Investment Conditions by Private Equity

Every Investment made by a private equity fund in a startup is an arduous process. From sourcing of proposal to initial contact to signing of term sheet. Since every investment holds high level of risk attached to it. A private equity fund safeguards their investments by incorporating various conditions as part of the investment transaction.

  1. Seat on the Board of Directors and/or Advisory Board – The right for the fund to nominate directors on the Board is incorporated in almost all private equity investment arrangements. The number of board seats would depend on the stake. For instance, the fund may be promised one board seat for every 10% stake they hold in the company. Thus, if a fund takes a 20% stake, it would be entitled to 2 seats on the board. If on a dilution in favour of other investors, its stake goes below 20%, it will have to surrender one of those seats. There may be a provision limiting the number of directors representing the promoter or management.
  2. Right to change management – Performance of the company depends on its management. Therefore, funds retain the right to change the management team or the CEO/COO/CFO if the corporate performance is not up to the mark. Change of entire management team is rare in practice, though CXOs do get changed at the initiative of the fund.
  3. Lock-in of shares of Promoters/Management– The PE investors brings in money on the basis of faith in the promoters and the management team. Therefore, they insist that the latter hold their investment stake, while the fund remains invested in the company. This limitation on promoters is incorporated as part of the Shareholders’ agreement. The restriction on management’s right to sell is incorporated in the subscription agreement or other document based on which the shares are allotted to them.
  4. ESOPs– The fund may insist that the company have an ESOP structure. In that case, the fund will also have the right to influence the ESOP structure, including the maximum number of shares that will be allotted to the plan and to employees under the plan.
  5. Assured Return– The funds like to be assured of a certain return on their equity investment, while retaining the right to earn something better through valuation gains. If given, the assurance has to come from the promoter of the investee company. So long as the company does well, there is no problem. The fund will be able to find outside investors or sell in an IPO to earn the assured return. However, if the company does not do well, or if the financial market conditions are poor, the promoter can be saddled with the liability of having to buy back the fund’s shares at a high price. Therefore, promoters try their best to avoid committing to such an arrangement.
  6. Right of First Refusal – This is a condition that promoters ask for from the fund. If the fund were to consider selling their stake to another investor, then the promoters would have a right to buy the stake from the exiting fund at the same price.
  7. Right of First Offer– This is slightly different from the right of first refusal. With first refusal, the fund goes through the entire process of finding an investor for its stake, and then tells the promoter about the planned sale. At that stage, the promoter may say that he will prefer to buy it. Thus, the fund and the new investor ends up wasting a lot of time, and it can get unfair to the new investor. In right of first offer, the fund first approaches the promoter with its proposal to sell at a particular price. The promoter is given the time specified in the shareholders’ agreement to confirm his interest. If he does not confirm, then the fund is free to sell to another investor at the specified price or higher. Right of first offer thus is a lot friendlier to the fund and the new investor, as compared to Right of first refusal.
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