Exit strategy forms an integral part of the investment process, enabling investors to realize returns from their investments. In India, various exit strategies are available for private equity investments, each with specific legal implications that both investors and companies must consider. These strategies primarily include: (a) Exit through Initial Public Offerings (IPOs), (b) Secondary Sales, (c) Mergers and Acquisitions (M&A), (d) Exit through Share Buybacks, and (e) Exit through Put Option.
An IPO represents the first instance in which a private company offers its shares to the public, serving as a significant avenue for raising capital. Large private companies with robust track record frequently employ IPO as a strategic exit route. This exit strategy can generate substantial returns for investors but necessitates meticulous adherence to regulatory requirements and legal formalities. In India, the Securities and Exchange Board of India (SEBI) regulates IPOs under the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018. Companies must ensure strict compliance with such disclosure norms and regulations, which mandate comprehensive disclosure obligations, the submission of a draft red herring prospectus (DRHP), and a thorough scrutiny process by SEBI. Existing shareholders, including private equity investors, are typically subject to a lock-in period, usually ranging from six months to a year, during which they restricted from divesting their shares. Accurate and comprehensive disclosure in the prospectus is crucial to mitigate potential legal repercussions. The prospectus must clearly provide detailed information about the company's financials, business operations, and the potential risk factors.
Secondary sale of sales shares by existing shareholders of a company to other investors is considered a feasible option to get exit from the company. Secondary sales offer a mechanism for providing liquidity to investors without the need for a public listing. Secondary sales must adhere to the regulatory framework established by the SEBI and, in the case of unlisted companies, comply with the provisions of the Companies Act, 2013. Proper filings with the Registrar of Companies (RoC) are mandatory, and for transactions involving foreign investors, compliance with the Foreign Exchange Management Act (FEMA) is essential. The Shareholders' Agreement (SHA) should explicitly outline the terms and conditions governing secondary sales, including pricing mechanisms, transfer restrictions, and provisions such as the Right of First Refusal (ROFR). Additionally, both the buyer and seller must consider the tax implications associated with secondary sales, which may include withholding taxes and capital gains taxes, ensuring full compliance with the relevant tax laws.
Mergers and Acquisitions (M&A) transactions involve the sale of a company or its assets to another entity, serving as a strategic exit route that can potentially deliver significant returns. M&A transactions often require approval from regulatory bodies such as SEBI (for listed companies), the Competition Commission of India (CCI), and, in some cases, the Foreign Investment Promotion Board (FIPB) if foreign investors are involved. Extensive due diligence is imperative to identify and address any legal or regulatory obstacles that could impede the successful completion of the transaction. This process involves a comprehensive review of the target company's legal, financial, and operational status, ensuring that potential issues are uncovered and mitigated before proceeding with the M&A deal. The process may involve reviewing contracts, authenticity of intellectual property rights, and adherence to labor law compliances, etc. The exit structure i.e., whether it should be an asset purchase or share purchase should be designed meticulously taking into account tax implications and potential liabilities.
Share buybacks refer to the process of a company buying back its shares from the shareholders. It is a way of providing liquidity and is beneficial when a company has surplus cash reserves. In India, share buybacks are regulated by the Companies Act, of 2013. Companies must strictly adhere to the formalities and conditions outlined in the Act when considering share buybacks. This includes obtaining Board approval and ensuring compliance with statutory buyback limits. Additionally, the required documentation must be properly filed with the RoC. For listed companies, compliance with SEBI regulations is also mandatory. Failure to meet these obligations can result in legal and regulatory repercussions. It is pertinent to note that the buyback option may affect the valuation of the company and the economic interests of the remaining shareholders. Obtaining legal advice is essential to ensure the fair and equitable treatment of all shareholders. Legal counsel can help navigate the complexities of corporate governance, ensuring that all actions comply with applicable laws and that the rights of each shareholder are adequately protected. Put options grant investors the right to sell their shares in the company to either the company itself or to other shareholders at a predetermined price. This contractual right provides investors with an exit mechanism, offering a predefined exit value and a degree of financial security.
Put options are regulated by both the SEBI and the FEMA. Historically, put options guaranteeing assured returns were often deemed invalid; however, recent regulatory amendments now permit such options, provided they comply with specific conditions. The terms of the put option, including triggering events and pricing mechanisms, should be explicitly detailed in the Shareholders' Agreement (SHA). Enforcement of put options may necessitate litigation if disputes arise. Additionally, exercising put options can have tax implications, including capital gains tax and other relevant taxes.
In Cruz City Mauritius Holdings v. Unitech Ltd (2017) (3) ARBLR 20 (Delhi) the honorable Delhi High Court held that so long as the put option that offered an assured rate of return was exercisable only in the event of a breach of the contractual assurances, it was not violative of FEMA. Similarly, in the case of NTT Docomo Inc. v Tata Sons Ltd (2017) SCC OnLine Del 8078 a provision was put in place where the unique feature was that the put option had to be exercised in case, Tata Teleservices Limited was unable to achieve certain performance benchmarks. This clause was held to be enforceable because there was no fixed price at which the option holder could exit the SHA making the option more akin to a ‘downside protection’ option as against FEMA’s downright ‘assured return’. Thus, now the general impression has been created in their favor to enforce put option contracts although there are no guarantees of assured returns.
However, various challenges can arise with these exit strategies. Key issues include market uncertainties that may impact both the feasibility and timing of the exit. These uncertainties can affect the overall success of the exit strategy and introduce risks that must be carefully managed.
In the first quarter of 2024, there has been a notable surge in private equity (PE) exits and investments in India. PE exits increased significantly, with 50 exits valued at $3.6 billion, compared to just 11 exits worth $121 million in Q1 2023. This represents a remarkable 354.5% increase in the number of exits and an almost five-fold rise in exit values. Open market exits, in particular, saw substantial value growth.
Given these developments, it is crucial for investors to identify and plan their exit strategies well in advance of finalizing an investment deal. This proactive approach ensures a smoother transition when the time to exit arises. Unlike in the past, exits are no longer solely associated with poor company performance; instead, they have become a standard and positive component of the investment lifecycle, serving as indicators of success.