By: Sharanya Ranga, Laxmi Joshi and Aditi Rani
Year 2016 was a good one for exits, instilling confidence in Indian and foreign investors and funds as the total exit value grew marginally by 2% to reach $9.6 billion from $9.4 billion in 2015.[1] This happened even as the total reported exits declined by 8%. It is interesting to note that the top 10 exits collectively constituted around 45% of total exit value, similar to 2015 with manufacturing, healthcare and IT being the key sectors. Today’s market is a dynamic space where there exists a sharp contrast between the exit options available to an investor and the ground realities of such options being exercised due to the prevailing legal issues and market uncertainties. So how does an institutional investor plan its exit, to cash in on growth at the right time and exit with agreed return on its investments? And what is the best option for an exit in the Indian ecosystem from a legal perspective?
There is no straight jacket answer to this question as it depends on several factors such as business of the investee company, its growth trajectory at the time of proposed exit, nature and phase of investment, risk appetite of the investor and prevailing market conditions. Generally, the promoters and investors (both new and existing) of a company agree on a roadmap to ensure a timely and acceptable exit for the investors after the completion of an agreed investment term. We take a quick look at some common exit options adopted in most investment deals below:
Initial Public Offer (IPO): This route provides the investors a right to offer their shares for sale under a public offer and then exit from the investee company. As a part of the business is sold to the public through shares, it is preferred if the company/business has considerable liquidity requirements. As the investors exit when its shares are actually sold on the stock market, which might not happen concurrently with the IPO, the investor might be exposed to related market risks after the IPO is carried out. An IPO is likely to enable the investor to realize very high returns as higher valuation can be achieved so long as the markets are on the rise and other factors are conducive for the company to go public. However, the company’s valuation may get impacted depending on, inter alia, prevailing market conditions and extraneous factors.While the IPO route as an exit option has been popular for private equity transactions in developed economies, its popularity has plummeted of late. Thanks to the global financial slowdown, crystallisation of this option in most markets especially for a start-up is easier said than done. It is not only heavily reliant on external factors such as market condition, national and international economic stability, but also involves high execution costs owing to a plethora of disclosure and compliance requirements under the exchange control regulations and company law. In some cases, an IPO may not even provide large private equity investors a full clean exit. Therefore, while it is included as an option in most investment transactions, the decision to go through the IPO route is not as easy as it may appear on paper.
Buy-Back: Buy-back involves providing the investors an option to require the investee company to buy-back their shares at an agreed rate of return. Since buy-back of shares by the company is subject to various company law norms, working out the modalities of the transaction in a manner that is compliant with the law and also the agreed return can be a challenge. A buy-back should confirm to the provisions of the Companies Act, 2013 read with the Private Limited Company and Unlisted Public Limited Company (Buy-Back of Securities) Rules, 1999, in case of private companies and unlisted public companies and the SEBI (Buy-Back of Securities) Regulations, 1999, in case of public listed companies. These provisions of law set out for several restrictions to make a buy-back of shares, such as, the prescribed threshold of 25% shares that can be bought in a year through buy back and that it is permitted only from free reserves or from the securities premium account of the company. Also, the Companies Act, 2013 prescribes a cooling off period of one year between two buy-backs which means multiple buybacks in a year is not possible. Hence, due to the long list of legal restrictions and compliances, this option is usually also available against the promoters through a process called promoter led buy-back typically structured through a call/put option. Promoter led buy-back is nothing but a transaction involving secondary sale of shares between two shareholders. Promoters prefer providing this alternative as the last option exercisable by investors when all other exit provisions have failed, while investors invariably insist on having the right to exercise this option at their discretion upon the expiry of agreed timeline or happening of certain trigger events.
Merger & Acquisition (M&A): As the name suggests, this exit route comprises a strategic integration or acquisition of the investee company with the acquiring company. M&A in the private, unlisted companies space has been gaining traction in the Indian ecosystem of late thanks to the funding slowdown over the years. This is a win-win situation when merging companies with complementary businesses is considered a more efficient and quicker way to grow their revenue, increase/consolidate market share and acquire expertise or know-how than creating new products/services organically. ‘Acquihires’, a different type of transaction combining acquisition and hiring is gradually finding its spot under the sun amongst Indian start-ups. In this case, a bigger company buys a smaller company to get its talent as it is not so much interested in the product as it is in the team/key employees.
Sale to Third Party: This option can be exercised as a trade sale or strategic sale of investor shares to a third party buyer from the same industry or sale to financial investors such as private equity, venture capital or investment fund. Third party sale especially trade sale is preferred by many investors as it provides them a complete and quick exit from the investment with a say over the share valuation and the sale process. It is also a relatively hassle-free process since it is not subject to an array of legal/regulatory compliances as in the case of IPO or company buy back transactions. However, trade sale is not favoured by the promoters and management due to the high possibility (risk) of management changes that routinely follow such sale, especially when such purchaser is also a competitor of the company.The third party sale right is also often accompanied by the right to drag along the promoters and other shareholders if required for the investor to get the desired valuation necessary to achieve the promised Internal Rate of Return (IRR) on investment. In such cases, provisions are created for protection of promoters and other shareholders interest by guaranteeing sale of their stakes at the same price as agreed between the investor/s and the third party. The drag along right exercise mechanism is set out in detail in the investment agreement and generally requires the investor to notify the promoters and shareholders of its intent to exercise of such right and also disclose the third party purchaser, sale price and the other key sale details to the other shareholders of the company.
Liquidation: When nothing seems to work, simply shut down and close the business of the company! Liquidation is usually a last resort when the investee company has been on a loss-making spree and has little or no market value. Investment agreements generally define and capture the probable liquidation events, which typically include the following:
merger, acquisition, change of control, consolidation, dissolution or winding up of the company;
transfer of all or a substantial amount of the company’s assets; or
transfer of the business or closure of a substantial part of the business.
In case of liquidation, investor interest is protected by way of liquidation preference granted to the investors; whereby the investors are entitled to receive their contribution as the stakeholder prior to other shareholders and also the agreed IRR. Thus, prior to opting for liquidation, it is important to consider the quantum of the company’s debt and its ability to repay them, including the investor contribution plus the IRR through sale of its assets in liquidation. Further, liquidation preference is only a contractual right and its actual working is subject to compliance with applicable laws, including foreign exchange regulations in case of foreign investments.
When capturing the exit option in the investment agreement, it is advisable to provide the options in a sequential manner with the timeline calculated from the investment date. For instance, IPO in 5 years from the investment date, else provide for M&A or sale to third party depending on the prevailing circumstances, beyond that, the company/promoters may permit the buy-back at a pre-agreed IRR and only if nothing works or such liquidation events trigger in, shall the investors be provided with the recourse to liquidation.
Practical challenges
Business Factors: Market instability, global economic slowdown, changes in regulatory regime and myriad other extraneous factors can impact the performance and growth of the investee company which in turn adversely affect the success probability of agreed exit options for the investors.
Regulatory factors for exits by foreign Investors: For a long time now, questions on the legitimacy of exits at assured returns on foreign investments has been one of the biggest challenges faced by most foreign investors while structuring their options to exit from the Indian market. India’s exchange control regulations (“FEMA”) prohibits foreign investment on an assured return basis and therefore, all agreements which are structured to ensure a predetermined return on equity are considered to be violating the regulations. As per FEMA, a foreign investor can exit the investment made in India only at a valuation as on the date of exit. However, the position seems to have changed with the precedent set by the Delhi High Court in the case of Cruz City 1 Mauritius Holdings v. Unitech Limited and NTT Docomo Inc. v. TATA Sons Limited. The High Court in these cases upheld the validity of assured return contractually guaranteed to foreign investors. The court’s finding was subject to the returns guaranteed not being absolute or unconditional, the right to invoke the same being agreed only under specific circumstances and that such right was not in contravention of the Indian public policy in any way.
Thus, the clear emphasis evident from the recent trends is on the honouring of investment agreements rather than taking plea of violation of FEMA provisions to get away with breach of agreed contractual obligations. It has also become critical to rationalise the Indian exchange laws governing the capital flows to exempt such similar cases from the prohibition on fixed return where the fixed return provides downside protection to an investment.
[1] American global management consulting firm Bain & Company’s India Private Equity Report 2017.
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