Following a tough few years for most business owners, investors are coming up for air, dusting off their prerecession business strategies and looking to either realize value or secure capital and a business partner for the next leg of the journey.Getting a company off the ground and expanding it requires funding. As banks are chary of lending, raising the right kind of finance is a difficulty...
Following a tough few years for most business owners, investors are coming up for air, dusting off their prerecession business strategies and looking to either realize value or secure capital and a business partner for the next leg of the journey.
Getting a company off the ground and expanding it requires funding. As banks are chary of lending, raising the right kind of finance is a difficulty for Small and Medium Enterprises (SMEs). Such SMEs are often actively wooed by Private Equity (PE) and Venture Capital (VC) investors. The goal of PE and VC is to help businesses achieve ambitions for growth by providing finance, strategic advice, material information and at the same time securing a high return on investments within a span of 3-5 years. Although the overall awareness of PE and VC in India has improved in recent years, a clear understanding of its mechanics is yet required by SMEs. This is even more obvious in the case of smaller firms and family owned businesses. Lack of information, together with the fear of relinquishing control through the exchange of shares for cash flow, hampers SMEs in calling on PE and VC.
Finding the Right Investor
SMEs need to find out what potential investors are looking for. This will enable them to approach investors interested in investing at their current stage of development, in the sector they are engaged in, as well as an amount of funding they are looking to infuse.
PE firms raise their own funds, invest them and reap the profits over a period of 3-5 years. Their funding cycle often determines the duration they will invest in a business, how they wish to get their returns and when they seek to exit from the business. It is useful to find out when a potential investor raised its last fund, its size and the amount of investment they have already committed. It is pertinent to know, if an investor has already invested in businesses that the promoters could have collaborated or if the investor has invested in promoter’s competitor. Promoters should look for investors that can offer useful knowledge, experience and relationship, as well as capital funding.
Initial Negotiations
If the investor is satisfied with the business plan, the negotiations regarding the condition of the transaction will begin and investor will offer an initial term sheet. This will set out the broad guidelines for future negotiations. The investor will then take each section of the business plan and verify or change it using its knowledge of the sector and his previous investments.
At this stage, advisors have a major role to play in assisting SMEs to select the best investment proposals at each stage of the negotiations. It is not enough simply to compare the valuations offered. It is pertinent to analyse the non-financial aspects of the alliance under construction, inter alia, the role of the board of directors, investment conditions, exit strategies, ways in which shares could be sold, preferential rights, etc.
Valuation
Potential investor would like to know how the value of a business is likely to change over time. Milestones, which are markers of how a business is developing and has developed over a period of time, are of utmost importance. Providing one measure of this might give investors a sense of confidence in a business. Investors will be interested in the milestones that have already been achieved and the future milestones that must be reached to be successful.
A milestone could be the number of customers who've signed contracts for a new product or service and if one can show that it has reached such milestones, the value of such a business will automatically increase in the opinion of the investor. Negotiating power will highly depend on how developed a business is and the same should match with the investor's long-term interest and to build a balanced relationship rather than imposing extreme conditions form the outset.
Securing Equity Finance vis-a-vis Protecting Promoters' Interest
Accepting funds from an external investor often results in profound changes to a business and can be fraught with potential legal issues that are overlooked by first-time entrepreneurs. At the same time, if a third party is allowed a stake in equity, one must be ready to allow them to take part in strategic discussions and be transparent in decision-making procedures. The shareholders’ agreement will play a vital role by establishing the principle of joint decisions on certain key matters and by balancing the interests of the shareholders’. Based on the above premise this article deals with issues which SMEs and the promoters shall be aware about while negotiating a PE/VC transaction.
Securing Equity Finance vis-a-vis Protecting Promoters' Interest
Accepting funds from an external investor often results in profound changes to a business and can be fraught with potential legal issues that are overlooked by first-time entrepreneurs. At the same time, if a third party is allowed a stake in equity, one must be ready to allow them to take part in strategic discussions and be transparent in decision-making procedures. The shareholders’ agreement will play a vital role by establishing the principle of joint decisions on certain key matters and by balancing the interests of the shareholders’. Based on the above premise this article deals with issues which SMEs and the promoters shall be aware about while negotiating a PE/VC transaction.
Opportunity to develop business with capital injection:
Parallel to injection of capital, promoters shall have liberty to run their business in a manner they deem fit along with appropriate guidance and strategic advice as an when required from the investor. Promoters shall be cautious while negotiating managerial rights with the investors. A situation may not arise where the promoters require consent of investors for day to day functioning of the company. Limiting the list of matters requiring investors consent to certain key matters and a prior agreement to a set business plan/strategy may help the promoters to run their business smoothly.
Employment security and adequate remuneration:
Typically the employment of the promoters with the company is at the pleasure of the board and the board always has the right to terminate the services of the promoters. However, the promoters should consider including an appropriate termination process. Promoters shall make it sure that they have sufficient representation at the managerial level and shall hold the key position like CEO, COO and CFO.
Limiting personal liability and restrictions:
The promoters shall release themselves from existing personal guarantees, if any. The indemnification that investors generally expect is threefold
- indemnity against the warranties being untrue or false,
- indemnification against breach of covenants made to the investors and
- indemnification for the nominee directors against legal claims.
While it is customary to have such indemnification, it is also customary to limit such indemnification and to put a cap in respect of breach, which is generally a certain percentage of the investment amount.
Liquidation preference:
The liquidation preference determines how the pie is shared on a liquidation event. A term generally used to specify which investors gets paid first and how much they get paid in the event of liquidation, an event such as the sale of the company. Liquidation preference helps protect the investors from losing money by making sure they get their initial investments back before other parties. If the company is sold at a profit, liquidation preference can also help them be first in line to claim part of the profits. Investors are usually repaid before holders of common stock and before the company’s promoters or employees. The promoter may express that he requires a multiple of his original investments in these situations.
Equity participation and return:
The greater the equity participation rate, the higher the percentage of shares owned by the investors. Allowing the investors to own shares ties the investors' success with that of the company. A more profitable company will provide investors with greater gains. It is suggested to tie the financial rewards of executives to the fate of the company, increasing the likelihood that executives will make decisions that will improve company profitability. This type of compensation may be delayed, reducing the possibility of executives making short-term decisions to boost share price.
Ability to deal with shares and sell before "Exit":
Envisaging various exit options needs to be dissolved. The investors negotiate fairly drastic rights. It is important to negotiate with the investors the threshold where rights such as board representation, affirmative voting provisions, drag along rights, right to first refusal, lock-in requirements, promoter (put if given) fall away. The thresholds may vary for different rights and are also dependent on the initial shareholding of the investor
Right of first refusal:
A promoter shall seek to have this right when an investor proposes to sell their shares in the company. While investors typically do not agree to grant a right of first refusal but are usually comfortable with the promoters setting a price at which they may offer to buy the investors shares. While the investors are not bound to accept any offer made, they agree that they will not sell the shares at a price below the price set by the promoters.
This right may seem meaningless at the first thought; however, it is important because it gives the promoters the ability to indentify a buyer whom they are comfortable with. Such clauses also prevent the entry of unwarranted third parties within the company. SME may not have sufficient capital to buy-out; it may be advisable to exclude direct competitors or identified adversary parties under this clause.
Tag along /drag along:
In case investors is making sale of an identified number of shares that may affect the company operations (in terms of total shareholding and board representations or strategic interest) to any third party, promoters may choose to have all/a proportionate number of their shares sold on the same terms and conditions to such third parties (tag along).
This will allow SME with a minority shareholding to benefit from the ability of the investor to get a good valuation of the shares from another investor as well as provide respite in situations where the third party may not be a known entity. A mirror provision for situation where a majority SME shareholder would get more value by selling the minority investor’s stake and may also be a good exit option for minority investor (drag along).
Sale to competitor:
Given the nature of the rights that investors have, they typically agree that they will not sell the shares that they own in the company to any competitor of the company for an agreed duration. A company would not want to permit a competitor to sit on its board and exercise rights such as affirmative vote rights. In addition to this restriction, promoters at times negotiate that they can sell their shares in the company along with the investor in case the investor sells their shares to a competitor.
Anti-dilution/preemptive rights:
This is a right given to the existing shareholders to maintain their fractional ownership of the company by buying a proportional number of shares of any future issue of common stock. A privilege that will give the promoters the right to purchase additional shares in the company before the general public has the opportunity in the event there is a fresh offering.
Such a right is written in the contract but does not function like a put option. When investors, usually a majority shareholder or an investor committing large amounts of capital to a SME, purchase shares, they want to ensure they have as much voting power in the future as they did when they initially invested in the company. By getting preemptive rights in its shareholder's agreement, the promoter can ensure that any fresh offerings will not dilute their ownership percentage.
Conclusion
Following a tough few years for most business owners, investors are coming up for air, dusting off their prerecession business strategies and looking to either realize value or secure capital and a business partner for the next leg of the journey. Many have had their business model stress-tested and survived the down turn, and are now looking for opportunities for fresh investments.