Key Exit Strategies: An Investors' Perspective

It is important for any investor to divest its holdings and exit in the most profitable manner. As such, exit strategies are a very critical part of undertaking investments, for both private equity players and strategic business investors. The investment horizon is typically pegged to 5-7 years. That said, exit mechanisms are not always time bound and are often articulated as remedies available to the investor, owing to default / breach by the investee company or key promoters, thus triggering a possibility of an early exit. It is therefore important to efficiently understand and negotiate the exit rights of an investor (preferably, at the term sheet stage), to ensure maximum returns.

Exit mechanisms unequivocally represent an investor's confidence in the market. In the last couple of years, India has witnessed varied ups and downs in the exit curve, with exits being on a splurge in 2018 and hitting a low in 2019, attributable to the slowdown in the economy.

In this article, we have identified some common and viable exit strategies (based on the current market trends), to help investors realize full returns on their investment:

Key Exit Strategies:

1. IPOs:
   One of the key factors for IPOs being a preferred route is investors getting access to public markets. The timelines and execution of an IPO has to be strategized taking into account the economic conditions and its potential impact on the public market over the coming years, ie, the year the execution of such IPO is pegged to. An IPO may be implemented through an offer for sale of existing shares or a fresh issue, or a combination of both, in onshore or offshore stock exchanges. Applicable laws also impose restrictions / compliances on the key promoters. IPO clauses give enough room to investors to negotiate favourable positions, including priority to offer up their shares for sale, veto rights re IPO processes etc. At the same time, investors having substantial
   stakes in the investee company may run the risk of being recognised as 'promoters'. IPOs with pre-determined conditions like pricing, minimum valuation etc are, for ease of reference, often termed as 'qualified IPOs'. That said, given IPOs are largely market driven, the obligation on the promoters and the investee company to implement an IPO / qualified IPO are on a 'best effort basis'. As such, IPO clauses should be articulated to provide sufficient flexibility to the investor, to realign its exit strategy, if need be. The IPO, however, is a lengthy process requiring approval from Securities and Exchange Board of India (SEBI). An interesting alternative therefore can be SME (defined below) IPO, in case the size of the entity is not large.
   
   
2. Small and Medium Enterprises (SME) IPO:
   There are two platforms in India where small and medium size entities can reach out to public to subscribe to their IPO, viz NSE EMERGE and BSE SME Exchange. It is a hassle free and a fast route to tap market, where SEBI approval is not required. SME IPOs are mostly managed by stock exchanges, as such, draft prospectus of an SME IPO entity is not examined by SEBI. The post issue paid capital of the company must not exceed INR 25 Crore to be eligible to list on SME exchange. There is enough flexibility in terms of eligibility norms with respect to profitability track records. If the size of the entity is small and promoters are looking to provide an early exit to the investors, the success story of some of the SME IPOs is becoming an attractive proposition.
   
   
3. Private Sale (Strategic Sales, Trade Sales or Third-Party Sales):
   
   
   1. This exit route has gained preference, primarily for being independent of promoter intervention. Any limitations on private sales are largely contractual, such as co-sale rights, ROFR-ROFO obligations, put and call options etc., which typically do not entail any complicated processes / obligations on the investors. Having said that, any transfer by a non-resident investor will attract the applicable pricing guidelines
      prescribed under the Indian foreign exchange control laws and/or under the applicable SEBI regulations, in case of a listed company. Such pricing restrictions
      may curtail the ability of the non-resident investor to charge a high premium on sale of its stakes. To sum it up, 'one man's ceiling is another man's floor' – ie, price of shares to be transferred by a resident to a non-resident cannot be less than the fair market value of the sale shares, and in case of a transfer by a non-resident to a resident, the price of the shares cannot be higher than the fair market value of such sale shares. The law also states specific procedures to compute the fair market value of shares. For completeness, the pricing guidelines do not apply to transfer of shares between non-residents.
      
      
   2. Investors may also consider a secondary buy-out by selling their stake to other strategic or financial investors / funds. It is recommended to identify potential acquirers at an earlier stage to understand such buyer's investment criteria. For any other strategic or financial investor / fund to be interested in a secondary buy-out, the investee company should be positioned in a manner to show robust and continued shareholder value growth. Further, selling investors must negotiate to not provide any unreasonable post-closing recourse, going beyond customary protections (such as indemnities limited to title of sale shares) to such buyers.
      
      
4. Merger or acquisition:
   Mergers typically entail court processes, whereas an acquisition may either be executed by way of an asset sale or entity sale. Often, we come across investors reserving the right to trigger an exit event in case the investee company proposes to merge with or acquire a business in the same / competing sector. Investors may seek a full or a partial exit in this event, depending on the potential profits such merger or acquisition may entail. Merger of an unlisted investee company with a listed company is sparingly seen, given the significant regulatory processes and time delays involved.
   
   
5. Buyback:
   Investors may negotiate for a forced promoter buy-out or a company buyback clause, at a pre-determined price. In this regard, note that much like a merger of an unlisted investee company with a listed company, a company buyback entails complex regulatory requirements to be complied with prior to implementation, for instance: (a) restrictions on the sources of funds for buyback and redistribution of profits; (b) a buyback cannot exceed 25% of the free reserves and paid-up capital of the company; (c) the offer has to be made to all shareholders, to name a few. Further, there are views in the market that buyback of preference shares held by non-resident investors is not permissible, unless such preference shares are first converted into equity. As such, exit via a company buyback is often considered as a last resort. As regards to a forced promoter buy-out, the promoter rarely agrees to unconditional obligations at the risk of personal contractually liability / going out of cash. For completeness, refer to paragraph #5 below, on put options.
   
   
6. Put option:
   While put option clauses have faced the ire of Indian regulatory authorities, the developing jurisprudence trends in India have shown the willingness of the Indian courts to side with the investors. The Indian courts have time and again upheld the validation of put options, which is evident from the judgement of the courts in NTT Docomo Inc. v. Tata Sons Ltd., where it was opined that there exist no provisions under the Indian foreign exchange control laws which absolutely prohibit contractual obligations from being performed. As such, for the much debated 'assured returns' to be enforceable, put option provisions may be articulated as damages / remedy for default available to the investors, upon the investee company or even in some cases, key promoters committing a breach, whether in contract, tort or otherwise.

In conclusion, while other exit routes (as discussed above) are commonly trending in the market, exit via a buyback or implementation of put options are highly negotiated rights. Given the dynamic nature of the Indian economy and the changing market trends, it is key for the investors to articulate flexible exit strategies which do not restrict them to take advantage of other viable exit opportunities, which may present itself over the course of time.

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.