The second exit. Why the fund’s clock decides when the company is sold

We met in his office because he wanted someone to read a single paragraph from four years earlier with him. Four sentences that, by his reckoning, had cost him PLN 18 million. It was the drag-along.

Four years earlier he had sold 70 percent of the company to a private equity fund and kept 30 percent for himself. Now the fund was selling the whole company to another fund, and he was selling alongside it, because that is what the agreement provided.

The company was generating PLN 30 million of normalized EBITDA, that is, EBITDA with one-off costs stripped out. The deal was closing at a multiple of seven, which gave a valuation of PLN 210 million. His 30 percent was worth PLN 63 million. Two years later, once the changes in the business were complete, a multiple of nine would in his view have been realistic: PLN 270 million, and PLN 81 million for his stake. Both amounts are 30 percent of the value of the whole company before deducting net debt, meaning bank loans, other loans and leases less cash, and before taking the order of payouts into account. I have changed the details so that neither the company nor the parties can be identified, and I have rounded the figures.

Nobody dishonest took that PLN 18 million from him. The fund used a right that the owner himself had given it, and the fund’s calendar ran out before the company’s plan did.

The clock you will not see in the presentation

A private equity fund invests other people’s money. It raises it from pension funds and insurers, from development institutions and sometimes from wealthy families. Always for a fixed term, usually ten years, with an option to extend by a year or two.

The first five years of that term are the investment period. After that the fund has to sell everything it has bought and return the capital to its investors together with the profit. If it buys a company in the fourth year of its life, it has roughly four or five years with it before it sells it on.

Investors judge a fund by two measures: how many times it has multiplied their capital, and what annual rate of return it achieved in the process. The second depends on time. Doubling capital in four years gives about 19 percent a year; doing it in seven years gives about 10 percent. Holding a good company for longer can lower the average annual return that the managers will show investors when they raise capital for their next fund. Closer to the end of the term for which the capital was raised, what counts above all is cash actually returned to investors, because the valuations of companies not yet sold cannot be paid out.

Seen in this light, the opening example looks different. Growth in the value of the whole company from PLN 210 million to PLN 270 million in two years is about 13 percent a year, and only if the plan works. If the company is paying down debt from current profits over that time, the value of the shares alone grows faster. For an owner who knows the business from the inside, two years of waiting make sense. The fund checks whether another two years will raise its average annual return measured from the day it invested, and weighs that against the risk that the multiple of nine stays on paper. Both sides did their sums correctly, each by its own calendar.

There is one more thing entrepreneurs learn only in practice. Toward the end of its life a fund often sells several companies at once, because it is winding down its portfolio and returning capital. Each of those companies is then one line in that schedule.

Drag-along and tag-along

Both clauses appear in almost every investment agreement with a fund, also called a shareholders’ agreement. It is the document that governs cooperation after the deal: who appoints the board, which decisions require the investor’s consent and when each party may sell its shares. The share purchase agreement sets the price. The investment agreement determines what the owner’s next four years and his second exit will look like.

A drag-along, or drag right, allows the majority shareholder to require the minority shareholder to sell his stake together with it. To the same buyer, on the same terms, on the same day. The minority shareholder’s consent is no longer needed at the time of the sale, because he gave it earlier, when he signed the agreement.

A fund will not give up this clause, and for good reason. A buyer usually wants one hundred percent of the shares, because a minority shareholder limits its freedom, and that lowers the price. Without a drag-along right, every future buyer would have to negotiate separately with the holder of the minority stake. That adds months to the process and creates a risk the fund tries to avoid.

A tag-along, or co-sale right, works in favor of the minority shareholder. If the fund sells its stake, the minority shareholder can join that transaction and sell his shares on the same terms. Without this clause he could end up sharing the company with someone he had not chosen, who had paid the fund a control premium and paid him nothing.

The drag-along protects the fund, and the tag-along protects the owner. The fund decides whether to use the first. The owner can use the second only when the fund is selling its stake, within the deadline set in the agreement.

Who buys the second time

Entrepreneurs assume that the fund will be followed by a trade buyer that takes over the company and folds it into its own business. In Central and Eastern Europe this is still the most common exit route. According to Invest Europe figures, in 2024 funds exited 123 investments in the region. In 37 cases the company was bought by a trade buyer, in 10 by another private equity fund, and 5 companies were listed on the stock exchange.

A sale to another fund, known as a secondary buyout, happens less often, but it shows up where the selling fund is short of time. Another fund can close a deal in a few months, because buying and selling companies is its everyday work. A trade buyer decides more slowly and at its own pace. In the opening example the buyer was, in fact, another fund.

A new fund rarely buys a company without the people who run it. It often expects the owner to stay on the board and reinvest part of the price he receives. For an owner who agrees, a secondary buyout means a second four-year cycle: a new plan, new debt taken on to fund the purchase, a new way of reporting and a partner he did not choose himself.

A secondary buyout does, however, give him one argument. The drag-along right obliges him to sell his shares on the same terms as the fund. An obligation to reinvest part of the money with the new acquirer, or a new non-compete, does not usually follow from it. If the buying fund makes its offer conditional on the existing owner staying with the company, the owner gains a stronger position in that conversation.

A trade buyer usually pays the most, but the company then loses its independence. The third option is a continuation fund: the manager sets it up in order to move the company into it and hold it for more years. In that case it is worth checking the valuation closely, because in practice the same team sits on both sides of the deal.

Why 30 percent of the shares does not always mean 30 percent of the money

Net debt is deducted from the value of the whole company first. Only the remainder is the price for the shares, and the fund’s shares and the owner’s shares need not carry equal rights to that amount. The fund pays cash for its stake and wants to get that cash back even in a weaker sale. It can reserve in the investment agreement a priority in the split of the price, known as a liquidation preference, or put in part of its capital as an interest-bearing shareholder loan. In both cases the capital the fund put in comes back to it first, sometimes increased by interest fixed in advance for each year. Only the surplus is divided according to the percentages.

At a high price the owner barely feels this, because a lot is left to divide after the fund’s contribution has been returned. At an average price the priority changes his payout by an amount nobody had calculated beforehand. At a weak price, when the company’s value grew more slowly than the interest accruing to the fund, little or nothing is left of his 30 percent, even though the whole company was sold for more than the fund paid for it. I wrote about this separately when discussing funds that say no: what counts first is your place in the payout queue, and only then the percentage.

What to negotiate when the fund comes in

All the terms below are negotiated before the investment agreement is signed, while the fund is still competing for the company. After signing, none of them will come back to the table. At Capital One Advisers we go through this list with the owner before the first meeting with the investor. I treat the first three points as mandatory and the last two as worth pushing for.

The first is a price threshold on the drag-along right. The clause applies only when the price exceeds an agreed level, for example a set multiple of EBITDA or a set rate of return for the owner. Below the threshold his consent is required. Another owner negotiated a threshold of eight times EBITDA. The fund sold the company a year later than it had planned, because at seven times it could not use the drag-along right.

With a threshold like this, the definition of EBITDA matters. At the same price, a lower EBITDA gives a higher multiple, so a fund that wants to sell the company and controls its governing bodies has an interest in calculating the result conservatively, for example by booking additional provisions. Sample wording: “The Investor shall be entitled to exercise the Drag-Along Right only if the enterprise value implied by the acquirer’s offer, equal to the aggregate price for all the shares plus Net Debt, is not less than [X] times the Company’s EBITDA for the last twelve months, calculated in accordance with the principles and adjustments set out in Schedule […].” A safer structure combines the multiple with a minimum amount in zlotys or a minimum rate of return for the owner’s stake. This also protects him if EBITDA itself falls in the year of the sale.

The second is a protection period. The drag-along right does not apply for the first three years after the fund comes in. This clause is worth as much as the owner’s forecast: if the plan needs four years, it is worth negotiating four.

The third is the same payout order, or a difference that has been calculated. Ideally, the owner’s stake should be settled in the same way as the fund’s stake. If the fund will not give up its priority, it is worth asking, before signing, for the payout to be calculated under three valuation scenarios. Only then can you see what 30 percent really means.

The fourth is a right of first offer. If the fund intends to sell, the owner can be the first to make an offer, within the deadline set in the agreement. This rarely ends in a buyout, but it gives him information about the price and time to arrange financing.

The fifth is a partial sale when the fund exits. The owner can reserve in the agreement the right to sell part of his stake and keep the rest, if the buyer does not demand one hundred percent of the shares. Funds agree to this more often than entrepreneurs ask for it.

Liability on the second exit is a separate matter. In the share purchase agreement the sellers give representations and warranties about the company, and if these are breached they pay the buyer compensation. A fund exiting an investment usually limits itself to representations about its legal title to its own shares, because it has to settle up with its investors and cannot keep reserves for claims. The buyer, however, expects warranties covering the company’s entire business and looks for them from the owner who stays on the board. Without a provision in the first agreement, in a forced sale the owner may be liable for the whole company even though he receives 30 percent of the price. What protects him is a provision that, under the drag-along right, he is liable in proportion to his stake and only up to a predetermined portion of the amount he received.

What these clauses will not fix

In most processes the fund exits at a reasonable moment, and the entrepreneur earns more from it than he would have on his own. Access to capital and experience from other companies can be worth more than two years of waiting. The fund’s calendar does harm only when the company’s plan needs more time than the fund has left.

No clause will help if the company does not achieve the planned result. A price threshold protects against selling too cheaply, but it does not change what the company is worth.

An entrepreneur who does not want a second four-year cycle with a new investor can consider, even before talks begin, selling all his shares at once. Keeping a stake makes sense when he believes it will be worth clearly more in four years’ time, and when he is prepared to work those four years on someone else’s terms.

At Capital One Advisers we negotiate the investment agreement in parallel with the price. The price is one number that the parties agree in a few conversations. The terms of the second exit stay with the entrepreneur for years.

A stake alongside a fund

The same arithmetic applies to any minority stake held alongside a larger shareholder: in a venture capital round, and when a trade investor comes in with the right to buy the remaining shares. A stake left in the company gives you a share of a price that someone else will set, in a year that someone else will choose.

For years I recommended that owners keep a stake when a fund came in. After several exits like this, I now start with a different question: does the owner want to work another four years on someone else’s terms?

Practitioners see this differently. Some regard a minority stake alongside a fund as the best way to share in growth that the owner could not have financed himself. Others point out that the timing and price of selling that stake are decided by someone who counts time differently. The first group is right when the company’s plan ends before the fund’s deadline. The second is right when the plan needs two more years. When a fund comes in, it is rarely clear which of these will happen.

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