How to raise finance from private equity investors?

Introduction:

Private equity, as an alternative form of investment, plays a crucial role in providing capital to businesses that lack access to public markets. Unlike traditional investments, private equity involves funds and investors directly injecting capital into private companies, often with longer holding periods. This infusion of capital enables companies to fuel their growth, expand market reach, adopt innovative technologies, and pursue strategic acquisitions. The private equity industry in India has experienced significant growth over the past decade, reflecting the country's increasing appeal as an investment destination and the rise of innovative and disruptive businesses.

The evolution of the private equity industry in India has been marked by substantial growth, with investments soaring from US $8.4 billion in 2010 to US $47.6 billion in 2020. This growth has been accompanied by notable shifts in deal structures, sizes, and investor profiles, reflecting the dynamic nature of the market. As India continues to attract attention as a thriving hub for investment opportunities and entrepreneurial ventures, the private equity sector's role in driving economic growth and fostering innovation becomes increasingly significant.

The process of raising funds

1.      Term Sheet and Primary Negotiations:

·         Term Sheet: This is a document outlining the key terms and conditions of a potential deal between parties. It includes essential components such as the purchase price, payment terms, conditions precedent, representations and warranties, etc. The term sheet acts as a blueprint for the deal and provides a framework for further negotiations. Importantly, it is non-binding, meaning that either party can walk away from the deal without legal consequences at this stage. It serves as a guide for both parties to understand each other's basic expectations from the deal and helps in creating a clear picture of the transaction.

·         Primary Negotiations: This stage involves initial discussions and negotiations between the parties involved in the deal. It's where both parties seek to understand each other's positions, interests, and objectives. The primary negotiations may revolve around the terms laid out in the term sheet, as well as other aspects of the deal that need clarification or adjustment. The goal of primary negotiations is to reach mutual agreement on the key terms before moving forward to more detailed due diligence and drafting of legal documents.

2.      Information about the Company:

·         At this stage, the investing firm engages with the founders or key stakeholders of the target company. They gather information about the company's operations, market position, financial performance, growth potential, and other relevant factors. This stage is crucial for the investing firm to assess the viability and attractiveness of the investment opportunity. For the founders of the company, it's an opportunity to present their business in the best possible light and establish a positive relationship with potential investors. Building rapport and trust with the investing firm's partners is essential during this stage, as it can influence the outcome of the deal.

3.      Due Diligence:

·         Due diligence is a comprehensive investigation or audit of a potential investment or acquisition target. It involves examining various aspects of the target company, including legal, financial, operational, and strategic aspects, to assess risks and opportunities associated with the investment. For the investor, due diligence is a critical step in mitigating risks and making informed investment decisions. It helps verify the accuracy of the information provided by the target company and identifies any potential red flags or issues that may impact the investment. The findings of due diligence often shape the negotiations and terms of the deal, as well as the drafting of legal documents. The due diligence process is essential for both parties to ensure transparency, trust, and alignment of interests before finalizing the transaction.

4.      Discussions on Conditions, Representations, and Warranties:

·         At this stage, negotiations focus on finalizing the terms and conditions of the deal based on the findings of the due diligence report. Conditions precedent and subsequent are discussed and agreed upon. Conditions precedent are actions or events that must occur before the deal can be finalized, while conditions subsequent are actions or events that must continue after the deal is completed. Additionally, discussions revolve around representations and warranties, which are statements made by the parties regarding the accuracy of certain information or the fulfillment of certain obligations. Negotiations may also cover other rights and obligations such as anti-dilution provisions, drag-along rights, tag-along rights, etc. These discussions aim to address any remaining concerns or issues and ensure clarity and alignment between the parties before moving to the next stage.

5.      Drafting of Definitive Contracts:

·         In this stage, final agreements such as the share or debenture subscription agreement and shareholders agreement are prepared. These agreements incorporate all the terms and conditions negotiated throughout the process, including those related to conditions precedent, representations, warranties, and other rights and obligations. The drafting process involves legal professionals who ensure that the agreements accurately reflect the intentions and agreements of the parties while providing necessary legal protections. These definitive contracts serve as the legally binding framework for the transaction and outline the rights and responsibilities of each party moving forward.

6.      Disbursal of Money:

·         Once the definitive agreements have been drafted and signed by all parties, the investor disburses the agreed-upon consideration to the investee company. This typically involves transferring funds according to the agreed method and process outlined in the final agreements. The disbursal of money represents the culmination of the investment process and the fulfillment of the financial aspect of the deal. It marks the transition from negotiations and legal documentation to the actual implementation of the investment, allowing the investee company to utilize the capital for its intended purposes.

Instruments used by Investors:

·         Private equity investors commonly invest in convertible instruments to mitigate risks and bridge valuation gaps between promoters and investors. Compulsorily Convertible Preference Shares (CCPS) are a popular choice, offering preferential dividend rights and protection in case of company liquidation. CCPS help founders safeguard their stake, prevent dilution, and align valuation expectations. Compliance with Companies Act, pricing guidelines, and foreign investment regulations is crucial for CCPS issuance.

·         Another instrument favored by private equity investors is Compulsorily Convertible Debentures (CCDs), which are debt instruments that convert into equity based on predetermined terms. CCDs provide enhanced investor protection compared to CCPS. Issuing CCDs requires adherence to Companies Act, FEMA, FDI Policy, and Income Tax Act regulations. These instruments offer flexibility and security for both investors and companies seeking private equity funding.

Private equity transactions involve several important legal documents that govern the relationship between companies and investors:

·         The Term Sheet, also known as a Letter of Intent or Memorandum of Understanding, serves as an initial agreement outlining critical deal points like valuation, capitalization, and conversion rights. While non-binding, certain clauses such as confidentiality terms and no-shop provisions carry legal weight to protect sensitive information and restrict the company from seeking alternative financing options.

·         Share Subscription Agreements and Debenture Subscription Agreements are formal contracts detailing the terms of share sales to investors, facilitating capital raising. These agreements specify the sale particulars, obligations, representations, warranties, tax provisions, and non-disclosure terms.

·         Shareholder's Agreements establish binding rights and responsibilities between the company and investors, safeguarding interests and outlining provisions like rights of first refusal, tag along and drag along rights, anti-dilution clauses, board nominations, affirmative voting rights, and liquidation preferences.

Careful negotiation of Shareholder's Agreements is crucial to balance investor protection with founders' management control. Provisions like anti-dilution clauses prevent valuation erosion for investors in subsequent funding rounds. Affirmative voting rights grant investors veto power over specific decisions, while liquidation preferences prioritize investor payouts in case of company liquidation. Understanding and structuring these legal documents are essential for a successful private equity investment deal.

Conclusion:

In conclusion, Private equity offers vital financial support to new and small businesses lacking access to capital markets, enabling growth through investment in exchange for ownership stakes. However, founders must be vigilant in understanding and negotiating the rights investors may acquire, balancing the benefits of funding with the potential implications on their control and long-term vision for the company.