preferential structure, unlike shareholders who are bound by the agreement.

To secure flexible exit opportunities, it is advisable to ensure that contractual provisions regarding drag-along and preferential distribution of proceeds apply to all shareholders. If they do not become parties to the shareholders' and subscription agreements, such shareholders should, at least, make separate undertakings confirming these provisions. Naturally, not even unanimous adherence to the agreements can guarantee that the obligations are enforceable in an action for specific performance. A final observation is that normally it would not be in line with market practise to require joint and several liability among the founders where these are individuals. Thus, in the event of a breach of provisions of this type, an investor may have to rely on several independent claims for damages.

Convertible preference shares
The Swedish Companies Act only allows conversion from one class of shares to another class of shares applying a ratio of one-to-one. In the articles of association it is customary to include the right to convert one preference share into one common share at any time, and an obligation to do so in the event of an initial public offering (IPO). The obligation to convert in an IPO situation is based upon the standard market practice that banks assisting in a Swedish IPO would - for reasons pertaining to the valuation - recommend conversion before any listing.

Given the mandatory conversion ratio, the anti-dilution protection required by investors must be constructed differently in Sweden from elsewhere. Anti-dilution protection is used to protect against a reduction of the value of the investment because of future share issues by the target company at a subscription price below the price paid by the investor. In the US, for example, anti-dilution protection normally is created by the use of preference shares convertible into common shares in accordance with specific formulae taking into account the effects of future issues.

The technique normally used in Sweden is for the founders and other shareholders, if any, contractually to undertake to vote for an issue of new shares directed to the investors with a subscription price amounting to the nominal value (a so-called compensation issue). Because shares may not be issued for free in Sweden, consideration amounting to at least the nominal value must be paid to the company. The investor's payment of the nominal value in the compensation issue must be taken into account when constructing the anti-dilution formula. Alternatively, protection can be achieved by requiring the founders to agree to transfer shares to the investors for free in the event of an issue that dilutes their investment. This, however, is rare.

In other words, the investors will need to rely on contractual undertakings from the other shareholders also for anti-dilution protection. Again, it is vital to secure full adherence to the shareholders' and subscription agreements. Even if a directed issue only requires a two-thirds majority vote by the shareholders, the compensation issue may be challenged by reference to the principle of equal treatment of shareholders, since the compensation issue may be deemed to be unfair enrichment of the investors at the other shareholders' expense. Securing prior consent by all shareholders to compensation issues reduces the risk that equal treatment issues arise at the time of the issue. But, as with provisions on drag-along and preferential distribution of profits, even unanimous adherence cannot fully ensure the enforceability of the compensation issue or a transfer of existing shares for free.

One way to secure the contractual obligations, and a way to shift the risk involved in relying on such obligations, is to arrange for an issue of warrants to subscribe for new shares to the investors. This has a strike price equivalent to the nominal value and an exercise period of, say, three years (these are called anti-dilution warrants). Thus the investors do not have to rely on the other shareholders' undertakings to vote for the compensation issue, but may instead exercise the anti-dilution warrants in the event of any future share issues. To make this procedure more acceptable to the founders, the investors must typically undertake not to exercise the anti-dilution warrants unless there is an issue that dilutes their holding. It may also be agreed that the warrants be placed in escrow.

These techniques for providing anti-dilution protection may be replaced with a more refined international technique within the next couple of years, should the current proposal for a new Swedish Companies Act be adopted. The proposal seeks, among other things, to abolish the nominal value of shares.

Representations and warranties
Representations and warranties form a natural part of the structure in connection with investments in more developed companies, but also feature (although to a more limited extent) in most seed and start-up investments.

Most international investors come from a background where the target company is the entity that will provide the representations and warranties - in our experience, term sheets drafted by non-Swedish investors typically contain a provision concerning target company representations and warranties. In Sweden such a provision would meet the argument that a target company cannot give any representations and warranties to investors in connection with an issue of securities, and that any representation and warranties provided would not be legally enforceable. The overwhelming majority of legal scholars in Sweden are of the opinion that a payment under target company representations and warranties given in connection with new equity capital would undermine the company's equity and would therefore conflict with creditor protection rules. In addition, it is arguable that any such payment would favour certain shareholders and thus conflict with the fundamental rules regarding equal treatment of shareholders.

An investor may require that, instead of the target company, the existing shareholders of the company give representations and warranties for the benefit of the investor. The investor will then have to rely upon the shareholders' ability to pay compensation should a breach of the representations and warranties occur.

Normally, founders who are private individuals may be reluctant to give up their 'houses' and risk bankruptcy. There may also be institutional investors who argue they are not allowed (by their constitutional documents or otherwise) to give representations and warranties, or that they only have board representation and are consequently not in a position to verify any representations and warranties.

The negotiations normally end with the founders being forced to give representations and warranties, but with the liability capped at the value of their shareholding in the target company. The value of such is open to question. Should there be a breach of the representations and warranties leading to a black hole in the target company, the founders' shares would be worthless. The understood value of representations and warranties of this type is that the founders are forced to carefully review the representations and warranties, and to disclose any potential risks that the investor may not have been able to identify during its due diligence of the target company.

As an alternative, or usually in combination with this solution, investors can stipulate that the target company compensate them for any breach of the representations and warranties in the form of newly issued shares. Where all shareholders are party to the shareholders and subscription agreements it is possible to argue that the shareholders have agreed to set aside the principle of equal treatment, such that the new share issue would not be susceptible to challenge.

An even safer solution for investors is to make an arrangement whereby the company will issue warrants to subscribe for new shares (combined with an undertaking from the investors not to exercise the warrants except in case of breach). As with anti-dilution warrants, the investor would then have the corporate instruments in its hand and would not have to rely upon the other shareholders' contractual obligation to approve the share issue upon a breach of the representations and warranties. The disadvantage with this solution is, of course, the dilution that exercising such instruments would have and the impact of the arrangement in future investment rounds involving new investors.

Proposals for a new Swedish Companies Act will most likely enable target companies to give, and investors to enforce, representations and warranties in relation to an issue of equity securities.

Summary
An overriding concern for investors seeking to invest in Sweden should be to ensure that all shareholders in the target company sign up to the shareholders' and subscription agreements, or at least to separate undertakings covering the most essential provisions outlined here. New legislation, which is likely to come into force some time in 2005, may eliminate some of these particular issues arising under Swedish law, making the Swedish market place even further efficient.

Copyright © 2003 Vinge

Fredrik von Baumgarten is a partner and Sara Bohman an associate at Swedish law firm Vinge.

Vinge is a modern commercial law consulting company that provides a comprehensive range of services at international level. It has a solid reputation as a valuable adviser on mergers and acquisitions, corporate finance and other large-scale transactions. For more information please visit www.vinge.se