This article is written by Vedant Pai, pursuing Diploma in General Corporate Practice: Transactions, Governance and Disputes from LawSikho. The article has been edited by Amitabh Ranjan (Associate, LawSikho) and Dipshi Swara (Senior Associate, LawSikho).
The opportunities provided by the Indian economy are unrivalled. During the year 2021 in the midst of an economic pandemic, India saw an increase in Foreign Direct Investment (‘FDI’) by 27% while all other G20 nations saw a decline. India even partly experienced a surge in cross-border M&A activities in the second half of the year. Other developed countries do not provide the diversity of opportunities as provided in India. According to the ‘World Bank’s Ease of Doing Business Ranking 2020′, India ranked 63rd among 190 nations in the year 2020. India has jumped 79 positions, that is from 142nd position in 2014 to 63rd in 2019.
The FDI policy of India has been a major non- debt resource for India. Foreign countries invest in India to take advantage of the relatively lower wages and other special investment privileges. India is expected to attract foreign FDI of US$ 120-160 billion per year by 2025, according to the Confederation of Indian Industry report. Companies around the world are always looking to expand their operations to various parts of the world. This entails additional costs to be borne by such companies. One would then wonder, why would such companies want to expand at all? They do expand for the following reasons;
- Larger profit margins: The larger an organisation grows, it can get the benefit of economies of scale.
- Playground for Innovation: Foreign companies can test out products or services without the risk of it affecting them in their domestic markets. Even Disney tests out their policies, parades and rides in Disney Shanghai and then introduces them in the USA.
- First-mover advantages: Companies may face tough competition in their domestic markets but may be the first to introduce a product in a foreign market and hence reap advantages being the first mover. They get a chance to define a product forever, for example in India toothpaste is commonly referred to as Colgate.
- Talent pool: Initiating operations in a foreign country gives them access to a whole new talent pool bringing new concepts, expertise and helping them navigate the local market.
There are various challenges while entering a new market and certain factors to be taken into consideration such as ;
- Administrative differences.
- Economic regulations.
- Cultural differences.
- Different accounting standards.
- Transportation of goods abroad.
- Laws, rules and policies are unique to the country.
What is a market entry strategy?
Entry of enterprises in India or any other foreign country requires a certain strategy without which its foundation in the foreign country will be baseless and haphazard. Market strategy is the sales and marketing framework a business adopts as it expands internationally. These include factors such as resources and technology allocation, product awareness, translation and other services required to make this possible.
Legal compliance while entering Indian markets
Foreign enterprises while establishing any form of business in India whether directly, through a partner or third-party enterprise have to comply with provisions, rules and regulations of following enactments;
- Companies Act 2013.
- Labour and Employment Legislations such as Maternity Benefits Act, 1961; the Industrial Disputes Act, 1948; The Contract Labour (Regulation and Abolition) Act, 1970; the Trade Union Act, 1926; the Equal Remuneration Act, 1976; the Payment of Gratuity Act, 1972; the Workmen’s Compensation Act, 1923’ the Employees’ Provident Funds and Miscellaneous Provisions Act, 1952, and so on.
- Environmental Laws such as the Environment (Protection) Act, 1986; the Water (Prevention and Control of Pollution) Act, 1974; the Air (Prevention and Control of Pollution) Act, 1981; Hazardous Wastes (Management, Handling and Transboundary Movement) Rules, 2008; the Manufacture, Storage and Import of Hazardous Chemicals Rules, 1989; the Indian Forest Act, 1927; the Forest (Conservation) Act, 1980; the National Environment Tribunal Act, 1995; and the Public Liability Insurance Act, 1991.
- Goods and Services Tax Act,2017.
- Foreign Exchange Management Act, 1999.
- Limited Liability Partnership Act, 2008.
- Indian Partnership Act, 1932
- Reserve Bank of India regulations.
Strategies for entering the market
This is a passive means of interacting with the market. The Indian market may not justify local manufacturing. This adds to production elsewhere which leads to an increase in marginal profitability. This can be done directly or indirectly.
In this scenario, the company has to set up its own export department and take care of the packaging, branding and shipping. This way the company has control over its processes and saves on cost. The success of direct exporting depends on the relationship between the exporting firm and the distributor. The foreign enterprise can further cut down on intermediates by establishing its own sales subsidiary. If the sales volume is not large enough, employing a distributor makes better sense. Using this strategy may require creating exporting infrastructure and training employees. Although the benefits of control may outweigh this cost in the long run.
This includes handing over packing, branding, shipping and distributing to intermediaries such as agents, exporters, wholesalers, retailers and distributors.
These intermediaries have the expertise as to the local market conditions and hence avoids the risk of failure. Although this way the firm will not be able to interact with its customers and may lose control over sales and marketing abroad.
The foreign enterprise may allow an Indian entity to use its trademark or its patents at a particular fee which is known as royalty. The foreign enterprise may not have the time and knowledge to enter into the Indian market or production size may not be large enough to justify a manufacturing operation. The enterprise may not have enough resources to invest in the Indian market and by licensing they may be able to access a large market and yet retain a good profit margin. Economic and political instability in India may not justify the risk of setting up a facility from scratch and employing managerial resources. This risk is borne by the licensee instead. The scale of royalties depends on the licensee and the licensee may not be competent to market and sell the product efficiently. Substandard products may be produced by the licensee and hence spoil the image of the licensor. The intellectual property held by the licensee are licensed only for a certain period of time and after such expiry date, the licensee may utilise the same process or technology and pose as a local competitor.
This is a special type of licensing in which a foreign enterprise offers its brand, marketing methods, logo and processes to an Indian enterprise at a certain fee.
The foreign enterprise has to engage in a lot more research about the market, Indian legal structure and organisation of franchise and potential franchisees before it engages in this operation. It differs from licensing as to the scope of quality control on all operations of the franchisees.
Foreign companies may benefit from manufacturing locally in India. This is due to factors such as tariffs, market size, costs, law and political considerations. Broadly speaking there are three kinds of arrangements that can be made;
Manufacturing is done by an independent firm in India on a contract basis. This may be for the production of parts, finished products or assembly of parts into finished products. This is done by enterprises to avoid high tariff protection and other barriers to the import of their products. Low labour costs in India are an incentive for entry through this route. This method is used when production technology is widely available.
This is usually the last stage of production including the assembly of parts. Access to parts imported from foreign countries is a prerequisite for this operation. Assembly operations involve less capital and technology investment and larger investment in labour. Enterprises do this to take advantage of the low labour costs prevailing in India. This method is also used in countries where the import of certain finished products is banned by the local government.
Fully integrated local production unit
Setting up an independent plant requires substantial capital investment and hence enterprises indulge in this practice when demand in India appears almost certain. Often the reason for this stems from lower costs and hence enhancing their ability to compete with Indian and foreign enterprises already in the market. High tariffs and transportation costs may also prompt this practice. Sometimes setting up a plant is associated with building trust with the customers and therefore influencing the customers’ decision to change suppliers. Enterprises may also do this to protect what they have already gained through their export. Further political and economic conditions may also influence this decision.
A foreign company may use an Indian enterprise’s distribution system to sell their product in the market. This may be for the sole reason of sharing transportation costs or a low-risk method of testing a product in the Indian market. Small enterprises may specifically use this method. Once they are certain about the potential of the product, they will eventually set up their own export system.
Foreign companies may enter into a partnership with an Indian partner to form a separate entity known as Joint Venture. The success of this entity depends upon a common focus on similar goals by both partners. Indian partners offer the advantage of providing expertise regarding the local market conditions and having government contacts. The foreign company gets the status of a native in the new market and advantages of a greenfield start-up at a lower investment than merger or acquisition. It is important to have a dispute resolution agreement between the partners, that helps facilitate business regardless of conflict.
Mergers and acquisitions
Acquiring or merging with an Indian firm in India allows for a fast-track entry into the local market. The foreign firm does not take time to establish itself that way or acquire resources that are otherwise difficult to accumulate. International mergers and acquisitions are difficult although not impossible, they are costly and time-consuming. Market research is of paramount importance before entering any such agreement. Integrating an acquired company into a new entity is quite a challenge for the top management. Foreign companies can also acquire Indian competitors this way and eliminate competition. These agreements usually entail acquiring unwanted assets and incurring costs to maintain them in real term or management time. Acquiring a small stake in an Indian company reduces risk and investment but also lowers overall control.
This includes setting up independent facilities in India. Such investment requires a big commitment but also includes huge advantages. The foreign entity has complete control over the operations in the new market. Setting up locally also helps build trust with the customers and better interact with them. The Indian Government also encourages such investments.
The internet revolution has allowed businesses to enter the Indian market without actually touching base. Small businesses have profited from this, as it helps them overcome barriers usually faced by them. Enterprises can set up a website without much investment and transact with customers through this medium. In the year 2020, more than two billion people purchased goods or services online, and during the same year, e-retail sales surpassed 4.2 trillion U.S. dollars worldwide. Although there are different challenges that come with this such as completion of sales, packaging, shipping, collecting funds and after sale services to customers around the world.
Notable examples of market entry around the world;
- McDonald’s in France
- Red Bull in the U.S.A
- IKEA In China
- Starbucks in China
Exit of business
A business regardless of the success and profit it has gained in the Indian market may want to exit it due to a plethora of reasons such as:
- Meeting of criteria/objective: A partnership or entity may be set up in India only for a certain project or to meet a certain criteria/objective. On achieving this it may want to exit the market.
- Unprofitable business: A company set up in India may not be profitable for a long duration or may have only had a profit for a brief period of time. The company’s revenue may not justify the cost incurred and hence to minimise losses may need to exit the market at the right time.
- Catastrophic event: A foreign entity may have faced the loss of resources due to a natural or manmade catastrophe. The entity may not have insurance or may have insurance, but choose to rather claim the insurance amount and exit. This way the entity reduces its losses.
- Legal reasons: New laws enacted or laws amended by the Indian legislature may not be favourable for business. Rules and procedures to comply with may warrant heavy costs, leaving not enough of a profit margin for the business.
- Cash-out: The business being profitable, the owner or investors might want to sell their share in the company.
Business exit strategy
The existing business must have a certain strategy, the same way a strategy is devised for formulating a business. Without such a strategy, the enterprise may suffer greater losses or incur more liabilities than required. A business exit strategy must be devised at the same time a plan is formulated for its formation. This might seem counterproductive but rather helps build the business in a certain direction. Venture Capitalists very often insist on an exit strategy to be included in a business plan before making any investment.
Choosing an optimal business exit strategy may depend upon various factors such as;
- The amount of control the owners want to retain in the business.
- Whether the owners want the business to be run in the same or in a certain way.
- If or not the owner wants to make sure the legacy of the business remains intact.
- Conditions in the market.
- Nature of business.
- The scale of operations.
- The interest of shareholders, members, partners or founders of a business.
Types of exit strategies
Merging a business with another provides for various advantages because of economies of scale. It also increases the value of the business. This way the owner does not lose complete control over the business. If the owner wishes to sever ties with a business this may not be the best option.
In this scenario, a company is bought over by another. The advantage of this method is that the selling company gets to name its price and hence have better bargaining power. The more time the company has to bargain the more advantage it possesses and less time narrows its options. If a company’s objective from the very start is to get itself acquired, it shouldn’t deal with products so niche or specialised that getting acquired becomes a hurdle.
This is not suitable when owners or members want to retain at least some degree of control.
Initial Public Offering (‘IPO’)
An Initial public offering means a company is offering its shares for sale to the public. This is commonly referred to as ‘going public’. This way a company can raise a lot more capital and pay off its debts. This is ideal for venture capitalists as they sell their share in the company once it goes public. The owner can also exit the business or give up the majority of his control by selling all or most of the shares respectively. IPO’S don’t take place very often in comparison to the number of start-ups as there is a high cost associated with it. In India the process of issuing an IPO is as follows;
- The hiring of an underwriter or investment bank.
- Registration for IPO.
- Verification by Securities and Exchange Board of India.
- Making an application to the stock exchange.
- Creating a buzz by Roadshows.
- Pricing of IPO.
- Allotment of shares.
The abovementioned is a costly and time-consuming affair not available or feasible for small businesses. Although many companies have had great success utilising this method.
Sale to a friendly buyer
Selling to a friendly buyer may be more beneficial than selling to an unknown buyer. These friendly buyers include family, friends or colleagues. This way less due diligence is required on both sides and leads to less legal cost for everyone involved. Although, this may eventually lead to dysfunction and strained relationships between the owner and friendly buyers.
Management buyout (‘MBO’)
This is when the management of a company buys over an organisation or a particular department. This is suitable for a business owner of a private company who wants to retire. The management is well acquainted with the business, which leads to a smooth and trustworthy transfer of ownership. Public companies may use this strategy to sell a non-core department to the management. There are certain drawbacks associated with this exit such as;
- The management may not be ready or competent to take up responsibilities of the ownership.
- The owner may have to sell at a lower price than an external party.
- The management may actively sabotage the value of a company with the object of acquiring the company at a lower price.
In this scenario, the business is shut down permanently. The assets of the company are sold and the proceeds from this is distributed to the creditors first and then to the investors. This can be said to be the easiest and fastest way to exit a market. Liquidation is the least rewarding way to exit as market value, business relationships, customers and all other invaluable assets are lost forever. An entity may even file bankruptcy under the Insolvency and Bankruptcy Code, 2016. This is the last resort when there is no proper exit plan. Bankruptcy has a huge stigma attached to it.
Exit plans must be properly planned with the help of professionals. This may add to cost but avoids future chaos and larger cost. By exiting intelligently one can maximise financial return for shareholders and investors. The business exit strategy should be treated as important as a plan for the formulation of the business.
Entry and exit strategies are important aspects of the ability of any business to respond and adapt to changing circumstances. The capacity to respond and adapt relatively quickly is often referred to as flexibility, and is important for effective performance in any market, particularly in periods of substantial change.
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