While an idea may be the genesis of an entrepreneurial venture, it’s the economic viability that defines its success. Drawing an analogy from the above statement, it is fair to state that while starting up a venture may be convenient to achieve, expansion of the business requires certain funding requirements apart from the initial seed capital. One of the common methods of infusing additional capital into the business is seeking external third party’s investment through private placement. Being less compliance-oriented from a regulatory standpoint, such investments in the equity share capital of the company are commonly preferred through private equity funds or venture capital funds. The entity making such investments may be referred to as the “Investor” for purposes of further discussions.
Third Party Investments:
Seeking third party’s investment in the business is a viable option for the industry and there are several professionally managed private equity funds and venture capital funds that are willing to fund the business through investments in the company (“Company”). Investments are typically structured through subscription in the equity or preference share capital of the Company and shares are usually issued at a premium. The Investor prefers to have a representation in the Board of Directors of the Company through its nominee director(s) having certain affirmative voting rights on critical financial and management issues related to the Company.
The issues related to the share holding pattern, issue price of the shares issued to the Investor, control and management of the Company, reserved matters requiring affirmative voting rights of the Investor (or its representatives), representation on Board of Directors, etc., are addressed in detail in the Joint Venture and Shareholders’ Agreement (“Investment Documents”) that are executed in relation to the investment. While the funding provides the necessary fuel for growth and expansion of the Company, there are some important terms that should be careful in negotiating while seeking investment including:
• Affirmative Voting Rights.
The Company should carefully administer the affirmative voting rights exercised by the Investor. Investors generally require a catalogue of reserved matters where no action or decision can be taken either at the shareholders meeting or the board meeting unless it has received the affirmative vote of the Investor (or its representatives). It is important to carefully review the list of reserved matters so that it does not impede the day-to-day operations and flexibility of the promoter group to take decisions with regard to management and operation of the Company. Ideally, only those actions such as approval of the annual audited financial statements; issue and transfer of shares; alteration of the Memorandum of Association or the Articles of Association or change in the Company’s objectives; transfer of substantial assets, etc., should require affirmative vote of the Investor.
• Lock-in for Promoter Group.
Investors usually require the promoter group of the Company to not transfer in any manner (be it by way of sale, pledge, mortgage, etc.) part or whole of their respective shareholdings in the Company. Such restriction may be either until dilution of Investor’s share holding to a specific % in the issued, subscribed and paid-up share capital of the Company, or for a pre-agreed time period (“Lock-In Period”). Compliance with this provision is made a condition precedent to the registration of any transfer of any shares of the promoter group by the Company. Post expiry of the Lock-In Period, any transfer of shares to a strategic buyer requires a notice for right of first refusal to the Investor. Usually Investors impose this obligation only on the promoter group and not on themselves and may also retain a right of co-sale of their (Investor’s) own shares to strategic buyer on similar terms and conditions. The obligation on the promoter group not to sell its own shares to a strategic buyer in absence of sale of the Investor’s rights, becomes an onerous obligation and sometimes difficult to implement.
• Exit Options.
Also discussed under the Investment Documents, are issues related to exit to the Investor from the Company. All the above terms and conditions are subject to mutually negotiated and agreed terms and conditions. Usually an Investor would negotiate for combination of more than one alternative option to exit the Company, typically being any one of the following options:
• Public Offering.
The Investor can seek the Company to achieve a Public Offering and obtain listing of its shares on any recognized stock exchange(s) in India or abroad which provides the right and/or ability to the Investor to divest or sell its shares on expiry of a pre-agreed term from the closing date of the investment.
For purposes of a Public Offering, the promoters usually agree and undertake to offer their shares for restriction on their transfer, as applicable to “promoters” under the applicable Security and Exchange Board of India (“SEBI”) guidelines, and ensure that the share holding of Investor is not subject to any such restrictions. In the event of a Public Offering, the parties will need to modify the Investment Documents to facilitate the Public Offering and make it compliant under any SEBI guidelines or applicable laws.
• Buy-Back of Shares.
In the event the Company is unable to undertake the Public Offering, the Investor may negotiate for the option (to be exercised at its discretion) to require the Company to buy back any or all of the Investor’s equity shares at a price which may be pre-agreed or at the then prevalent fair market price. Usually the Investor negotiates for a price which may be a multiple of the subscription price for its shares, plus all declared but unpaid dividends thereon or then applicable fair market price, whichever is higher. In case of foreign Investors, the price would additionally need to be ascertained in terms of the methods of calculation prescribed by the Reserve Bank of India (“RBI”) from time to time.
• Put Option.
In the event the Company is not able to effect a buy back as aforesaid, the Investor may require the promoters to acquire all of the Investor’s shares and on the exercise of such option, the promoters would be obligated to purchase and acquire the Investor’s shares at a price which may be based on an internal rate of return of X% compounded annually on the value of the aggregate amounts invested by Investor towards the subscription/purchase of Investor’s shares, or the fair market value thereof, whichever is higher (subject to guidelines of the RBI in case of foreign Investors).
• Strategic Sale with Drag Along Rights.
The Investor may also seek to exit by procuring a strategic buyer to purchase its shares. If the buyer wishes, as part of the same transaction, to also acquire the entire (100%) share equity capital of the Company, the Investor may negotiate for a right to require the promoters to sell to such buyer in connection with such sale, such number of the shares as the buyer may specify.
• Investor Mandatory Put Option.
If the promoter(s) fail(s) to buy all of the shares held by the Investor and in case the Company is unable to implement the buy-back option and the Investor fails to find a strategic buyer desirous of acquiring the shares of the Investor, then sometimes the Investor negotiates for a provision that entitles it to a ‘Investor Mandatory Put Option’ and obtain specific performance to enforce the obligations of the promoter(s) to ensure the Investor’s exit. This is an option which is a must avoid for the Company as it imposes onerous contractual obligations on the promoters.
• Liquidation/Winding up of the Company.
In the event the promoters are unable to provide an exit for the Investor as aforesaid, the parties may agree that the Company would be immediately wound up and no party would have any objection to such winding up, and the winding up proceeds shall be distributed to the then existing shareholders, including the Investor (subject to any statutory liabilities and payments). The Investor may negotiate that it be paid out of the winding up proceeds, prior to and in preference over any distribution of any other shareholders.
As is evident from the foregoing discussions that though the funding is necessary for taking the franchise business to the next growth level, any Investor funding arrangement should be carefully structured and legally vetted to ensure that it does not take away the management powers of the promoter group and imposes stringent & compulsory exit options on the promoters group.