EXPLORING EXIT MECHANISMS: STRATEGIES AND IMPLICATIONS FOR INVESTORS AND PROMOTERS Flashcards
(9 cards)
Initial Public Offering
An Initial Public Offering (“IPO”) is the process by which a privately held company offers shares to the public for the first time, transforming into a publicly traded company. In India, the IPO market has grown significantly over the years, driven by increasing investor interest, corporate growth, and economic development. Companies use IPOs to raise capital for expansion, debt repayment, or other strategic initiatives, and they are governed by a robust legal and regulatory framework to ensure transparency, investor protection and market stability.
The IPO process in India involves several steps, governed by SEBI regulations:
- Appointing intermediaries: The company appoints merchant bankers, underwriters, legal advisors, and auditors to facilitate the IPO. SEBI requires the lead merchant banker to be registered with SEBI and oversee the entire process.
- Filing the Draft Red Herring Prospectus (DRHP): This is a detailed document containing the company’s businesses, financials, risks, and intended use of the IPO proceeds. SEBI reviews the DRHP to ensure all relevant disclosures are made to protect investors’ interests.
- Approval from SEBI: Once the DRHP is filed, SEBI scrutinizes the document and may raise queries or request clarifications. After SEBI’s approval, the company can proceed with the IPO process.
- Roadshows and Book Building: The company, along with the lead managers, conducts roadshows to attract institutional investors and gauge market interest. In India, IPO pricing often follows a book-building process, where investors bid within a price band, and the final offer price is determined based on demand.
- Public Offering: Once pricing is finalized, the shares are offered to the public. SEBI mandates a minimum percentage of shares to be reserved for retail investors, institutional investors, and non-institutional investors.
- Allotment and Listing: After the IPO subscription, shares are allotted to investors. The company’s shares are then listed on a stock exchange (usually the Bombay Stock Exchange (BSE) and/or the National Stock Exchange (NSE)), where they can be traded by the public.
- A Few key considerations for an Indian company with respect to an IPO are as follows:
7.1. Eligibility: To be eligible for an IPO in India, a company must meet certain criteria laid out by SEBI. This includes a minimum net tangible asset base, positive cash flows, and a track record of profitability for a specified period.
7.2. Pricing and Valuation: IPO pricing is crucial, and SEBI regulations allow both fixed-price and book-building methods. Companies often hire independent valuation experts to determine a fair price range, while SEBI ensures that pricing is transparent and justified.
7.3. Lock-In Period for Promoters: SEBI mandates a lock-in period for promoters’ shares post-IPO to ensure their long-term commitment to the company. Typically, promoters are required to hold a minimum percentage of shares for at least three years post-listing.
7.4. Disclosure Requirements: Companies are required to make full disclosures about their business operations, financials, risks, and future prospects. Misrepresentation or failure to disclose material information can lead to severe penalties, including civil and criminal liabilities for company directors.
7.5. Investor Protection Mechanisms: SEBI has several measures in place to protect investors in the event of price manipulation, insider trading, or mismanagement. SEBI regularly monitors post-listing activities to ensure that companies and intermediaries adhere to the legal requirements.
STRATEGIC SALE
- A strategic sale refers to an Exit strategy that requires the company and the promoters to sell the entire share capital of the company to another company or entity that sees strategic value in the acquisition. Unlike a purely financial sale, the buyer in a strategic sale aims to gain competitive advantages such as entering new markets, acquiring innovative technologies, expanding product offerings, or leveraging synergies with their existing operations. Accordingly, this may be viewed as a particularly onerous Exit requirement imposed on the promoters since the promoters lose control over the company and the acquirer may operate the business entirely differently. A common variation of this Exit mechanism is a trade sale where substantially all the assets and the business of the company are sold to a third-party purchaser instead of merely the stock of the company.
TAG ALONG
A Tag Along Right is primarily a protection for the investors to ensure that any sale of securities by the founder is contractually unenforceable unless the proposed purchaser also purchases the securities of the investors who possess the tag along the right. There are primarily 2 (two) kinds of Tag Along Rights incorporated in a shareholders’ agreement. The first, allows the tag right holders to tag along in proportion to the percentage of shares being transferred by the Founder. Accordingly, if the promoters are selling 20% (Twenty percent) of their stake, the tag right holders shall be entitled to tag along up to 20% (Twenty percent) of their stake in the company.
- The second variation of a Tag Along Right, being more relevant to the context of this module, allows investors to sell their entire stake in the company, and accordingly procure an Exit, in the event the promoters are selling more than 50% of their stake in the company and thereby transferring control of the company. Accordingly, while a pro-rata tag along right is a transfer restriction on the transfers by the founder, a full tag along right has dual characteristics since it also is an Exit mechanism. It is to be noted here that a TAG Along Right is seldom a stand-alone right and is tied in with a right of first refusal. Accordingly, if a founder intends on transferring his shares, such a founder will need to provide the investors vested with the right of first refusal- the right to purchase the shares at the same price and terms that applied to the original purchaser (“ROFR”). When the right holders elect not to exercise the ROFR, a TAG Along right triggers which entitles the TAG Right Holders to require the Founder to sell its shares along with the shares of the TAG Right holders to the third-party purchaser.
PUT OPTIONS
Put Options are contracts that obligate the company and the promoters to purchase securities held by an investor in the company at a pre-determined price and within a specific time frame. The right to trigger a Put Option is usually tied in with the occurrence of certain events which are egregious scenarios that can potentially impact the value of the investment or the investor’s rights in a company. Accordingly, events that enable a Put Option holder to trigger the Put Option range from the failure to provide an Exit as per the terms of the shareholders’ agreement or material breach of the transaction documents by the company and the promoters.
ASSURED RETURNS
. For instance, in the case of Cruz City 1 Mauritius Holdings v. Unitech Ltd., the parties involved, and their subsidiaries formed an agreement to develop a real estate project through a joint venture. Cruz City opted to exercise its put option, which obligated Unitech’s subsidiaries to buy its shares due to delays in the project. The Delhi High Court determined that the put option, was enforceable and compliant with FEMA, as it could only be exercised if there was a breach of contractual commitments to the foreign investor specifically, the delay in starting the project. Accordingly, since the option could only be exercised within a designated timeframe and only if construction had not begun within that period, it was not an open-ended and simpliciter guarantee for an Exit. In another case, NTT Docomo Inc. v. Tata Sons Ltd., a clause required the exercise of the put option if Tata Teleservices Limited did not meet specific performance targets envisaged in the contract between the parties. This clause was deemed enforceable because there were multiple Exit options available to the company and the promoters to provide to their investor. However, having failed to provide any such Exit, the only recourse available to the investor was to exercise the Put Option and provide itself the Exit. The court accordingly indicated that in the given context, the option functioned as downside protection rather than an “assured return” under FEMA. As a result of these cases, the prevailing perspective has leaned towards upholding Put Options that lack assured returns, as long as they are triggered by a party’s specific actions. Thus, Indian courts are likely to enforce put options that do not provide guaranteed returns for investors.
PRICING GUIDELINES
The underlying premise behind the pricing guidelines applicable for any Indian company – whether a private company, a public unlisted company or a public listed company is that the valuation of the equity instruments being transferred at the time of an Exit should be as per any internationally accepted pricing methodology for valuation on an arm’s length basis and accordingly the principle and the applicable pricing guidelines are set out in the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (“NDI Rules”).
DRAG ALONG
A Drag Along Right is a right vested with a specific set of shareholders (“Dragging Investors”) that compel all the other shareholders of a company, including the promoters, to sell their stake in a company to a third-party buyer identified by the Dragging Investors, including at a price and on terms prescribed by such Dragging Investors. The determination of which investors would constitute the ‘Dragging Investors’ is usually based on percentage thresholds held by such investors, inter-se, in the share capital of the company but depending on the round size, this right may be vested with a single investor who is leading the round with the largest investment and therefore the highest post-closing stake in the company apart from the promoters.
LIQUIDATION EVENTS
An Exit on account of a Liquidation Event is to ensure that investors have downside protection to recoup the amount invested in the company, if no return is yielded on such investment. However, a Liquidation Event in shareholders’ agreements is not defined solely in the context of statutory liquidation but includes other corporate actions as well. The triggers to a Liquidation Event are premised on the company ceasing to exist on account of statutory liquidation or winding up, or if the control of the company is transferred to a different entity or set of individuals either by transfers of more than 50% of the voting power of the company or by transfer of all the assets of the company. The underlying premise of Liquidation Events as defined in shareholders’ agreements, is that such provisions outline the distribution of proceeds and the rights of shareholders in the event of certain occurrences that lead to the company’s assets being liquidated or transferred. These events usually trigger the redistribution of the company’s value among stakeholders, and accordingly, the clauses surrounding Liquidation Events are vital because they protect the interests of different classes of shareholders, particularly in ensuring a fair return on investment, priority in payments, and safeguarding minority shareholders’ rights.
The distribution of the liquidation proceeds is designed in a manner that shareholders are entitled either to recoup the investment amount or, if the proceeds from the liquidation event are sufficient, even get a return on their investment in certain scenarios. This is when the value of their stake in the company at the time of the Liquidation Event is more than the amount invested. Accordingly, the entitlement is designed in a manner that shareholders are entitled to the higher of (i) either 1x of their investment amount; or (ii) the pro-rata value of their stake in the company at the time of liquidation.
