As financial education grows, more and more high net worth individuals (HNIs) are beginning to realise that diversification is important. Traditionally HNIs have believed in sticking to what they know – their own business and investments in property, listed stocks, mutual funds and the like. But over the last few years we see a rising number of HNIs investing in a private company with a strong growth map or a distressed asset.
The investor though often finds himself in a difficult spot with the investee company – he may believe the company's growth story and long term strategy but may also not be sure of everything he is signing up for. Investing in a private company (which is usually founder-dependent) comes with complexities that are far beyond a financial investment. It therefore requires careful consideration not only by the investor but by experts in the matter.
Some things to remember while investing in a private company for growth purposes:
1. Go beyond the Information Memorandum / pitch book
Every investment banker representing a vendor company is presenting its best facets to you in the information memorandum. This is unsurprising because that is what they were engaged for. This creates a need for you to have your own advisers when investing in a private company. The sector you are investing in may be completely new to you and if so, it's important to have an adviser who understands the sector. A good investment adviser will also ask some of the difficult questions on items that were left out of the pitch.
2. Get an external due diligence
Most investors have neither the time nor the interest to do a full due diligence on the investee's books of accounts. The key difference between a due diligence exercise and an audit is that a good due diligence will look at the macro aspects as well as micro aspects. For example, an audit may tell you that a bad debts provision is missing. A due diligence will give you a range of what the provision should be, who the defaulting customers are and which customers have been showing lower volumes in the last two years. A due diligence also helps in finding out whether all costs are accounted for, whether liabilities are fully disclosed, whether there are any transactions with related parties that are not arm's length, etc.
In our experience with due diligence projects, we know that there is no one-size-fits-all approach to DD and that every project must be tailored to the unique characteristics of the investee companies. The product of a DD is not just a list of observations on the company, but also some insights on how to run it better, and what factors can potentially increase or reduce the business value.
3. Tax and transaction structuring
Are you investing in a private company personally or through a special vehicle? Are there any co-investors? How will you treat upfront and deferred consideration? Is the payment being made to an existing shareholder (transfer of shares) or to the company itself (via issue of new shares)?
Tax losses available to a company in India may lapse if a shareholding change of over 50% occurs. For companies with large tax losses, this can be a serious problem. No investor wants to infuse a large amount of capital into a company in a year, only to have to pay tax the next year because of a lapse in tax loss. It is important to seek advice from the experts on ways to structure the transaction to make sure you have the best outcome both for yourself and for the company you invest in.
4. Share purchase agreement and safeguards
The share purchase agreement can be an extremely important document, especially if things do not go to plan in future. Do you require a certain IRR on your investment? If you are a minority shareholder, do you want tag-along rights? What are the conditions precedent to this transaction being complete – i.e. what does the investee need to change before the agreement can be considered final?
Investing in a private company usually comes with a seat on the Board of Directors. As a director, are there any special rights (voting rights, veto rights or otherwise) that you require? Any safeguards from actions against the company? Most investors will remain non-executive directors in the investee companies, however as we have seen recently, a NED title is often not enough to avoid liability.
5. Personality and team
More often than not, investing in a small or mid-size growing company in India is based on the investor's belief in the people. The founder is usually the key to the whole business but the team can often be equally important. How well do you know and trust the founder? How dependent is the business on their continuity? What has the employee attrition been like and can you speak to a few independent parties to check the founder's credentials? Often, speaking to the company's auditor, or an important customer, or suppliers can give insights that are not terribly obvious but are very important.
Finally, it is important to take a measured decision. There are never any guarantees in entrepreneurship and investing, but there are always methods to mitigate risks. An adverse due diligence finding is not necessarily the end of a transaction – it could just be another negotiating factor that helps you achieve a better price for the same investment. Investment decisions need to be guided by three pillars – the information the investor has, the advice of experts and finally a degree of personal judgement and trust.
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The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.