Understanding Exit Rights: An Investor’s Perspective
As much time and energy is spent entering into a business relationship, the same, if not more, attention is paid to getting out of one. Although each company and its dynamic between its shareholders differ on a case-to-case basis, the need for a suitable exit strategy is universal. In any case, the primary objective of an investor is to divest his/its holdings and realize the return on investments made in a company by exiting profitably.
As such, exit strategies are a highly crucial part of undertaking investments for both private equity players and strategic business investors. The investment horizon is customarily pegged to 5-7 years. That being said, exit mechanisms are not always time-bound and often take shape as remedies available to investors, owing to default by the investee company or key promoters, thus prompting a likelihood of an early exit. It is, therefore, essential to efficiently understand and negotiate the exit rights of an investor to guarantee maximum returns.
This article explains some of the key exit rights that investors possess to obtain considerable returns on their investments.
Key Exit Rights
1. Initial Public Offering (IPO)
One of the main reasons for IPOs to be a preferred exit route is that investors get access to public markets. It is a strategy where the company’s shares get listed on the stock exchange allowing the investors who’ve invested in a company during the pre-IPO to sell their shares for a profit. The timelines and implementation of an IPO are generally strategized considering conducive market conditions and its potential impact on the public market over the coming years, i.e., the year the IPO is proposed to take place. The IPO may be executed as a ‘fresh issue’ or through an ‘offer for sale’ of existing shares or a combination of both. That being said, investors generally offer their shares in an ‘offer for sale’ in an IPO.
While IPO might present investors with liquidity risks as insiders can be subjected to lock-up restrictions or risk of being recognized as ‘promoters’, it also offers several advantages to the investors. It gives them room to negotiate favourable positions, including priority to offer up their shares for sale and affirmative voting rights regarding IPO processes, among others. IPOs also enable investors to leverage their contacts from the newly public company to assist future portfolio companies in several ways, whether by acquiring customers or partners or initiating acquisitions.
From an investor’s point of view, IPO clauses should be structured in a way that provides the necessary flexibility to the investor to realign its exit strategy if need be. Although IPO is a lengthy process requiring the Securities and Exchange Board of India (SEBI) approval, Small and Medium Enterprises (SMEs) can undergo SME IPO by listing their shares at BSE SME or NSE Emerge platform.
2. Third Party/Private sales
The reason why third-party or private sales have gained preference is due to minimal promoter intervention, as any limitations on third-party sales are primarily contractual. Transfer restrictions include the Right of First Offer (ROFO), Right of First Refusal (ROFR), co-sale rights, etc. It enables investors to bypass complex processes and legal obligations under Indian laws and exercise a significant amount of control over the whole process. However, when a private sale is from or to a non-resident investor, care should be taken to comply with FEMA regulations administered by RBI. The pricing guidelines stipulated by RBI provide that sale of shares from a resident to a non-resident shall not be less than the fair market value determined by international valuation methodology certified by a Chartered Accountant or SEBI-registered Merchant Banker. On the other hand, in the sale of shares from a non-resident to a resident, the said floor cap applies as a ceiling instead.
3. Secondary Buy-out
The investors can also adopt a secondary buy-out wherein one investor can sell shares to other strategic or financial investors. This exit right shortens the lifespan of the transaction, as the investor making the original investment might seek an early exit even before the company gears up for a trade sale or an IPO. However, investors find this exit strategy attractive as it provides them with instant liquidity. However, for any other strategic or financial investor to be involved in a secondary buy-out, the investee company should be positioned to show strong and continued shareholder value growth. This exit strategy provides an immediate exit and can be executed faster and more efficiently than an IPO.
4. Mergers or Acquisitions
Mergers usually involve court processes, while an acquisition can be accomplished through the sale of assets or the sale of a company. It’s common for investors to include a clause that allows them to initiate an exit event if the company they’ve invested in plans to merge with or acquire a business in a similar or competing industry. Investors may choose to exit partially or fully depending on the expected gains from the merger or acquisition. By selling their portfolio to larger companies, investors can realise a considerable return on their investment.
Investors can negotiate for a mandatory buy-out by the company promoter or a company buyback clause at a pre-determined price. This approach is usually adopted when the portfolio company has substantial cash reserves and can acquire back shares from its investors. This method offers investors prompt and efficient exit while enabling the portfolio company to maintain its ownership percentage. However, it is essential to note that a company buyback requires adherence to complex regulatory requirements before implementation. These requirements may include restrictions on the funding sources for the buyback and the redistribution of profits, a cap on the buyback amount, which cannot exceed 25% of the company’s free reserves and paid-up capital, and the need to offer the buyback to all shareholders, among others.
6. Put Option
The Put Option has gained widespread acceptance as an exit strategy in business practice and is typically incorporated into Shareholders’ Agreements and Share Subscription Agreements as a “Put Option Clause”. The right to sell is not granted to shareholders by law but rather through contractual arrangements established between the parties involved. Simply put, a put option gives an investor a right (not an obligation) to mandatorily require the founders to purchase the shares held by such an investor upon the happening of any specified event at a predetermined price. Thus, this provision allows investors to exit the company, but the decision to exercise this right remains entirely up to the investor’s discretion. The promoters are responsible for purchasing these shares at a fair value or a predetermined internal rate of return.
The investors seek put option rights in the event of a failing IPO or any material default or breach by the founders. For example, if Mr A, an investor, has put an option over, say, 25% of his shares in the company, which he can exercise when the company becomes insolvent. In such a case, he can sell his shares to Mr B, the founder. Now B cannot refuse to purchase shares from A.
All businesses require an investment to operate, and when investors inject money into a company, they aim to safeguard not only their investment but also secure exit rights and generate profits. Investors have various exit strategies at their disposal, which they can select based on the portfolio company’s requirements and market conditions. Investors should acknowledge the risks involved with each approach and collaborate closely with the portfolio company to determine the most suitable exit strategy. By choosing the appropriate exit strategy, investors can optimize their returns and provide start-ups with opportunities to expand and compete globally.