Coupon Accepted Successfully!


Exit mechanisms contemplated under SHAs


What are the exit mechanisms contemplated under SHAs?


The key exit mechanisms that financial investors specify in SHA are discussed below:


1. Initial public offer (IPO)


An IPO is the ideal choice for exit by an investor. Most investors determine a timeframe for exit at the time of making the investment into the company, and specify it in the SHA. The promoters will have the responsibility of ensuring that the company is in a position to undertake an IPO within such timeframe. Sometimes, investors may also specify a minimum valuation that the company must have when it undertakes the IPO – this helps the investor in setting expectations with the promoters for the exit.


The valuation exercise is usually undertaken by a merchant banker. The SHA can restrict the choice of merchant bankers – sometimes it must be one of the ‘big four’ accounting firms. The expression ‘Big Four’ refers to the accounting firms of PriceWaterHouse Coopers, Deloitte, Ernst & Young and KPMG.


The remaining exit mechanisms (explained below) are triggered usually when the IPO cannot be undertaken at the stipulated time.



Negotiation points

  1. Promoters should specify a ‘best efforts’ requirement on their part for causing the company to undertake the IPO and not a mandatory one. 
  1. Ideally, any provisions specifying that the company must attain a certain minimum valuation at the time of undertaking an IPO should be excluded – the only criterion should certification from a reputed investment banker (called a merchant banker in India) that the IPO is viable.


2. Third party sale/ subsequent round of funding 

In case of a failure to undertake an IPO – the next best alternative available is to either look for a fresh round of investment (from a financial or a strategic investor) or to enable the financial investor to sell his stake to another investor. In case of startups which are scaling up operations, usually a new (and a larger) round of funding from another financial investor is the way forward (e.g. if the earlier investment was a Series A funding, the new round would be a Series B investment), which may take place either near the investment horizon or even much earlier.


New round of financial investment - A subsequent round of funding involves a fresh investment into a company (includes a fresh issuance of shares) and it may involve a partial exit from one of the previous investors. Sometimes in early stages of a startup, instead of exiting, an investor from one of the earlier rounds may also co-invest with the subsequent investor. A new round of financial investment usually involves an entirely new set of investment documentation (shareholders agreement, articles of association, etc.) to replace the documentation from the previous round.


Third party sale – A third party sale usually involves sale of the shares of an existing investor to a new investor interested in buying his stake.  Third party sales may either be made to new financial investors or to strategic investors. For example, in 2013, KKR (a PE firm) acquired a stake in Alliance Tire from a Warburg Pincus affiliate (another PE firm) (see here for more information). This was an exceptional exit transaction for Warburg Pincus in two ways – a) KKR, as a private equity investor took control over the company by buying over 90 percent stake (usually private equity investors do not take control) and b) Warburg Pincus made a return of more than four times the investment they made – usually non-IPO exits do not provide financial investors such high returns (see here for more information).


Strategic investors are likely to insist on a controlling stake. Although a financial investor does not usually have a controlling stake, it may have drag along rights (see explanation below) which require the promoters to sell their shares along with the financial investor to facilitate the latter’s exit and allow a strategic investor acquire control over the company.


Finding a willing investor may not be easy if the economic conditions are not favourable. Whose responsibility is it to facilitate the investor’s exit? SHAs specify that in the event an investor’s exit rights are triggered, the promoters must ‘assist’ the investor in identification of a third party for such a sale. This is a soft obligation, as the promoters are only required to provide due assistance to investors and are not actively bound to search a buyer.


When exit is sought through a third party sale, existing shareholders may either exercise any pre-emption rights (if they possess such rights under the SHA and the Articles of Association of the company) to purchase a portion of the shares offered by the investor, or issue a ‘waiver letter’ to waive such rights and let the investor proceed with a third party buyer.


3. Drag Along Rights and their relevance in third party sales


A drag-along right permits an investor to force founders to sell their shares to a third party identified by the investor. Since financial investors do not have a controlling stake, third party buyers (especially strategic investors, who are typically interested in exercising control) over the company may be unwilling to acquire their shares in ordinary situations.


This makes it more difficult for financial investors to exit just by selling their stake. Hence, investors include a drag-along right enabling them to drag the founders along (i.e. compel them to sell their shares) in a sale to a third party buyer.


Further, selling off the founder’s shares to an interested acquirer enables them to command a higher price per share as compared to the price that they would have received if they had merely sold their own shares (the difference is called ‘control premium’).


Some shareholders agreements impose a personal obligation on the founders to pay any difference between the required IRR of the investor and the amount it is able to realize through the exit mechanism.



Negotiation points for buy-back, third party sale and drag-along

  1. Promoters should limit the rate of return to a reasonable level – most investors tend to insist on a 25 percent internal rate of return annually. Practical exit scenarios will indicate that investors have often not been able to exit at this rate of return unless the company has successfully been able to undertake an IPO. In several cases return has been in the range of 6 – 10 percent per annum. 
  1. Promoters should exclude any requirements to personally finance any difference in the exit price paid by a third party buyer and the internal rate of return. Any such differences should be explained as a loss arising out of the risks inherent in an equity investment.


4. Put options


A put option clause compels the promoters to purchase the investor’s shares in the company (at a price determined as per the SHA) upon the exercise of the option. The option can be exercised on the happening of any of the events of default or failure to undertake an IPO.


The price may be based on a fair valuation of the shares or a specified internal rate of return (IRR) over the investment. For example, if the put option is exercised upon failure to undertake the IPO, promoters must buy investor shares at a minimum IRR of 25 percent.


As explained in the annexure, put options on shares of listed companies and put options on shares held by non-residents (foreigners) may be illegal in certain circumstances. However, despite issues regarding the legal validity of the same, put options are a common feature in investment agreements. The discussion below explains the situations under which put options are legal.


1) A put option on shares of a private company granted to an Indian investor will be legal. Most early stage startups are usually structured as private companies (they are only converted into public companies before undertaking an IPO).


2) A put option (on shares of a private company) granted to a foreigner must not guarantee a minimum rate of return over his initial investment (unless it is consistent with the RBI’s pricing guidelines). When the foreigner contemplates an exit, the exit price must be calculated as per the prevalent pricing guidelines of the RBI. For details of pricing guidelines, refer to Part II on Pricing, documentation, filing and other compliance requirements of the chapter on Foreign Direct Investment.


3) An option in which the promoter is not bound to purchase after the foreigner has exercised the right to sell, but can freshly consider whether he intends to purchase would be valid. However, these are soft options, as the owner is not bound by the clause to purchase. He may, however, be inclined to act as per the wishes of the investor for various other reasons. These were used in the case of Multi-Commodity Exchange v. SEBI.


Note: 2012 (114) BomLR 1002. See Business Standard report here.



Negotiation points for founders

  1. Investors typically specify the ‘minimum internal rate of return’ at which they would like to exit. By requiring the promoters to purchase investor’s shares, a put option imposes a personal financial burden on the promoters. 
Promoters should not accept artificially high rates for the minimum IRR figure and should mutually agree upon a reasonable IRR figure, to the extent possible, especially because they will be required to personally bear the cost of purchase. Some VCs insist on a 25 percent IRR, which is unreasonable even in view of the market rate of interest for loans. This clause can potentially lead promoters to personal bankruptcy, as it is very difficult to finance such a high IRR over what is already a huge amount of financial investment.
However, there have been cases where promoters have sought to resist enforcement of put options and made it difficult for financial investors to exit at the IRR stated in the SHA. This is especially the case with promoters of large corporate houses in India who are willing and able to entangle in long-drawn court processes, which foreigners prefer to avoid. 
  1. In the event of failure to IPO, promoters should consider offering an exit at a fair valuation or the ‘minimum internal rate of return’ figure, whichever is lower.


5. Buy-back


Investment agreements also provide that the company may be required to buy-back shares of the investors at a price which provides the investor a specific ‘internal rate of return’ or IRR.


As per the Private Limited Company and Unlisted Companies (Buyback of Securities) Rules, 1999 (Buyback Rules), the company must offer to buy back the securities on a proportionate basis from shareholders. To prevent the promoters and non-investor shareholders from offering their shares in a buy-back the SHA imposes an obligation on the promoters and other non-investor shareholders not to offer their own shares in such a buy-back.


There are certain limitations on using buy-back by the company as an exit mechanism and investors should not expect the buy-back route to help them extract the desired internal rate of return from their investment:


a) As per the Companies Act (both under the 1956 and 2013 Acts), a company can buy back up to a maximum of 25 percent of its shares (a greater buyback involves court approvals and a relatively long procedure to be followed under the Companies Act, which is not feasible for investors). Therefore, a financial investor who has a higher shareholding (e.g. in a company where founders own 65 percent and investors own 35 percent) cannot get his entire holdings bought back. He will have to rely on another method if his holdings are higher.


b) A buyback amounting to greater than 10 percent of the shares requires a special resolution of the shareholders. Although shareholders agreement imposes a general obligation on the founders to co-operate in passing any resolutions required to carry out the purposes of the agreement, buying-back more than 10 percent shares can be difficult if founders (or any other members of the company) refuse to co-operate in passing the special resolution subsequently.


c) The funds for a buy-back can only be generated from the securities premium account, proceeds of a new issue of shares or accumulated profits of the company. Many startups are loss-making at an early stage. Further, the premium at which the investors have funded the company is usually spent on the operations of the company.


6. Tag-along

Tag-along clauses are designed to protect the interests of minority shareholders in circumstances where majority shareholders wish to exit the company and sell all (or a substantial portion) of their shares. To discourage founders from diluting partially (or to be able to profit from such an event), investors could insist on a proportionate tag-along. For example assume the founder holds 70 percent and the investor 30 percent in the company. If the founder intends to sell 7 percent stake in the company (that is 10 percent of his holding), a partial tag along right will enable the investor to sell 3 percent of his stake to the purchaser (3 percent stake in the company is 10 percent of the investor’s shareholding), else the the founder cannot exit.

Investors also insist on a tag-along right as founders may find it easier to find a willing buyer if they intend to exit from the company, especially since they possess a much larger and controlling stake as compared to the investor. Further, an investor wants to have the option to piggyback with the founder, if the founder chooses to substantially exit, as he had invested in the company on the basis that the founders would operate and manage it. The tag-along provision permits the founder to sell his stake only if the investor is also given a corresponding opportunity to exit.



Negotiation points

  1. Founders can negotiate and exclude the right of the investor to tag along when the dilution is of a small amount pre-agreed amount – e.g. a less than 5 percent stake.
  2. Founders should consider permitting an investor to fully-tag along only if they collectively retain less than a 51 percent stake.
  3. From a founder’s perspective it is possible that he discovers a more profitable business in another sector, in which case he may want to exit from the current business and commit himself to the new one. To retain the freedom to achieve this objective, founders could negotiate with an investor to permit them to exit even prior to the investment horizon if the investor is able to tag along with them and is able to realize a certain ‘internal rate of return’ (which could be as high as 25-30 percent).


Although investors are unlikely to agree to this point, founders (or lawyers/ consultants representing the founders) could use it as a bargaining chip. An investor will not ordinarily want to exit in a scenario where he is likely to get 25-30 percent IRR from a buyer, under the bona fide expectation that the business may do better and enable him to realize a greater return.


(An investor aims to make returns in many multiples of his investment amount (10x or 15x). Exit with a minimum IRR is his last option, which he would not like to choose for a company which is growing fast.)


Test Your Skills Now!
Take a Quiz now
Reviewer Name