The period between 2006 and 2008 saw a large number of venture capital and private equity (VC/PE) deals in the Indian market. The exit rights negotiated by VC/PE investors during the haydays of India’s growth story gain importance in today’s context, as most of the funds have now reached the end of their fund lifecycle. In view of decelerating capital markets, exits remain a key challenge for VC/PE investors, and this has hampered fresh fundraising prospects from their limited partners (LPs) in the absence of a track record.
Key factors in an exit include: 1) the promoters managing and negotiating rights and expectations of the new investor with those of the exiting investor or any other continuing investors; 2) the exiting VC/PE preference for a complete release and waiver from the investee company, its promoters and the new investor from all past and future liabilities, and negotiating representations, warranties and consequent indemnities; and 3) the new investor conducting thorough due diligence.
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VC/PE investors should negotiate the following five exit challenges as early as the term sheet stage:
Due diligence: A common challenge VC/PE investors face includes negotiating and agreeing on the scope of the diligence exercise. An exiting investor should always try to limit the scope of diligence to the bare minimum and ensure it is conducted in a timely manner. Some other challenges include: 1) procuring the active cooperation of the promoters; 2) absence of enough secondary data; and 3) reluctance among promoters of a family-run businesses to share information with investors conducting diligence. From the purchasers’ perspective, it is imperative to gather as much market intelligence on the credentials and background of the promoters, in particular the reason for the VC/PE exit.
Warranties and indemnities: The extent and nature of warranties to be sought from an exiting VC/PE investor will entirely depend on the status of that investor (i.e. financial investor or a strategic investor). An incoming investor would want a full set of representations and warranties, but to what extent the exiting investor can provide such indemnities is a moot question. The exiting investor should limit its representations and warranties to title, author and performance.
Tax indemnities: Post the Vodafone judgment, seeking a withholding tax indemnity on capital gains from the seller has become a key challenge. Some safeguards that purchasers have considered include cash holdback for an agreed percentage of purchase consideration, tax insurance, and backstop indemnities from LPs. These mitigators, however, need to be evaluated keeping in mind the lifecycle of the fund and provisions relating to clawback contained in the fund documentation. The recent protocol of 10 May which amended the India-Mauritius double taxation avoidance agreement has cleared the air of uncertainty by exempting transactions undertaken prior to 1 April 2017 from the purview of capital gains tax (CGT), after which the tax on capital gains will be charged at 50% of the domestic CGT from 1 April 2017 until 31 March 2019, and at the full rate after 1 April 2019. The above issues continue to be relevant until the India-Singapore treaty is formally modified.
Buyback: This route is predicated upon the target company having enough resources to honour its buy-back commitments. There is a view that buyback of compulsorily convertible preference shares (CCPS) issued to a foreign investor is not permissible under India’s foreign direct investment (FDI) policy as such buyback would be akin to the redemption of preference shares, which would indirectly run afoul of the FDI policy, which states that preference shares should be compulsorily convertible. In view of this, CCPS would have to be converted to equity mandatorily, and after conversion the company would have to meet with the conditions specified in the Companies Act, 2013.
Put/call options: Enforceability of put and call options has always been a topic of debate with conflicting regulatory and judicial views. Clarifiications by the Securities and Exchange Board of India on 3 October 2013, and the Reserve Bank of India on 9 January 2014, specifically recognizing put and call options as valid contracts have helped ease investor concerns. But their implementation still requires promoter cooperation and has resulted in such disputes being referred to arbitration.
There are enough issues in terms of economic progress, sector-specific legal and regulatory compliance, and risks associated with implementating an exit strategy that could jeopardize the returns of exiting VC/PE investors. Active promoter cooperation is vital for any successful exit. A systematic approach by PE/VC investors towards their investments and returns, and managing their relationship with the promoters is key to a successful exit.
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Rajesh Begur is the managing partner at ARA LAW, a first-generation law firm with offices in Mumbai and Bengaluru.
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