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Private Equity/ Investors Clash with Promoters- Mitigation Plan

By April 7, 2021 No Comments

A.    BACKGROUND:

Historically spate of cases has involved marquee PE names — from General Atlantic to TPG to Premji Invest. In this article, I have tried to summarize my observations based on my experience on why Private equity (“PE”) /venture capital (“VC”) investors end up fighting with the promoters and vice versa which generally cost them dear, and also the mindset required for promoters to handle the investors.

B.    REASONS FOR SPATE: 

  • Poor Due Diligence by the Investors:  While obviously, investors perform various due diligence, a more stringent due diligence is required especially when Indian private equity is essentially about minority growth investing and the investors are always at the mercy of smart and shrewd promoters. Poor due diligence can erode the entire investment of the investors in case a financial liability hits the company due to a regulator or a third party claim on the Company.
  • Desperate Promoters versus demanding investors: VC and PE investors justify the demand for a large portion of equity by citing the high risks of investing. VCs believe that only one out of 10 start-ups become a super hit. This makes them feel that they have to own enough of the winning company to make their money. The second is that there is a lot more demand for money than supply, which results in a few investors calling the shots. The Promoters tend to forget the control game in desperation of rising money and end up diluting and losing control of the Company.
  • Promoters Sweet Spot: The most common strife with Indian promoters includes related party transactions, failure to honor contracts, and inappropriate takeaways in salary and compensation.
  • Promoters Pushback on governance issues: While a large number of PE funds in India still believe that “promoters know best", a growing number of funds are playing a greater role in influencing the corporate governance practices of their investee companies. The proportion of buyout transactions as a percentage of PE investments in the country is rising where the fund is taking control of the business and either working with the existing promoters or completely overhauling the management. The PE Funds generally prefer to have a Chief Financial Officer reporting to the board. Further, some of the Indian promoters are still uncomfortable with this approach and are rigid to delegate any power to the management team.
  • Promoter mindset of Control: Generally, investors have the upper hand in dealings with Promoters. Some of the Indian promoters don’t understand this game of losing power after diluting equity and end up fighting for a power struggle.
  • High-value Investments: Due to limited opportunities, there is pressure within funds to deploy capital. Many investments have also been made at high valuations when the market was peaking and investors went berserk. When the companies underperform, the investors feel insecure and try all means to maximize the value.

C.    BEST PRACTICE FOR INVESTORS TO MITIGATE RISK OF LITIGATING:

Some of the best practices adopted by the PEs/VCs include:

  • Pre-investment Due Diligence of the Company including Environmental, Social, and Corporate Governance audit.
  • Background checks of the Promoters and the management team.
  • Watertight employment agreements for the Promoters and the management team.
  • 90 -120 days assessment plan to better understand conflicts of interest and other risks which they could not assess from the outside before the investment.
  • Audit at regular intervals from legal/ compliance and regulatory perspective.

D.    BEST PRACTICE FOR PROMOTERS TO MITIGATE RISK OF LITIGATING:

The promoters also need to do their homework on the investor so they can choose the right investor for their company. The promoters should look for more than valuation from the Investors like contacts, strategy and mentoring. The promoters should also keep good and regular communication with the Investor and provide all material information. The promoter should also be flexible and be willing to adapt quickly to the changes.

The Company which is raising funds from private equity/venture capital players will mostly witness tight obligations and limited rights, with the promoters being liable for most acts, as the Investor decides to invest relying solely on the representations given by the promoters. Many issues come up while discussing and negotiating investment terms with the Investors. Some of these issues, which require special attention of the founders, are detailed herein below:

  • Board seat bifurcations.
  • Restrictions on transfer of shares of the promoters
  • Indemnity obligations on the promoters.
  • Exit obligations of promoters towards the Investors.
  • Liability of promoters on their assets.
  • Non-Compete obligations of promoters.
  • Anti-dilution protection for the Investor.
  • Liquidation preference.

E.    CONCLUSION:

The race to raise and deploy capital in this competitive environment has made promoters and investors to forget certain basic principals of partnership. The promoters need to be flexible and should not promise heavens to the investors and should always show the flip side of the story. The investor should understand that equity investment is a risk-based investment and nothing is guaranteed. The promoter should hire a good legal counsel to negotiate the agreements to avoid any future surprises.

Author: Prashant Jain, Co-Founder & Partner

Disclaimer: The content of this article is intended to provide a general guide to the subject matter and that the same shall not be treated as legal advice. For any queries, the author can be reached at prashant@samistilegal.in.

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