Equity is said to be the cheapest form of raising funds for a Company since there is no obligation to pay any dividend to the Equity Shareholders but it is also highly risky in nature.
Since it is risky in nature, the maximum amount of profit can also be achieved through the form of Equity.
It goes with the economic fundamental which says “Greater the risk taken greater the profit / loss, lesser the risk taken lesser is the profit / loss”.
The very first thing that comes to our minds is what exactly is Equity or Private Equity?
It is a Share Capital introduced or invested into by any person into an Artificial Judicial Person known as a Company (either a Private Limited Company or a Limited Company). The person/s who invest their funds through Equity are actually the owners of the company to the extent of their percentage of their holding in the total Equity capital of the said Company.
If Mr. X has invested into 10,000 no. of Equity Shares of Rs. 10 each (face value) of an XYZ Private Limited Company whose total paid up capital is 1,00,000 no. of Equity Shares of Rs.10 each (face value), then Mr. X will be having 10% ownership right of the company, 10% voting right in the decision making power of the management of the Company as well as 10% right in the profit and loss of the company.
Now let’s discuss the matter from an investor’s point of view who wants to invest his money through Private Equity. In this situation a few questions cross the mind, such as:
1) How does one analyze where to invest?
2) How much to be invested?
3) How will the investor’s interest be safeguarded?
4) How and by what time will there be realization of profits?
Let’s take you through these steps one by one:
How does one analyze where to invest?
People or organizations searching for investment will always look for a country which is developing because of the scope to tap the growth potential and explore maximum profits. In this scenario the amount they invest will have the maximum potential to get double in a lesser period of time.
One can appoint Private Equity Analyst (specialized in advising regarding investment in private equity) for finding out the best industry to invest in, an industry which is potentially fit to deliver the highest rate of return and growth.
Under normal circumstances, Companies with high potential to growth, experienced management and high demand for the products are chosen.
Past track records of the profitability of the company, future of the product’s market share among other players and where the projected financials look promising are studied and thereafter investment is made.
Investment is also made in creating or purchasing rich assets for the company which helps in multiplying the production and increasing the market share of the products.
How much to be invested?
If you are a foreign Investor investing in India, you need to see the RBI guidelines for investment in India which cannot be more than 24% of the paid up capital of the company.
A few of the sectors are in the banned list where foreign investment cannot be made.
A complete list and guidelines can be obtained and reviewed at this link of RBI (Master circular on Foreign Investment in India).
If you are an Indian investor, you can invest as per your risk appetite and understanding of the business.
In general, investment of around 30% to 40% stake is considered to be ideal in a company.
Rather as per Indian standards, the Indian promoters will not be eager to let their shareholding go below 55% to 65%, so that they don’t lose on the ownership of the company.
Exhibit – 1 (Taken from Draft Red Hearing Prospectus (DRHP) of Just Dial Limited:
How to safeguard the interest of the investor?
Whenever any Private Equity investment is made the utmost priority of the investor remains to safeguard their interest and their money for which a Shareholder’s agreement is drafted wherein all the rules and regulations regarding deployment of funds, issue of fresh equity, utilization of funds, decision making powers and other points effecting the financial dealings are noted.
These agreements are often called Private Equity Shareholders Agreement. Few of the important clauses to be incorporated in the agreement are:
a) Mode of introduction of Private equity by the investor along with time period by which it would be invested should be mentioned.
b) A nominee of the investor to be appointed to the Board of Directors with special rights and privileges who will check on the investments done by the Company in right direction so that the funds invested by the Private Equity players are not diversified.
c) Appointing a neutral auditors for the Company who are not biased to the management and a true and fare view of the workings of the Company is presented in front of the Private Equity Investors.
d) Providing / prohibiting any further issuance of share capital without the permission of the Private Equity Investors so that their stake in the Company is not diluted.
e) Prohibition on selling of their stake by the promoters so that no new management can come up until the expiry of the terms and realization of money by the Private Investor.
f) Exit routes for the Private Equity Investors to be defined in detail as to when they can sell their stake and realize their money with profit.
g) In case the planning of the Company does not fall in place, the first right on the assets of the company so that their invested amount can be realized.
h) Other points as to the nature of the Industry (case to case basis)
Exhibit – 1 Sample taken from DRHP of Just Dial Limited:
Please note that Shareholders Agreement (SHA) differs from case to case, but do keep the note of above details to be included in the SHA. Here the company has replaced the SHA when any new Private Investor has stepped in, inculcating all the benefits and securing their interest in the company.
How to realize profit and in what time?
A detailed project report is prepared based on the futuristic estimations, providing the EBIT, PAT and book value of the Company.
Generally two ways are decided by the Private Equity players to realize profits out of their investments:
a) by sale of their stake in Market after IPO (Initial Public Offering) by the company in which they have invested, and
b) by selling their stake back to the promoters
It is the most common procedure followed wherein after getting the Private Equity and expanding the business, the Company goes for IPO (Initial Public Offer) within a span of 5 to 7 years. The time period may vary from case to case.
Since the performance of the company is developing over the year and it comes out with IPO, it gets the benefit of market capitalization which in turn helps the Private Equity players to realize huge profits on their investments by selling their stake in the open market.
In general the profit earned ranges from 22% to 30%. However, the profit percentage may increase and go up to 50% if the company profitability is exceptional.
Just Dial was listed on 20th May 2013 with a issue price of Rs.530/- per share, issued to retail investor at a discounted price of Rs.483/- per share. SAIF II Mauritius Company Limited earned handsome profits shown in the exhibit:
Selling the stake to promoters
Other option is to sell the shares back to the promoters at a defined price which may be close to the book value or at higher price, which depends upon the Companies performance over the years.
The buyback amount is often defined in the Shareholders Agreement or the mode of computing the same is mentioned or clarified.
Sometimes the rates are also flexible based on certain future events, book value and performance of the company.
In any case the minimum amount to be taken back is defined.
To sum up the whole process of Private Equity one can see or follow the following steps:
STEP 1 – Identify the Country and Industry where Private Equity funding is required.
STEP 2 – Get a detailed analysis on the performance of the Company vis-à-vis industry standards, past experience of the promoters in their business, financial potential of the business either through a professional or through self study. Get a detailed planning and study on future expansions and projected financials. Study the SWOT (Strength, Weakness, Opportunities, Threats) analysis of the Company and make a decision on the investment.
STEP 3 – Check the RBI circulars on FDI (Foreign Direct Investments) if the investor is a foreign Entity, since investing in India requires RBI guidelines to be followed.
STEP 4 - Drafting and negotiating on the Shareholders Agreement (the most important document in the whole process, since the entire legality, procedure, exit way, terms and conditions of the arrangements are recorded). The entire fate of the amount invested is protected through this agreement.
STEP 5 - Take control of the management of the company through appointing a nominee director in the Board of the Company and take a note on day-to-day affairs and decisions made by the Management or Board of Directors.
STEP 6 - After the expiry of the defined time period, realize profit by selling the stake in open market (if Investee Company goes for IPO) or selling it back to the promoters.
Thus, by following these steps one can enter into Private Equity in India while keeping in mind that investing in private equity will have its own pros and cons.
One should always look for developing industry which is in its growth phase and has a focused management behind it.
Before investing, one should go through the project report thoroughly and of course not to mention, should have belief and confidence in the success of the project.