Private Equity and Venture Capital Funding
In today’s corporate world, growth of any business depend upon various factor and one of the main factor for its smooth existence and growth is to have adequate amount of funding.
It is essential and obligatory on the part of every entrepreneur to meet the time to time working capital requirements of the business for its growth and survival. Normally it is seen that the companies running and continuing its business operation with adequate funds always make growth and survive for long time and on the contrary, companies running with inadequate funds face a lot of issues in its growth and survival in this world. Therefore, it can be said that having handsome funds is a weighty element in the success of any business.
There are various sources of funding available to a company i.e. Loan from Bank, Loan from Member, Director or Relatives, External Commercial Borrowing etc. But, sometimes the situation occurs that the all the above options does not work in favor of an entrepreneurs and as a last resort, entrepreneurs are required to go for Private Equity and Venture Capital Investment for making growth in its business and its survival.
Moreover, please note that getting Private Equity and Venture Capital investment is not a Cake Walk, sometime it may prove to be a great curse in absence of execution of balanced documents. There are certain Term Sheet/ Agreements like Share Subscription agreement, Shareholder Agreement, Investment Agreement etc are to be executed while any entrepreneur is dealing with Venture Capital Investor.
Further it is vital for entrepreneurs to have the clarity of the main points which used to be discussed in any above such transactions as mentioned below:
- Right of First Refusal:
- It is also known as ROFR Clause, under the Right of First Refusal Clause, if the Company/ Entrepreneur is intending to sell or transfer its share to any other person, then in such a case, a Private Equity/ Venture Capital Investor having the Right of First Refusal may urge the Entrepreneur/ Company to buy the shares of the Company/ Entrepreneur at the same terms and conditions and at the same price at which the Company is intending to sell it to the other person.
- For Example: Mr. A has invested in the shares of the Company named as ABC Limited with the Right of First Refusal, now suppose Mr. B (existing shareholder of the Company ABC Limited) is intending to selling its share to Mr. C at a price of 150 Per share, then just because Mr. A is having Right of First Refusal, Mr. B first has to offer the shares to Mr. A for purchasing it at same price and terms and condition at which it is intending to sell it to Mr. C. and Mr. A reserve the right to purchase it at same terms and condition from Mr. B. Further here Mr B can only sell its share to Mr C once the same is being refused by Mr. A to Mr. B.
- Ratched Clause (Anti Dilution Clause):
- It is also known as Anti Dilution Clause or price protection, under the Ratched Clause, interest of PE/ VC Investor is protected against the significant dilution in its shareholding.
- Example No. 1: At the initial stage of funding, ABC Limited had offered and Mr. A purchased the 5% Equity shared in ABC Limited at a price of 15/- Per share, now late on, In the second stage of funding, ABC Limited has offered the shares to Mr. B at a price 10/- per shares, Now Mr. A having Anti Dilution, may force the ABC Limited to convert his share at a price Rs. 8/- per share thereby increasing in number of shares.
- Example No.2: Suppose at the time of investing in shares of ABC Limited by Mr. A, it was agreed between both the Parties, i.e. ABC Limited and Mr. A, that Mr. A will only hold upto 5% of the Equity shares of ABC Limited, now in future ABC Limited again come up with issue of share and increased its paid up share capital from 1,00,000/- Rupees to 2,00,000/- Rupees, due to such increase in share, holding of Mr. A had been reduced, now Mr. A having Anti Dilution right, may urge ABC Limited to let him participate in the further issue of share so that his shareholding of 5% remain intact.
- Tag-Along Right:
- Through Tag along Right, significant interest of PE/ VC Investor is being protected. Under this if the majority of the shareholders sell their shareholding in the company, then in that scenario, PE/ VC Investor having Tag Along right, may urge them tag along him with them and sale its own shares also at the same term and conditions as it is applicable upon the majority shareholders.
- For Example: ABC Limited at the very initial stage of its funding had offered 5% Equity share to Mr. A with Tag Along Right. Later on, after 5 years of its business, ABC Limited and it shareholders are intending to sell entire of its business and found the buyer Mr. B, now just because Mr. A is having the Tag Along Right, he can also join the transaction and sell his 5% shares to Mr. B at the same price and term and conditions upon which ABC Limited and its shareholders has agreed with Mr. B.
- Drag-Along Right (Bring Along):
- Also known as Bring Along Clause, This type of clause are structured in such a manner that if the majority shareholders are ready to sell their shareholding or stake in the company to the third person then it would become obligatory on the part of the remaining shareholders to sell their share also.
- Further this drag-along right or Bring Along can be enforced only when the consent of majority shareholders of the Company are taken.
- For Example: ABC Limited at the very first stage of funding has issued 10% Equity shares to Mr. A at a price of 20/- per share by holding Drag Along Right, now suppose after 5 years of its business, ABC Limited and its shareholders are intending to sell entire of its business and found the buyer B, now just because ABC Limited is having Drag Along Right, it may compel Mr. A to sell his stake or shareholding in the Company to Mr. B at the same price and term and condition upon which ABC Limited has agreed with Mr. B.
- Pre-emptive right on new share:
- Under this Clause if the Company is intending to issue new shares then in such a scenario the Company has to first offer the shares to the Investor having pre-emptive right, to buy the shares of the Company, before offering the same to third person, at the same price and with same terms and conditions at which the Company is offering such shares to the third person.
- For Example: Suppose Mr. A had invested in the shares of the Company named as ABC Limited with pre-emptive right, now in case the company ABC Limited is desiring to offer the New Shares to Mr. B then due to such pre-emptive clause, ABC Limited had to offer such shares to Mr. A and only thereafter Company ABC Limited can offer the same to Mr. B.
- The right as mentioned above are also specifically mentioned in the Companies Act, 2013 wherein same right is provided to the investor. As per the section 62 of the Companies Act, 2013 under which if the Company is intending to issue new shares to someone then in that case the company would be required to first offer such shares to its existing shareholders.
- Management Control:
- Under this Clause, the PE/ VC investor shall be eligible to appoint any person from his side as a Director of the Company i.e. at the Board Level of the Company. Further under this clause, what would be the criteria for appointment of such person as Director be decided like whether he/she would be required to hold shares and how and in what manner he would have control over the management etc needs to be mentioned specifically.
- Conversion Right:
- Suppose if the PE/ VC Investor has purchased the preference shares in the investee Company with the conversion right, now the Investor reserve the right to choose or force the Investee Company to convert their preference shares into the equity shares of the Company before liquidation of the Company or after expiry of certain time period as decided at early stage of investment.
- Practically conversation of preference shares into equity shares are delayed till the time Investee Exit from the Company so that he/ she can easily enjoy rights of having preference over the Dividend on the preferences shares of the Company.
- Veto Right/ Power:
- It is also known as Protective Provisions, Veto Right or Veto Power etc, normally every investor while investing his hard earn money in any company compel the company to provide him veto right on certain reserved matter on which the company cant not take any decision without affirmative vote of the Investor.
- For Example: Suppose Mr. A has invested 1 crore rupees into the Company ABC Limited with Veto Power over the alteration of any clause under Memorandum of Association and Article of Association. Now in near future ABC Limited is intending to increase its Authorized share capital consequence of which would be required to amend its Capital Clause of Memorandum of Association. Now here they can’t amend it without the prior permission of Mr. A (having Veto Right).
- Information Right:
- Every investor always while investing his hard earned money into any company exact that his money is being used for right purpose and is not wasted. For evaluating this, he/ she should ensure regular scrutiny of certain documents such as financial books, budgets and other records etc. which provides insight of the financial conditions of the Company.
- Liquidation Preference:
- It is the contractual right of the Investor to get priority in receiving in case the company goes into liquidation. Practically as the Private Equity or Venture capitalist are investing their hard earned money at very early stage of business of any company, so in case Company goes into liquidation or Company sale their entire business to someone, then such VC shall get the preference, over the common stock holder, in receiving a certain amount of proceeding.
- There is also a concept of “Multiple” (2X, 3X or 4X) in case of Liquidation preference, put extra care while inserting these types of clauses. Under these type of Clauses Investor are entitled to get multiple of his original investment (double or triple etc) before common stockholder get anything in return.
- Material Adverse Changes:
- Also known as MAC Clause or Material Adverse Effect.Normally it grants the right to Investor to refuse to invest or renegotiate if some unforeseen material changes affecting the entrepreneur business occur between the execution of acquisition agreement and closing of transaction.
- It also provides the entrepreneur to qualify certain warranties and representation before closing of transaction for the purpose of ignoring certain breaches.
- Put Option:
- As per this clause the Investor reserves the right to sell his/ her shares to the Company where an exit opportunity is not provided to the Investor in the form of IPO/ Buy Back.
- It is pertinent to note down here that here that it is an option on the part of Investor and investor is not an obligation to sell his/ her shares to the company. However, if the investor exercises his put option right then the Company would be under an obligation to purchase the shares from the Investor at a pre-determined price.
- Call Option:
- It gives the right to the Investor to buy the underlying shares at the exercise price, at or within the specified time period. Further it is the right of the Investor and do not create obligation on the part of Investor.
- At very early stage of investment, it is normally decided between the Investor and the Company that until the closing of the transaction, content and existence of the agreement will be treated as confidential and shall not be revealed by the investor, Company or founders to any third person.
- Further this also contain that the above said things can only be revealed after execution of proper agreement or in order to comply with any statutory or other regulatory requirements.
After carefully reading of above said clauses, it can easily be seen that making investment in any startup or getting funding for any startup is actually not a cake walk. Both the persons i.e. Investor and Founder have to take care of above said clauses and have crucial view on aforementioned clauses, else they may find themselves in big trouble and create a big deadlock in the operation of business.