Series On M&A Transactions and PE/VC Investments in India: Part II

Himanshu Seth , Amit Shekhar , Isha Agrawal

June 19, 2023

Series On M&A Transactions and PE/VC Investments in India: Part II

INTRODUCTION
Private equity (“PE”) and venture capital (“VC”) transactions have gained significant momentum in India's dynamic business landscape over the years. With the rise of startups and a burgeoning entrepreneurial ecosystem, PE and VC investors are increasingly looking to invest in promising Indian companies with the aim of realizing high value gains over a relatively shorter period of time. However, navigating the legal and regulatory framework surrounding these transactions requires a thorough insight of the key steps encompassed in the beneficial conclusion of the said deal.
This article aims to provide an overview of the essential steps in a PE and VC transaction in India, shedding light on the process and highlighting important considerations and discuss and elaborate upon the entire lifecycle of a transaction, beginning with the initiation of a deal, a chain of deliberations amongst the parties and up to its completion and closing.

STEPS INVOLVED IN A PE/VC TRANSACTION
Investors utilize diverse approaches, including networking, participation in industry conferences, and leveraging professional connections, to discover potential investment prospects. For this purpose, investors actively search for startups that possess innovative concepts and significant growth potential. Thorough screening of investment opportunities is essential to assess the viability of the target company based on factors such as market potential, competitive landscape, scalability, and regulatory/legal compliances. Needless to say, that the strategies of the merger and acquisitions (“M&A”) and PE/VC transaction process differ from company to company, however, the following are the key steps in the lifecycle of a transaction:

  • Negotiations between the Parties: Valuation and negotiation play a critical role in determining the terms of the investment both for the company and the investor. Valuation in India's PE and VC transactions often involves complex considerations. Factors such as the target company's growth potential, revenue projections, market size, comparable transactions, and sector-specific dynamics are evaluated. Investors may use various valuation methodologies, including discounted cash flow analysis, and the net asset value approach. Once the valuation is determined, negotiations take place between the investor and the target company's promoters, founders, shareholders or other representatives. In furtherance, key terms, including investment amount, ownership stake, governance rights, liquidation preference, transfer restrictions and exit options, are discussed amongst the parties and agreed upon during this stage of negotiation.During this stage in the transaction, the involved parties, investors, promoters, company and/or other shareholders examine various factors such as the balance between risk and investment, the past performance of the company, notable growth and progress, the company's reputation in the market, its relationships with clients, suppliers, and customers, the necessary skills and expertise of the employees/consultants, and commercial strategies.
    Following the inquiries, the subsequent step involves negotiations with the primary objective of reaching an agreement that benefits both parties involved, creating a mutually advantageous situation. The key elements of the negotiation encompass the structure of the transaction, rights to receive dividends, the company's capital structure, rights to convert ownership, rights to redeem investments, preferences in case of liquidation, provisions to prevent dilution of ownership, rights of existing shareholders to additional shares, confidentiality measures, rights of the board of directors, representations and warranties of the company/investors, the need for experienced professionals, non-compete rights, and rights to access information and inspection.
  • Analysis and Preparation of the Term Sheet: A term sheet is a non-binding agreement that outlines the key terms and conditions of M&A, PE or VC transactions. It establishes the groundwork for potential investment, thereby establishing a framework within which the final agreement can be formulated and negotiated.
    A term sheet is prepared early in the process, typically after the initial stages of due diligence have been completed and before the final transaction documents are negotiated and signed by the parties. It is imperative to note that such summary of the vital terms governing the transaction ensures that the parties have an understanding of the essential terms before moving forward, aware of the confidentiality restrictions and effectively discuss the definitive agreements and other ancillary documents.
  • Conducting Due Diligence: Once a potential investment opportunity is identified, the next fundamental step is conducting due diligence over the company. Due diligence is a comprehensive examination of the target company’s legal, financial, operational, and regulatory aspects. The focus of legal due diligence is a comprehensive assessment of the documents and records of the target company in order to identify any associated potential and anticipated risks. Scrutiny of documents including but not limited to material contracts, employment matters, compliances under the labour legislations, insurance policies, loans and debts, intellectual property rights, requisite regulatory filings and litigation helps in identifying the potential liabilities associated with the company in relation to the applicable laws in India. Thorough due diligence enables the investors to identify potential risks involved in the investment, evaluate the target company’s value, potential of progression and negotiate key terms effectively. It also helps the investors as well as the target company to identify issues which may be agreed upon by the parties to be rectified or complied with, in the form of a condition precedent, closing or condition subsequent action under the definitive agreements.
  • Preparation of the definitive agreements: After the negotiation stage, the documentation and closing process commences by the parties. The parties prepare the requisite definitive agreements after finalization of a term sheet for the purpose of formalizing the terms of the intended investment which includes but is not limited to the share subscription agreement, shareholders’ agreement, and share purchase agreements. These definitive transaction documents typically cover provisions with respect to the investment terms, issuance of securities, board composition, rights and obligations of the parties (for example, tag along right, drag along right, pre-emptive rights), restrictions on transfer of securities (for example, right of first offer, right of first refusal), representations and warranties, anti-dilution protection, intellectual property rights, affirmative vote matters, and lastly the dispute resolution mechanism. Additionally, amongst other conditions precedent and subsequent, certain regulatory filings and approvals, such as those required by the Registrar of Companies (“ROC”), Reserve Bank of India (“RBI”) and the Securities and Exchange Board of India, may be a prerequisite to be obtained before closing the transaction. Once all the necessary approvals are in place, the transaction stands closed, and the investment amount is transferred to the target company by the investors upon issuance and allotment of the requisite securities by the company.
  • Conditions Precedent, Closing and Conditions Subsequent or Post Closing actions: Conditions Precedent (“CP”) refer to essential requirements that must be met before culmination of a transaction, specifically before remittance of the amounts of investment into the company which is dependent upon the fulfillment of these CP actions, generally included in most transaction documents. These may include, mitigating the issues identified during the due diligence process, submitting a detailed business plan, obtaining all necessary regulatory permissions, approvals, or consents required to operate the business, making relevant/necessary amendments to the company's articles of association, memorandum of association, and any existing shareholders' agreement to allow for the issuance of the subscription securities and associated rights.Closing represents the final phase of the transaction, during which the investment is realized pursuant to issuance of a ‘CP Confirmation/Completion Certificate’ to the investors, which serves as confirmation that all the identified CPs have been met. Post the closing of the transaction, the company still has certain obligations, including conducting board and shareholders meetings, to pass resolutions related to the issuance or allocation of securities and fulfilling all necessary compliances with the ROC and, if applicable, with the RBI, in accordance with the relevant applicable laws and within the specified timeframes mentioned under the definitive agreements, which forms as a part of Conditions Subsequent or Post Closing actions.

CONCLUSION
In recent years, there has been an upsurge in the PE and VC transactions in India which offer significant opportunities for investors however, navigating the legal and regulatory landscape is essential for the success of a transaction. By understanding the key steps involved in these transactions, including deal origination, valuation, negotiation and term sheets, legal due diligence, preparation of the definitive transaction agreements and closing, post-investment monitoring, and exit strategy implementation, the stakeholders can efficiently navigate through the transaction processes.
The upcoming articles in the ‘Series’ will further explore each stage of the PE/VC transaction extensively with respect to the legal, commercial, and regulatory implications.

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