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Exit mechanisms and related issues in Investment Transactions


Exit is a key goal for any financial investor and in specific cases even a strategic investor.


(As discussed in the chapter earlier on Introduction to Raising Investment, there are two broad kinds of investors – a financial investor such as a venture capital fund or a private equity investor and a strategic investor.)


A financial investor has a specific investment horizon. Making a profitable exit at the end of the investment horizon is a critical commercial objective for him while making the investment. An IPO is the ideal exit mechanism (but is not always achievable in a real-life scenario) – investors typically aspire to make windfall gains from their investment when an investee company makes an IPO. The gains are realized by selling their shares to the public at a much higher price than what they had initially paid at the time of investment.


Financial investors are primarily looking for exit over a very short investment horizon, typically 3-6 years (even if it is not eventually possible). Their exit horizon may also be related to the duration of the fund – e.g. a private equity or VC firm raises money from high-net worth individuals and institutional clients and invests it in specific companies. The fund raised by the firm is of a particular duration and may be sector-specific. For example, a US-based VC firm could raise a specific fund for investing in education startups in South Asia – the fund could be over a 5-year duration.


On the other hand, a strategic investor does not usually have similar exit plans for the short term (unless things go really wrong). In general, strategic investors may have other goals such as attaining higher profitability, realizing efficiencies, striving for an expanded market share or access to newer markets. Strategic investors contemplate an exit only in limited circumstances, such as when there is a deadlock on major business strategies or decisions between the parties.


In this chapter, we discuss the key exit mechanisms sought by financial investors in greater detail.


Since an early stage business does not have a proven market, there is no certainty at the time of investment that the company will be able to provide an exit opportunity as desired by the investor over the investment horizon. Although investors try to impose an obligation under the shareholders agreement (SHA) (and the articles of association) on the promoters and the company to cause them to undertake an IPO (the ideal exit mode for a financial investor), this may not necessarily happen eventually. Such an obligation also is more of a best efforts or a good faith obligation - achieving the desired scale and profitability for a company to undertake a successful IPO rests on a number of external factors as well.


Therefore, in the event the company is not able to undertake an IPO, investors specify various alternative exit mechanisms (as specified below). Some of the alternatives may impose a high financial burden on the company or personally on the promoters and they may not help the investor in making a hugely profitable exit (or even in getting a minimum internal rate of return), as the promoters and company may not have the required funds to repay the investors.


Instead, the practice more commonly adopted is to look for a subsequent investment round and identify an investor with a much higher investment appetite. For example, a startup which was initially funded for INR 1 crore could look for a second funding of INR 10 crores.


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