The most critical aspect in any investment deal for the investors is the exit clause, which is when they get to see the return on investment. In a typical early stage investment deal, the options are initial public offering (IPO), strategic sale to a third party, company buy-back and in some rare deals – a promoter / promoter led-buyback. In this post, we touch upon some of these exit avenues.
The term sheet refers to the exit options and to the definition of Liquidation Event.
A Liquidation Event covers
- Winding up. i.e. things don’t go well and the company needs to be shut down.
- Consolidation, merger, reorganization where the current majority of shareholders do not continue holding a majority after such corporate actions or change in control of more than 50% shareholding. Sale of more than 50% shareholding to another party.
- Transfer of substantial assets.
Given that the investor will have to repay his investor (limited partners or LP as well call them), the time-horizon is driven by the LP’s terms in the fund. We generally see 5 years to 7 years for investors seeking exit.
In early stage investment, (example, incubators, accelerators, mentors, friends and family round, individual angels), we have seen that they like to retain flexibility of exiting (either full or in part) at the next round of investment. This is a point that the entrepreneur has to be conscious about, because this has an impact on the deal closure timelines.
Tip: Angels may not be angels. (Please don’t get us wrong. Angels provide huge strategic value and the money required in the formative stages of the startup). In one particular case, we saw that the Angel Network actually negotiated the investment terms to an extent, that it was becoming a Series A investment deal breaker. Reasons – (i) they were not consulted by the founder prior to signing the Series A termsheet and (ii) wanting rights like the Series A investor without participating in the investment round. We finally figured that the underpinning thought of the Angel Network was to get an exit and at a price higher than the Series A round. This is where the experience of handling investment deals becomes critical and probably would also test the soft-skills of the Founder J.
In earlier posts we have discussed that the investors are keen on big exits and multiply their investment amount but are not so keen on the dividend amount.
Tip: Typically in a friends and family round, we have seen high dividend rates or a request for return of investment money when the business becomes ‘life-style business’. In these cases, a founder can think of structuring the deal as optionally convertible debentures (if investor is in India).
You would now realize that there is interplay of multiple instruments – dividend rates, exit options and liquidation preferences.
The clause on Exit talks about the process of exit while the clause on liquidation preference details the distribution of the money received on exit.
Let’s look at a strategic third party sale (also called a trade sale). The exit can either be for only the investors or all shareholders. M&A (Mergers & Acquisitions) of privately held company is the most popular type of exit strategy. Merger is typically through a court process wherein two or more entities combine and shares of the acquiring entity is exchanged. Acquisition, could either be an asset sale or entity sale. An Asset sale is wherein the acquirer cherry picks the assets and many a times, leaves the liabilities behind. An Entity sale is typically done as a share purchase agreement. Now, each of these is an extensive topic, since there are many nuances including taxes(if it is a majority stake-sale and the like.) In all of these scenarios, the purchase price is determined by the acquirer. If the investors like the deal, they should exit?
Tip: Remember, the investor wants to see the investment amount multiply. During exit, the investor evaluates the growth potential of the company, IRR (internal rate of return) on the investment amount and many other external factors. It is recommended that some base / floor price of exit (formula / fair market value /IRR) is determined, because if there is no exit provided within the 5-7 year horizon, then it gets linked to default-drag along right. (Default Drag Along Right is the ability of the investor to drag the shareholders and sell it to a party at the price /terms that the investor determines with such third party, only if the promoters have not been able to provide an exit).
Super Tip: Super important for the founder to not provide for a plain Drag Along Right, where the investor can drag at any point in time, rather, have only Default Drag Along Right.
In a buy-back of shares by the company, there are laws, rules and regulations governing such buy back. Up until recently, buy-back was also used to overcome the dividend distribution tax and the recent Finance Act, 2013 which imposes a 20% tax on the company undertaking the buyback, similar to the dividend distribution tax.
Another recent development is the cooling off period between buy-back in the new Companies Act 2013 as compared to the Companies Act 1956. Earlier, we had a board approval process for 10% of equity shares and shareholder approval process for 25% for shares. While a cooling off period of one year had been prescribed between two successive buy-backs authorized by the board of directors, however enabling provision was captured where a buy-back of up to 10% of the paid up equity capital and free reserves of the company by way of a board resolution, immediately followed by another buy-back of up to 25% of the total paid up equity capital and free reserves by way of shareholders’ resolution.
The new Companies Act 2013 prescribes a cooling off period of one year between two buy-backs which means multiple buyback in a year is not possible. This could have an impact of reducing the ability to give a timely exit to private equity investors even in cases where the company may be sitting on surplus cash.
Tip: We recommend that the promoters think about having a floor price (IRR may be a good one), so that, an exit discussion gets enabled.
While providing for a Promoter or Promoter led buy-back seems to be a great option,generally, we do not see that listed as an option in early stage investment. Strange, isn’t it? Do you think it is a notion that the early stage promoter would not have the money to buy-out or is it because the price and terms would not be favorable to investors?
Though the term used is ‘buyback’ the transaction is a secondary sale of shares between two shareholders.
Tip: Given the changes in taxation, promoters need to understand the concept of withholding of taxes. In one particular case, the Singaporean investor was not willing of the promoter to withhold taxes (completion of this transaction was a dependency on a Series B deal) and finally the promoter undertook a sub-optimal route of having a stronger indemnity clause.
We would really love to hear your experiences and thoughts.
In the next post, we will discuss other exit options.
Disclaimer: This is not a legal opinion and should not be construed as one. Please speak with your attorney for any advice.
This post was first published on the Novojuris blog.
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