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PE / VC Financing – A Broad Practice Process Perspective

Introduction

According to Jame Koloski Morries, “Venture capital is defined as providing seed, startup, and first stage financing and also funding expansion of companies that have already demonstrated their business potential but do not yet have access to the public securities market or to credit-oriented institutional funding sources, Venture Capital also provides management in leveraged buyout financing”.

Venture Capital (VC) firms bring to the table expertise regarding the business in which it is investing, as well as managerial capability, aside from the funds required.

Not only is VC fund invested in businesses that use new technology to produce new products, they will typically, continuously involve themselves with the investments by way of providing managerial and other support.

While it is commonly understood that the VC investments are made in equity of the target entity, it is often seen that VCs insist on a modified instruments, often in the form of Compulsorily or Optionally Convertible Debentures or Preference Shares, etc.  Depending on the nature of the business and appetite of the VC firm in that business, it is possible that other creative instruments for investment may also be used.   Ordinarily, debt instruments ensure a running yield on the portfolio of the venture capitalists, and hence, may be considered safer by the VC, apart from providing a liquidity preference above equity holdings.

Venture Capitalists finance high risk-return ventures. Some of the ventures yield very high return in order to compensate for the heavy risks related to the ventures at the time of exit.  It depends on what the exit is defined as, however, typically a VC would retain several rights of exit upon the happening of specific occurrences.

Since VC funds invest on the basis of the business plan, when the business may not exist in the ground, they take a significant project risk. Private equity funds, however, come in when the business has taken off.  They prefer to invest in the growth of the business, when proof of concept is established, and scalability of the business is clear. Thus, VC funds can be viewed as ‘seed capital’, while PE funds can be viewed as “growth capital”.

The definition of the two types of funds under SEBI (Alternate Investment Funds) Regulations, 2012 is as follows:

  • “Private equity fund” means an Alternative Investment Fund which invests primarily in equity or equity linked instruments or partnership interests of investee companies according to the stated objective of the fund.
  • “Venture capital fund” means an Alternative Investment Fund which invests primarily in unlisted securities of start-ups, emerging or early-stage venture capital undertakings mainly involved in new products, new services, technology or intellectual property right based activities or a new business model.

Investments by both PE and VC Firms are illiquid investments. While a PE would invest in the expectation of an IPO, most VC Firms do not remain in the target entity till the IPO stage.

PE funds may even invest post public issue or at the time of public issue of the target. These are called Private Investment in Public Equity (PIPE).  While the VC funds may not have a clear investment horizon and may be in the target entity for a longer investment horizon.  However, PE funds typically have a shorter investment horizon – anywhere between 5 – 7 years would be a typical time period.

Angel Funds, VC Funds and PE Funds are essentially progressions in terms of project risk, investment liquidity and stages in the life cycle of the business. Angels normally enter a business at the lowest valuations with PEs entering at the highest valuation amongst the three kinds of investors (Angel, PE and VC).

The Process

Normally, upon deal origination (which may depend on the internal policies of the VC firm, and the area of interest that they may have), the step that follow is roll out of a Term Sheet. It is entirely possible that the VC move to Evaluation or Due Diligence before rolling out the Term Sheet.  In case the business is absolutely new then the an evaluation into the quality of the entrepreneur is undertaken, before appraising the characteristics of the product, market or technology. Most venture capitalists ask for a business plan to make an assessment of the possible risk and expected return on the venture.  Oftentimes, the above procedure runs in parallel with the negotiation on a draft Term Sheet.

Thereafter, the process of Valuation may commence. Investment valuation is a specialised process, where various factors are considered including but not limited to the entrepreneur’s track record, the product itself, and whether it is innovating, overall economic scenario, unique proposition of the venture, size of the market and so on and so forth.

Assuming that the aforesaid steps are accomplished and an acceptable Term Sheet has been signed, the next step would be Deal Structuring.

Once the venture has been evaluated as viable, the venture capitalist and the investment company negotiate the terms of the deal, i.e., the amount, form and price of the investment. This process is termed as deal structuring. The discussions would also include protective covenants and earn-out arrangements. Covenants include the venture capitalists’ right to control the target company and to change its management if needed, buy back arrangements, acquisition, making Initial Public Offerings (IPOs), etc.  Discussions and agreement entered into would specify the entrepreneur’s equity share and the objectives to be achieved.  Various rights are retained by the VC, including that of replacement of the management in case the objectives are not met, or in case of specific circumstances arising.

The next important question, apart from the day to day operations and the VC Firm’s level of intervention in it is that of exit.  There could be:

  • Initial Public Offerings (IPOs)
  • Acquisition by Another Company
  • Buyback or Repurchase of the Venture Capitalist’s Share by the Investee Company / Promotors
  • Purchase of VC Firm’s Share by a Third Party

From a process perspective, the following stages are key:

Sourcing of proposal:  PE / VC funds receive proposals from Investment Banks as well as from the targets directly.  Most funds may not wish to directly engage with the promotors, especially when the promotors do not have a significant track records, and would prefer to pursue proposals that are initiated by Investment Bankers.

  • Initial contact / flier / pitch:  This refers to the stage when the Investment Bank or the promotor sends out a pithy flier, which may be just a page or two, outlining the bare details of the project – essentially, the issuer, the business and the nature of the proposed transaction.
  • Non-Disclosure Agreement:  If the fund is interested, they would seek further information by way of emails or by way of discussions.  To cover the subject matter and to ensure no possible leakages, a non-disclosure agreement is typically signed by the parties.
  • Information memorandum: Post the non-disclosure agreement, an Information Memorandum is shared between the parties. This may contain the following:
    • Highlights
    • Executive Summary
    • Promoter background
    • Industry background, regulatory environment, market structure and competitors
    • Key drivers of success in the business and the overall value chain
    • Company background, its management team and clients
    • Business model of the company
    • Strengths, Weaknesses, Opportunities and Threats (SWOT) analysis of the company vis-à-vis the chosen business model
    • Capital expenditure plan and proposed means of financing
    • Revenue model and strengths / uncertainties associated with each stream of revenue
    • Cost and Margin structure
    • Historical financials
    • Projected financials for about 5 years, or longer for long gestation projects
    • Patents or any intangible assets owned by the company
    • Key successes of the company
    • Litigation or tax issues associated with the company or its promoters
    • Proposed transaction, including purpose of mobilisation, size of mobilisation, proposed dilution and the valuation.
    • Justification for valuation
    • Risks associated with the investment
    • Likely exit possibilities for the investor
    • Time frame, or any other key aspect not covered above

This document is required to be professionally prepared in the interest of completeness and should ordinarily be vetted by professionals who would be assisting in the transaction should it go forward.

  • Management presentation
  • Initial Due Diligence
  • Preliminary investment note:  This is typically prepared by the internal team of the fund, and is a document private to the fund.
  • Non-Binding Letter of Intent:  Post the above, a Non-Binding Letter of Intent is issued by the fund outlining the nature of the investment, the kind of instrument, key parameters, investment conditions, amounts and other terms.  The LoI would also outline the key liquidity events, time frame, board representation, expected stake, costs and who is to bear them.  Any specific area of concern may also be addressed in such an LoI.
  • Final Due Diligence (FDD): FDD occurs on several parameters including commercial, financial and legal.  Legal DD would normally cover the following:
    • Incorporation certificate and various registrations obtained by the company
    • Licences and approvals required for doing business, scheduled expiry date of each of these, likely terms of renewal on expiry, any permissions not obtained by the company, reasons therefor, and the implications in terms of costs, penalties and culpability of owners / managers
    • Approvals required for the proposed PE transaction within the company, from other business owners, from regulatory authorities and from any other commercial partners
    • Review of the memorandum and articles of association including confirmation that all changes to date are suitable reflected in them
    • Changes that will need to be incorporated in the memorandum and articles as part of the proposed transaction
    • Non-compete agreements executed by the company and their validity and duration
    • Claims made against the company by any party, the status of these claims with various authorities and relative strength of the parties to the claims
    • Meetings of the board and share-holders, the dates on which they were held and the compliance with regulatory requirements
    • Filing of annual returns, resolutions and other forms with the Registrar of Companies (ROC) and other regulatory authorities
    • Material contracts executed by the company for financing, sourcing etc. and especially contracts the company has made with owners or senior management of the company
    • Standard terms of employment with employees, and special arrangements made with senior management of the company
    • Confirmation of ownership of key assets reported by the company
    • Adequacy of insurance taken on the assets and other contingencies, the insurers, key clauses in the insurance policy, pending insurance claims, impact of claims on future premia payable on those insurance policies etc.
    • Patents, trademarks, brands, copyrights, industrial secrets, proprietary software and other intangible assets of the company, the certifications of their ownership and validity, measures taken to protect them, and any further steps to be taken on these matters if the proposed transaction goes through
    • Cases against the promoters or senior management, whether related to the business of the company or otherwise, and their status in relevant courts or with regulatory authorities.
  • Final Investment Memorandum: This document covers all the areas through the Information Memorandum, and findings of the FDD, as well as valuations.  All the approvals and closing steps are also discussed in the Final Investment Memorandum.  This document is ordinarily discussed in the meeting of the directors / partners, and the authorised signatory for signing the Term Sheet is then decided and authorised.
  • Term Sheet: Term Sheet can be seen as a binding LoI as opposed to a Non Binding LoI containing the details therein as well as addressing any other issues that may need to be addressed pursuant to the aforesaid steps.  The Term Sheet is then binding on the fund, while containing the term for which it would remain firm.
  • Closure of the deal: After the term sheet is signed, and before the fund releases the money to the company, various other processes need to be completed, such as:
    • Drafting and execution of subscription agreement outlining the respective parties’ rights and obligations
    • Making relevant changes in memorandum and articles of association and other agreements with various parties, as may have been decided
    • Permission of Cabinet Committee on Economic Affairs, SEBI, RBI, Ministry of Finance, relevant Ministry for that industry, state government, local authorities etc.
    • Obtaining any no-objection certificates that may have been highlighted as part of the legal due diligence
    • If the transaction structure provides for any escrow arrangements or other guarantees, then effecting the same
    • If the deal is subject to any changes in the financial structure of the company including fresh borrowings, then obtaining firm commitments for the same and concluding the relevant documentation

There may be conditions subsequent and precedent as well that need to be fulfilled upon or before closure of the deal.

Key Investment Conditions

Certain investment conditions are typically addressed by the Funds in the course of the deal.  These are:

  • Board Seat
  • Right to change management
  • Lock in of Promotors / Management
  • ESOPs
  • Assured Returns
  • Veto Rights
  • Right of First Refusal
  • Right of First Offer
  • Right to MIS
  • Right to Audit
  • IPO Facilitation

The aforesaid conditions are incorporated into the deal by way of various documents such as Share Subscription, Share Holders, Share Purchase Agreements.  The Memorandum and Articles of the Company are also amended in keeping with the transaction structure.

For the purposes of this article, one confines oneself to the practice aspects of PE / VC transactions.  Of course there are other nuances, such as taxation, regulations of AIFs by SEBI, and the entire ecosystem surrounding them, which may form a part of another offering from Aureus Law Partners.

Till then.

From the Aureus Law Partners’ research desk. 

For queries: aureus@aureuslaw.com