(Think Like Founder Series- By Ductus Legal-Volume II)
What is a Private Equity?
In simple words, ownership in Companies which are privately held and are not listed on Public stock exchange. Private equity investment is popular for its high risk and greater rewards, it’s said that it generates better returns than stocks.
Popular Startups of present day have raised funds through private equity firms at one or other point of their Journey (For Instance Swiggy, Zomato, Bharat Pay, Lenskart and so on). It gives startup capital and professional support.
Private Equity Firm raises capital from PE Fund to invest in Startups with an intent to generate high rewards for such investors. Usually those who invest are known as Limited Partners (Which can be a big Provident fund or Banks or Government or Insurance Companies or Family Offices or HNI). A combination of these LPs is popularly known as PE Fund.
SEBI Regulates PE Firms and Funds through SEBI-AIF Regulations.
Angel Investing, Venture Capitalists all run under one big umbrella of PE Firm. As per public reports PE Industry in India is investing $40 Billion + per annum.
How does a Private Equity firm makes money?
Every PE firm has a fund, wherein, ultra HNI or HNI or Institutions invests in these funds. Therefore, a private equity general partner has to be precisely focus and clear about the ultimate target of investment in startups i.e. A good exit and return for PE fund and its investors.
Whenever a PE is investing in any startup a founder has to understand that the fund has limited time line i.e. 5-10 years(Regulated by SEBI AIF rules), that means fund has to get an exit in the said tenure. Acquisition of Startup (For Instance Minimalist), Secondary Buying (For Instance Theobroma) or an Initial Public Offer (For Instance Mama earth or Zomato or Ola) are common exit strategy through which PE firm earns returns.
A PE charges two nature of fee one is Management Fee for investment in startup (Somehow it is one a startup who is getting investment) and second is a two digit percentage share in returns generated for investor from the investment in startup.
IRR (Internal rate of return) is the measuring factor through which a PE fund measures the success of fund. CRISIL (a subsidiary of S&P Global) like institution publishes the IRR generated by each PE fund. It is a kind of parameter to measure their success in the startups. This rating is directly or indirectly a x-ray report on possibility of successful exit via e IPO.
A legal and investment banker majorly advises a PE on fund structuring, Legal Compliance of regulations under FEMA, Companies Act, SEBI regulations, drafting of LLP fund raising agreement, AIF instrument and so on. Similarly a startup need advisory on fund raising, compliance and share subscription and other agreements.
Private Equity Funds requires an approval from the SEBI. In actual sense a private equity fund founder has to justify how and by when, he or she is going to commit the return for the investors of its fund. How?
Private Placement Memorandum is the document which not only talks about the vision and usage of PE fund but risk and compliance associated to it. In simple sense whatsoever you have told your investors must be filed before SEBI. Post due diligence and analysis SEBI will imparts its approval/License to the fund.
SEBI (Alternative Investment Funds) Regulations, 2012 require the sponsor/manager to issue a Private Placement Memorandum to potential investors (Limited Partners or LPs) and files it with SEBI for prior intimation/approval before launch.
So in a very simple sense following is the path in forming a PE Fund:
A. PE Fund Manager/Founder/Sponsor launches a fund
B. Found Create a Vision Document of Fund
C. Fund Approaches the Investors (HNI or Ultra HNI or Institutions) to get the soft commitments
D. Fund files its PPM before SEBI
E. SEBI Imparts License to fund
F. Fund gets money from the investors
Like Real Estate has it agents as backbone, similarly, PE world has distributors (One who connects Investors and Fund)
What is the one parameter for PE Firms that measures the success of their investments in Startups?
IRR (Internal Rate of Return). IRR is simply the rate of return a project or investment gives each year, considering both the money you put in and the money you get back (cash flows), spread over time.
Faster returns = higher IRR. If two investments give the same profit, the one that returns money sooner will show a higher IRR and be more attractive.
IRR helps PE funds measure whether they’re meeting the hurdle rate promised to investors (LPs). PE firms showcase IRR to attract new investors (LPs).
What are the various ways and nature of funds through which being a startup founder you can raise money from the Private Equity ?
A. Primary Equity- Fresh issue of equity shares to the PE in exchange of capital.
B. CCP- Compulsory convertible Preference Shares provides exit preference to PE and are convertible into equity after a tenure or an event. Usually such shares don’t have voting right unless there is a statutory violation.
C. Compulsory convertible Debentures; Structured as debt fund but convertible into equity on a event as defined under the terms of issue.
D. Mezzanine Instruments (Debt + Equity): Structured debt with high interest and attached equity options/warrants. Provides PE investors fixed income along side upside potential.
Founder who are aiming to raise funding from the Private Equity Firms are advised to keep in mind the “PE Perspective” before raising funds or applying to a PE for fundraise. What is the perspective?
A. PE firm raises funds from investors to invest in the portfolio of startups, therefore, PE has to generate a return for their investors in a fixed timeline and they have to return their money.
B. PE fund is a SEBI registered fund and it has a limited timespan during which investments are being made, returns are generated and finally fund is closed and information of said winding up of fund is required to be placed with the SEBI.
C. PE has to take a exit from your entity after a time span and most probably the closure route options and your rights as founder at the time of exit has already been mentioned in the Shareholding agreement.
D. IPO, PE to PE stake buyout, M&A, Partial exits are some of the strategies that you should prepare yourself.
Therefore, Founder must prepare himself or herself that a funding from PE also pertains the great responsibility, extreme pressures, faster learnings. It is equally an opportunity to be a professionally organized entity from the very beginning. Your legal document as signed with PE, discloses the one or other way the situations or circumstances that you may face in future.
Copy Right: Ductus Legal & ADV Dixit Mehta
(Think Like Founder Series- By Ductus Legal-Volume II, For Founders and Law Students)
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