This article is written by Madhur Patel pursuing Diploma in M&A, Institutional Finance, and Investment Laws (PE and VC transactions) from LawSikho.

Introduction

Even during the pandemic year, the Indian private equity market saw enormous growth, and an unprecedented deal worth 38 billion USD was closed which was double than the 19 billion USD in 2019. This kind of data is a prime example to show how private equity investments are and going to be the preferred vehicle for corporate growth for the foreseeable future. This article aims to briefly discuss the private equity investments along with the important part that a shareholder’s agreement plays in such deals.

Private equity investments or fundings 

When it comes to expanding privately-owned companies i.e., which are not listed, private equity funding is the way to go for their capital needs.  It is an essential phase that helps these businesses that cannot afford to go through the tedious process of an IPO There are numerous private equity investors that deal in finding companies that are not listed, and they can potentially invest capital in them in exchange for equity with the hope that these companies will grow exponentially in the future So, the two parties/stakeholders that are part of the private equity deals are the investors and the investees (private companies/businesses), and both of them certain benchmarks/criteria’s that are important for them in the deal and these criterias that establish the foundation which is highly relevant while negotiating the various transaction documents that are part of this deal.

Investment criteria for PE investors

The two most important benchmarks deal with the market and finances of the potential company. 

1. Size of the market.
2. For the former, the investor’s gauge is the size of the market of that potential investment, along with what are the various competition of the company and how facile is the process of entering and exiting the company. Before investing, current market trends are taken into consideration. 
3. Due diligence forms a crucial aspect, for instance, due diligence with respect to environmental factors is also essential. 
4. With respect to finances, the investors from the first phase itself make sure that the financial data is thoroughly accurate, and within that financial data, the most important aspect that is relevant is that the company’s cash flow is trending in a positive direction and is healthy as per the usual business-standard. Along with the cash flow, the investors also are more likely to invest if the company is profitable and has had positive growth in terms of its turnover yearly. 
5. In this early phase, the investors care about the product criteria whereby, things like how scalable the product or the service is and also what the customer’s needs are with regard to that product/service. If that product can be protected through intellectual property and has that proprietary aspect, it acts as an immensely advantageous aspect from the investor’s point of view. 
6. Finally, the criteria which depend on a case-to-case basis deal with the specific company/business owners, whereby the investors probe into the knowledge and experience of the board members or the managers of the company and eventually even the relationship between the investors and the key managerial person of the company. 

Relevant criteria for the companies or businesses

There are not many benchmarks that Investment seeking private businesses care about considering the fact in these deals they often do not have enough bargaining power considering power dynamics due to the sheer imbalance in the number of businesses seeking investments and the number of investors. However, the past reputation of the private equity firm or investor is the prime criteria of concern, which includes aspects like how much experience, past performance the investor has which directly affects the future of their company. Another criteria would be how passive or active the investors are with regard to their investment portfolios. Now, active private equity investors are those who make investments into businesses that they believe they can make more efficiently and that is why they require obligations like active involvement within the management of the business and operations of the company. Passive private equity investors can be characterized with features like that they believe in the experience and knowledge of the managers of the company and aren’t keen in involving in the day-to-day workings of the business. Sometimes, they might push for obligations on behalf of the companies to meet specific milestones from time to time and only if these obligations are not being met then they might get more active, like active PE investors. Finally, few other desirable criteria include how hands on the investors would be for future financial support, and also finding a private equity firm in the same location is also an added perk.

Shareholders agreement within the private equity context

In a private equity investment deal, there are numerous transaction documents, and the most important document is the shareholders agreement (hereinafter SHA). A basic understanding of a SHA is that it is the first and elemental agreement that lays down the relationship that will subsist amongst the parties of that agreement. Within the SHA it’s these two relationships between the private equity Investor and the founders/owners and between the shareholders and the directors or managers of the company which is relevant. Unlike the other business agreements that are part of the transaction documents which prioritise the present scenario, it is only the SHA that is drafted with the focus on predicting the future of this whole investment/deal. As it is the most important document in the transaction, both parties are highly peculiar about the various clauses and each one of them is highly negotiated. These negotiations hinge upon the commercial intent of both the parties within the context of the criteria that have been discussed in the abovementioned section. Now, in this section of the article, all the key clauses/issues of negotiation have been discussed below.

Issue of governance 

Within the ambit of this blanket issue, aspects and clauses dealing with the control of the company are negotiated. As mentioned above, depending on the nature of the private equity investor these clauses are drafted and the common clauses under this issue are:

• Board Appointment Rights clause

It is pretty common even for passive PE investors to negotiate the power to appoint a director within the board of the company and active PE investors might even push for more members or even an overhaul in the management of the company. This is something that investors push for as these rights can be used proactively as well as protectively considering they are the ones putting their money in the business. Sometimes, these rights depending on the circumstances might also change for example if the business goes through a reduction in share ownership. From the investors’ perspective, it is imperative that in case of a conflict between the nominated director and the other directors or owners which should be the modus operandi to resolve the same. From the perspective of the company that prefers passive investors, the ideal scenario would be only giving observer status within the board meetings and limited power with regards to decision making.

• Veto Right 

The PE investors to further substantiate their involvement and control in the company, also negotiate to get the right to veto on certain specific issues. These issues are enlisted and often always include things like amendments with the articles of the company, if a change within the business is taking place, in case a merger or amalgamation with another business is being discussed, the investors also care about the various securities and collaterals of the business. These were the few issues that veto power is often wanted and is also non-negotiable and to make this power or right effective provisos like mandatory approval of 75% of the board are often added or even approval from the shareholders as well.

• Information clauses 

The Right to Information is fundamental to any kind of investor be it passive or active and is often non-negotiable and if often quite broad in nature. Within the clause, the PE investor obliges the company or business to mandatorily keep the investor informed of all the things that are vital to the company, and usually includes things like the right to examine the important documents of the company, visit the business at any time and also discussion with respect to the finances, affairs of the company. From the company’s perspective, they need to make sure that confidentiality is maintained by the PE investors with regard to all the information that is being provided to them.

Issues with regards to investment protection

The main purpose and the eventual goal of the PE investors in this whole transaction is to eventually get a highly profitable exit. Therefore, throughout the transaction the Investors would never want their stakes or shares to get devalued or their power is diminished and to achieve the same numerous clauses are negotiated by keeping the protection of their investment in mind and that is why usually the PE investors always want to draft them according to their preference and also are super edgy when it comes to negotiating the same. Hereunder, are the major clauses that are negotiated by the parties:

• The clause dealing with shares

The PE investors would always want to have control over the issuance and transfer of shares of the company as they never want their stakes to get diluted. Now, obviously not issuing shares ever in the future isn’t an option for the company if it wants to grow and get more capital, and that is why the parties usually negotiate that the PE investors get a preference right over all the futures shares if issued. Along with this they also want to get the rights to participate in all the future fundraising that the business does, as even that leads to dilution of their shares. Under the law, it has been established that for all private business share transferability is restricted under the company law itself and is also something that the PE investors care about highly. As they would get extremely wary of the company if in case the promoters or the owners of the company are transferring their shares and that is why they always want complete control over the same, and PE investors make sure that their affirmative consent is required if share transfer of these key people in the companies is happening.

• Pre-emptive rights clauses

As the name suggests these rights are pre-emptive in nature i.e., they would only be triggered if a certain specific event occurs. These rights are often negotiated by the company’s owners and promoters, like the investors, even they want to avoid a situation wherein the PE investor sells or transfers the shares that it holds and to restrict the PE investors power, two important rights are often negotiated called the Right of the First offer and Right of First refusal. In the case of ROFO, in case the PE investors want to sell their shareholdings, the owners of the company would get the first invitation to offer from the investors. In the case of ROFR, when the investor wants to sell their shares, it needs to make an offer to the owners to match the offer the third party is making and if they do, the investor would sell its stake to the owners/promoters of the company.

• Exit clause

As mentioned earlier as well, this is the final culmination of the whole transaction for the PE Investors, whereby they ideally grow the private company big enough to sell their stakes through an initial public offering. The investors push for rights like choosing merchant bankers and making sure that the investor’s shares are sold on a priority basis if an IPO is achieved. Again, an IPO is often the best-case scenario and isn’t actually what happens always. Therefore, the investors in case things don’t go as planned want to put in clauses dealing with the fact that the owners shall have to buy the shares of the investors if a certain specific event happens, and this is called a put option under the business terms.

Conclusion

For a developing economy like ours to turn into a developed nation promotion of entrepreneurship is paramount, and all these private companies and entrepreneurs can only grow if healthy private equity and Venture Capital infrastructure exist. Within these private equity deals, it’s the shareholder’s agreement that forms the backbone of the whole transaction and in this article, an attempt has been made to highlight the major and important points of discussion peculiar to and in the context of the private equity deals within a shareholders agreement ranging from governance issues to the protection of investment of the PE investors.

References

• http://www.streetofwalls.com/finance-training-courses/private-equity-training/private-equity-investment-criteria/
• https://www.lexology.com/library/detail.aspx?g=ec53b73d-92cb-4f53-b959-d3ed9436591d

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