This article is written by Vinay Yerubandi, pursuing Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from LawSikho. The article has been edited by Ruchika Mohapatra (Associate, LawSikho) and Indrasish Majumder (Intern at LawSikho).

This article has been published by Abanti Bose.

Introduction

Over the last decade, the Private Equity Industry in India has seen tremendous growth from a base of US $ 8.4 Billion in 2010 to the US $ 47.6 Billion in 2020. It also saw some pivotal structural changes in the deal type, deal size and investor mix. As India’s attractiveness as an investment destination is increasing at a great rate and also the number of new innovative and disruptive businesses increasing day by day, the role of the Private Equity industry in the country’s economy should be acknowledged.

What is private equity?

Private equity is an Alternate Form of Investment for those businesses which don’t have access to capital markets. It consists of funds and investors which directly invests in the capital of a private company and has considerably longer holding periods. This capital can be used by the companies to expand their market base, use new and more efficient technologies or make acquisitions.

The process of raising funds

Term sheet and primary negotiations

Term Sheet consists of all key and essential components between the parties to the deal and it is a non-binding agreement. In this stage, it is more about understanding the opposite party’s basic expectations from the deal and creating a picture of the transaction in the minds of parties.

Information about the company

In this stage, the investing firm interacts with the founders of the company, analyses the market and business potential of the company, and estimates the probable growth rate. This is a very important stage for the founders to drive forward the deal and they should be able to establish a good connection with the partners of the fund in this stage.

Due diligence

This is a very important stage in the investment process for both sides because all the actions in the future stages are directly dependent on this. Due diligence by the investor includes legal, environmental, financial, tax, accounting and technical due diligence. The extent of negotiations in the further stages is completely dependent on the due diligence report submitted to the investing firm. It is also a prerequisite to draft the transactional documents as different clauses like representations and warranties, conditions precedent, conditions subsequent, indemnities are based on the finding of the due diligence. 

Discussions on conditions, representations and warranties

This is the last stage of negotiations and is based on the Due Diligence Report. Obligations to perform various activities are laid upon the company in the form of conditions precedent and conditions subsequent. And also many rights like Anti-Dilution, Drag Along, Tag Along etc are negotiated in this stage.

Drafting of definitive contracts

Final agreements like the share/debenture subscription agreement and shareholders agreement are drafted in this stage after considering all the negotiations that happened after the due diligence of the investee company. 

Disbursal of money

Finally, after drafting the definitive agreements between the parties, the consideration shall be paid by the investor in the agreed method and process.

What are all the different instruments in which private equity investors invest?

In most cases, private equity investors prefer to invest in convertible instruments due to lesser risk than investing directly in equity. Almost two-thirds of the deals in Private Equity Space in recent years were made through compulsorily convertible preference shares, says industry trackers. This is mainly to bridge the gap in the “mismatch in valuation expectations” between promoters and investors. Some commonly issued securities for getting Private investment by the companies are:

Compulsorily Convertible Preference Shares (CCPS)

CCPS is regarded as an effective instrument as it continues to carry a preferential right to get dividends and also provides protection for investment in the event of a company being wound up. It is less risky. They are the Preference shares which are mandatorily convertible into Equity Shares of the company on a pre-decided date and with pre-decided conditions agreed between the company and the investors.

CCPS are very helpful for start-up founders in protecting their stake in the company as they are anti-dilutive securities. They also help in avoiding the gap between the investors and founders regarding the aspects of valuation.

Due Care is to be taken to make sure the issue of CCPS complies with the provisions of Section 42, Section 62 and Section 55 of Companies Act, 2013, Pricing guidelines and Sectoral Caps under FDI Policy and External Commercial Borrowing Regulations if the issue involves foreign investment. Stamp Duty is payable on the issue of equity share certificate post-conversions and is governed by the Stamps Act of the relevant state. 

Compulsorily Convertible Debentures(CCDs)

As the name suggests, CCDs are debentures that are compulsorily convertible on a predetermined date and with predetermined conditions agreed between the company and investor. It also carries the same features as CCPS but the main difference is CCD is a debt instrument that provides greater protection to the investor. 

Issue of CCD shall comply with provisions of Companies Act, 2013, FEMA and FDI Policy and Income Tax Act, 1961.

Important Legal Documents

Term Sheet/Letter of Intent/Memorandum of Understanding

Term Sheet is the first formal document between the Company and the Private Equity Fund. It is a non-binding agreement but some of the clauses of it are legally enforceable on both parties. The basic purpose of a term sheet is to help both parties in understanding and appreciate the needs and expectations of the opposite party from the transaction more clearly. It consists of all critical and essential points of the agreement like valuation, capitalization, conversion rights, proposed stake in the investee company, etc.

Provisions of the Term Sheet which are legally enforceable:

1. Confidentiality Terms: This is to protect sensitive information about the target company from being shared by the Private Equity Investor to a third party.
2. No-Shop Provision: This is a negative covenant working against the company. As per this provision, the company is prohibited to search for any other potential financing options up to a predetermined date.

Share subscription agreement/debenture subscription agreement

They are formal contracts that set out the terms and conditions relating to the sale and purchase of shares in a company. This may be related to any kind of security i.e., Equity Shares, CCPS, CCD, etc. Companies use Share Subscription Agreements to raise capital from private investors. Under this agreement, the Company issues new shares to the investors which will be subscribed by them at a mutually agreed price. The Transfer of shares from an existing shareholder to the investor is done through a separate contract called a share purchase agreement. 

These agreements should set out what is being sold, for how much, to whom and also any obligations and liabilities laid on the parties. Some Important provisions of the share subscription agreement include representation and warranties of investors and company, conditions precedent, completion mechanics of the deal, Tax provisions and Non-Disclosure provisions.

Shareholder’s agreement

Shareholder’s agreement is the final formal binding agreement between the company and the investors which govern the mutual rights and duties of the company and the investors. An existing investor in the company may also be a party to this contract. 

This is not a legally mandated agreement but almost all investors insist on having it as it protects their rights. The company and its founders should be very careful while negotiating this agreement because some provisions if not taken care will overpower the investors. This causes immense hardship to the founders in exercising their management control over the business and taking business decisions with freedom. 

Some of the rights of investors which can be protected by the shareholder’s agreement are:

1. Right of First Refusal: This is a right to the investors through which any other shareholder can sell their shares to a third party only after making an offer and getting a refusal from the investor.
2. Tag Along and Drag Along: Tag Along right protects the investor with the minority stake. If any majority shareholder of the company sells their share to a third party, then they are also obliged to sell the shares of this minority shareholder at the same price if he is protected by Tag Along rights. For instance, if investor X has Tag along right in his shareholder’s agreement, then when the majority shareholders are exiting the company, investor X has the right to get the exit opportunity at the same price along with them.

Drag Along rights work completely different from Tag Along rights and these rights were given to a majority shareholder. Under this right, If a majority shareholder negotiates an offer to sell his stake to a third party then he can force all other shareholders of the company to accept the offer from the third party so that the third party can acquire a full stake in the company. 

3. Anti-Dilution Provisions: This clause prohibits the company to raise further capital at a lower valuation than their investment. If the company raises capital at a lower valuation, then the company is obligated to issue new shares to the investors to match the newly made valuation aspects. Broadly, there are two types of anti-dilution clauses namely Full ratchet and weighted average ratchet. In the case of full ratchet, irrespective of the amount invested by the new investor, the company is required to issue shares to the existing investor to match his original shareholding percentage.

In the case of a weighted average ratchet, the company is required to allot the new shares to the existing investors by adjusting their original investment with the new valuation at which it raised the funds. Redbus allowed its investors to have full ratchet protection to their investments which resulted in the founders holding very little equity. Allowing full ratchet protection to the investors will be very dangerous to any start-up. 

4. Nomination on Board: The investors while making big investments in the company feel to have control over the company to regularly monitor its business activities. For this, the Investing Firms reserves the right to nominate X number of directors and sometimes even Vice-Chairman or Chairman in the Investee’s Board.
5. Affirmative Voting Rights: They were the protective rights or veto rights that were granted to investors on certain reserved matters. As per these rights, the investor has the right to stop any action by the company on these matters irrespective of the voting pattern. For example, when investor X reserves certain matters for his consent in the investment agreement, then unless with his consent it is not possible to approve a decision. They are inserted to protect the investors in some cases and to help the investor exercise control in other cases. Many times, they can create an undue hardship to the founders in day-to-day affairs, if these rights were also extended to the business decisions of the company. 
6. Liquidation Preference: Under this clause, the investors will get priority over other shareholders in the event of liquidation of the company. 

Conclusion

Finance is regarded as the “Life Blood” of any business. Many new and small business founders who don’t have access to capital markets find it very difficult to get this lifeblood for their companies. Private equity solves this big problem by providing finance to these companies in exchange for acquiring a stake in it. At the same time, the founders need to understand the different rights that the investors can acquire over their business through these transactions. An attempt has been made by the author to highlight the steps involved in the raising of funds by founders from a private equity fund starting from the term sheet to the final definitive agreements.

References

1. Private Equity in India: Evolution and Legal Overview, by B&B Associates
2. Everything you (Don’t) want to know about raising capital, by Jeffry A. Timmons and Dale A. Sander, Harvard Business Review
3. Understanding Private Equity (PE), Investopedia
4. https://www.livemint.com/Money/rkcStm18Wex1Z8yPvnAFuO/Private-equity-firms-prefer-convertibles-to-direct-equity.html

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