SME promoters should be unfazed by sectoral vagaries and instead focus on the tangibles within their control as such ventures are bound to find investors.On their part, investors should ensure that they enter into a transaction with eyes wide open and only after having studied the proposal thoroughly.Beyond the images conjured by their name, the small and medium enterprises (SMEs) have made...
SME promoters should be unfazed by sectoral vagaries and instead focus on the tangibles within their control as such ventures are bound to find investors.
On their part, investors should ensure that they enter into a transaction with eyes wide open and only after having studied the proposal thoroughly.Beyond the images conjured by their name, the small and medium enterprises (SMEs) have made a major contribution to the Indian growth story. SMEs in India account for up to 40 percent of exports and up to 70 percent of the employment in the manufactured goods sector and yet, their quest for financing is beset with numerous obstacles at both the domestic and the international levels. In these times of spiraling wage inflation, the need to ensure access to ready finance through debt or equity becomes all the more vital for an SME.
This article briefly discusses aspects related to structuring a private equity (PE) or venture capital (VC) deal in the SME sector.
The Financing Pyramid
Typically, the source of funding accessed by an SME varies as it grows in size, observable as a network of expanding concentric circles which gradually increase in complexity and sophistication. Over the years, the options available to an entrepreneur in a SME sector for funding expansion and growth has been restricted to self-generated business income, support from family and friends and loans from banks, which are neither adequate nor easy to come by.
In the scheme of the Micro, Small and Medium Enterprises Development Act, 2006 (Act), a micro enterprise refers to a business concern having capital equipment not exceeding rupees ten lakh or twenty-five lakh, depending on whether the enterprise is a manufacturer or a service provider. To raise capital further to the extent of one to three crore, entrepreneurs have to often rely on seed funds and angel investors.
This form of fund-raising has gained substantial momentum in the last few years as investors have recognized the value of investing in promising ventures at the seed stage. The risk in financing nascent ventures is more than set off by the higher returns expected as the company progressively grows in scale from small to medium and then to large. Angel investors are like-minded individuals organized in groups and capable of offering not only capital but also mentorship which is invaluable to start ups and micro businesses.
Often, an SME turns to PE or VC funds to obtain further financing for expansion of working capital, reduction of debt, diversification of business, etc. Often seen as the 'big brothers' of seed funds, they offer additional capital to foster the growth of companies with credible balance sheets.
Typically, while a VC fund invests in a small to medium enterprise, a PE fund targets well established companies with high capital requirements. In either case, there is no scope for promoters to sell their stake as PE and VC investors are usually insistent on promoters not diluting their shareholding significantly, till they are offered an exit.
Structuring a Deal
Most PE and VC players are financial investors who rarely wish to remain wedded to a company in perpetuity. However, they bring with them a great deal of experience, managerial skill and business contacts which could propel a fledgling company with potential into the big league of performers. A well structured PE deal is a win-win game in theory for both an investor looking for a lucrative return on their investment and for promoters of start-ups and mid-size companies, looking for that initial push or subsequent growth capital.
Through the period of transition and till the investor gets an exit as desired, the company remains accountable to the fund. Funds usually keep a check on the managerial autonomy of the promoters by being part of the board of the company till the time of exit. If all goes well and the agreed growth targets are achieved expeditiously, the company can regain full control and bolster its operations and the investor can walk away with a juicy return.
The following are the stages once a potential investor is recognized:
(i) Term Sheet Stage
Prior to finalization of the term sheet, the investor and the promoters negotiate the central elements of the transaction. The focus areas at this stage are valuation and growth prospects of the company. Once the investor is satisfied as to the prima facie financial health of the company, the investment amount is agreed on by the parties depending on the capital requirement and the intended use of the proceeds.
A significant part of the negotiations at this stage is typically centered around the types of shares to be issued, equity or preference, and the nature and extent of investor rights, including anti-dilution rights, exit rights and tag-along and drag-along rights. Investors usually insist on a list of items which the promoters or the company are not allowed to perform without the investors' prior written approval. Though the term sheet is non-binding, it forms the basis for drafting of the definitive agreements to be entered into by the parties.
(ii) Due Diligence
The outcome of the due diligence on the company is often a crucial factor in the decision-making process of the fund on whether it should persist with the investment. While the financial due diligence is concerned with the financial statements, accounts, assets and liabilities of the company, the legal due diligence is concerned with the legal existence of the company, the material contracts entered into by the company including the contracts with its key personnel and the overall legal compliance of the company. In this regard, the need for SMEs to maintain up-to-date accounts and remain in strict compliance with the law of the land cannot be overemphasized.
(iii) Agreement
If the due diligence does not throw up any nasty surprises for the investor, the parties then proceed to the agreement stage, where the commercial understanding in the term sheet is captured in the definitive covenants - the shareholders agreement and the share subscription agreement. The agreement stage can be protracted depending on the comfort between the parties and their respective legal counsel.
At the agreement stage the respective counsel would be guided by the commercial understanding between the parties and ensure that provisions in the agreement, particularly the manner of enforcement of rights, are set out in a clear and detailed manner. Upon all the parties and their respective counsel reaching consensus, the definitive agreements are signed and executed by the parties or their authorized signatories.
(iv) Exit: IPO v. M&A
While an investor may exit a company by more than one route, making an Initial Public Offer (IPO) by the SME remains a perennial favorite. While this may be an ideal way for the company to tap into the vast reservoir of public funds in order to unlock its true growth potential, this mechanism has its fair share of drawbacks. Listing of a company is an expensive and time consuming process, and requires an SME to put in the necessary toil to ensure that it is compliant with all applicable regulatory norms and requirements. Additionally, it is hard to ignore the fact that external factors outside the control of the SME, such as prevailing market sentiments, have a huge role to play in the outcome of an IPO.
Recently, induction of funds through mergers and acquisitions (M&A) has gained a lot of currency in the market. The M&A route protects, to a certain degree, the downside risk as valuation of stock will be made on negotiated terms to the satisfaction of all parties, injecting some much needed certainty into the proceedings. Therefore, instead of having to convince the world at large of the fundamentals of the company, a successful pitch needs to be made to only one party or consortium of acquirers. Further, if the seller can attract more than one suitor to the altar, the resultant bidding war will ensure IPO-like valuations.
Regulatory Turmoil
The enforceability of restrictions on free transferability of promoter shares has come under the judicial as well as regulatory scanner on more than one occasion in relation to both listed as well as unlisted public companies. There have been news reports indicating that the Reserve Bank of India treats fixed-price exits promised to foreign investors - a ubiquitous feature in PE investment agreements involving offshore investors - as external commercial borrowings or debt, which is not permitted in all sectors and therefore, investors in such regulated sectors may find their exit option blocked. Only time will bring more clarity to the above issues.
Despite many indices suggesting that SMEs are finding it difficult to survive the prevailing adverse business climes, the fact remains that the market always has space for an enterprise characterized by value addition and growth prospects. Therefore, promoters should be unfazed by sectoral vagaries and instead focus on the tangibles within their control as such ventures are bound to find investors. For their part, investors should ensure that they enter into a transaction with eyes wide open and only after having studied the proposal thoroughly. Sound legal advice is also a pre-requisite for the investor class, especially to ensure that proposed exit routes do not turn out to be mere cul de sacs.