Investing in a Private Company – Things to Consider – Corporate/Commercial Law


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As financial education expands, more High Net Worth Individuals (HNIs) are beginning to realize that diversification is important. Traditionally, HNIs have believed in sticking with what they know – their own business and their investments in real estate, publicly traded stocks, mutual funds, etc. But over the past few years, we’ve seen an increasing number of HNIs invest in a private company with high growth or a distressed asset.

However, the investor often finds himself in a difficult situation with the recipient company – he may believe in the company’s growth story and long-term strategy, but may also be unsure of just what it undertakes. Investing in a private company (which usually depends on the founder) comes with complexities that go far beyond a financial investment. It therefore requires in-depth reflection not only on the part of the investor but also of experts in the field.

A few things to remember when investing in a private company for growth:

1. Go beyond the Information Memorandum / pitch book

Each investment banker representing a selling company presents their best facets to you in the briefing note. It’s not surprising because that’s what they were hired for. This creates a need for you to have your own advisors when investing in a private company. The sector you are investing in may be completely new to you and if so it is important to have an advisor who understands the sector. A good investment advisor will also ask some of the tough questions about items that have been left out.

2. Get external due diligence

Most investors don’t have the time or interest to do a full due diligence on the investee’s books. The main difference between a due diligence exercise and an audit is that good due diligence will look at macro as well as micro aspects. For example, an audit may tell you that an allowance for bad debts is missing. Due diligence will give you a range of what the provision should be, who the defaulting customers are, and which customers have had lower volumes over the past two years. Due diligence also determines if all costs are accounted for, if liabilities are fully disclosed, if there are transactions with related parties that are not at arm’s length, etc.

From our experience with due diligence projects, we know that there is no one size fits all approach to SD and that each project must be tailored to the unique characteristics of the recipient companies. The product of a DD is not just a list of observations about the business, but also some ideas on how to better manage it and what factors can potentially increase or decrease business value.

3. Tax and transactional structuring

Are you investing in a private company personally or through a private vehicle? Are there any co-investors? How will you handle initial and deferred consideration? Is the payment made to an existing shareholder (transfer of shares) or to the company itself (through the issuance of new shares)?

The tax losses available to a company in India may expire if a change in shareholding of more than 50% occurs. For companies with significant tax losses, this can be a serious problem. No investor wants to inject a large amount of capital into a business in one year, only to have to pay taxes the following year due to an unused tax loss. It’s important to seek expert advice on how to structure the transaction to ensure you get the best outcome for both you and the company you’re investing in.

4. Share purchase agreement and guarantees

The stock purchase agreement can be an extremely important document, especially if things don’t go as planned in the future. Do you need a certain IRR on your investment? If you are a minority shareholder, do you want a resale right? What are the conditions precedent to finalizing this transaction, i.e. what does the issuing entity need to change before the agreement can be considered final?

Investing in a private company usually comes with a seat on the board. As an administrator, are there any special rights (voting rights, veto rights or other) that you need? Are there guarantees against actions against the company? Most investors will remain non-executive directors in the recipient companies, but 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 growing small or medium business in India is based on the investor’s trust in people. The founder is usually the key to the whole business, but the team can often be just as important. How much do you know and trust the founder? How dependent is the business on their continuity? What does employee attrition look like and can you speak to a few independent parties to verify the founder’s credentials? Often talking to the company’s auditor, a major customer, or suppliers can yield information that isn’t very obvious but is very important.

Finally, it is important to make a measured decision. There are never guarantees in entrepreneurship and investing, but there are always methods to mitigate risk. An adverse due diligence finding is not necessarily the end of a trade – it could just be another negotiation factor that helps you get a better price for the same investment. Investment decisions should be guided by three pillars: the information available to the investor, expert advice and finally a certain degree of personal judgment and trust.

To learn more about this topic from Asit Mehta & Associates, please click here

The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.

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