Private Placement – A Practitioner’s Guide

There are a lot of questions about funding and the right way to work with them. Considering the changes in the Companies Act, 2013 which has changed some of the basic fundamentals and imposed some restrictions for investor protection, the challenges faced by startups have increased.

So we thought that putting these thoughts together in an instructional FAQ would help as part of our ‘Practitioners Guide’ series.

Disclaimer: Please note that these are our answers  based on our experience in being advisors on various Seed/ VC/ PE/ Technology collaboration transactions. They are for the limited purpose of educating founders. The facts and the procedure to be followed can vary significantly based on the exact nature of the transaction and the stage of the business. 

How can I receive
funding into my venture?

There are primarily only 2 ways in which money enters and rewards leave the business.

 

Debt

(Loans, Debentures, Guarantees, LCs, Convertible Debentures)

 

§  Harder to access for most start-ups

§  Usually taken when business is likely to generate cash flows in the near future

§  Expensive in the short term, Cheaper in the long term

§  Utilization is primarily for shorter gestation based purposes – marketing of a B2B product, new factory premises, new equipment, working capital

§  Usually comes with covenants on how the funds need to be put to use

 

 

Equity
(Common Stock, Equity shares, Preferential shares, Convertible Debentures)

§  Easier to access for most start-ups (as cash required is not in relation to their asset base but their ability to generate future value)

§  Usually taken when expenditures are in longer gestation activities such as product R&D, customer acquisition, content development, platform development

§  No outflow in short term, Really expensive in the long term

§  Occasionally comes with covenants on how the funds need to be put to use

 

 

Where do start-ups go wrong?

Roopa’s Notes: As a start-up, one of the things Founders fail to understand is that Equity carries a rate of interest of between 20-30% (sometimes as high as 40%). Businesses tend to think that the fact that they are saving current cash flow and pushing repayment liability is the only consideration. Equity on an average costs the Founders 2.5x to 3x more than debt does.

Nag’s Notes: What is important is the long term value that this person/ institution brings to you. If the value is as short-lived as the cash brought in, you need to reconsider parting with Equity. For a great VC, we have seen Founders chose lower valuations. Further, Equity does not mean that you don’t need to repay a VC/ PE. They are a business just like you. Just that they need to see viable ways to access returns from investing in you.

For the purpose of this document, we will delve a little deeper into the second one – EQUITY, where most start-ups/ mid-sized companies wish to have more clarity.

 

 

 

Ok. For Equity,
what options do I have for my raise?

2 ways provided by Companies Act, 2013 –

  • Private placements
  • Rights and Bonus issues

 

Where do start-ups go wrong?

Dilip’s Notes: A private placement is when an offer at a certain valuation is made to potential investors. Investors need to bring in the required capital for the valuation fixed in the offer for private placement. Investor discussions are usually the first activity that happens in such cases and term sheets get signed. The offer is then made and noted in the respective places. A rights issue on the other hand is made to investors who are already shareholders of the company. An offer is made to all the existing shareholders to subscribe at a certain value and every shareholder has a right to offer his interest to subscribe.

Nag’s Notes: There is a logical reason that the 2 routes of placement have been provided. Private placement is the right route for a new investor who is coming in at an agreed upon valuation. During our consulting of start-ups, we have encountered several circumstances where the minimum capital requirement of INR 20,000 (as explained in the table to follow) of face value cannot be fulfilled especially at the seed stage. Founders tend to take a shortcut method here at times to comply. This might not always be the right way  in the long term scheme of things.

 

What is a
Private Placement really?

Private Placement is a term that is often heard of but rarely understood in its entirety. Let’s look at a few pertinent questions.

When you are making an offer to issue new equity shares (to less than 200 persons/ institutions), you need to comply with certain provisions of Companies Act, 2013.

Ref: Section 42(2) of the Companies Act, 2013

Where do start-ups go wrong?

Roopa’s Notes: A common problem that persists in the system is a lack of understanding of Private Placement. There have been many instances where companies have resorted to other ways of structuring an investment which are perceived to be less cumbersome. They may issue shares to investors through the rights issue channel since it does not require a Valuation Certificate by a registered valuer or a requirement to adhere to the provisions relating to the minimum face value of the equity instruments.

Dilip’s Notes: There are a few things that a Founder should be aware of when choosing the route to be followed.

  1. Private placement allows for a valuation exercise to be conducted which may be a logical arms-length basis for an investor discussion.
  2. It sets the precedent and valuation parameters in stone. This can be leveraged in future rounds of funding.
  3. It is a lot cleaner way since it ensures that companies comply in letter and spirit of the law.

Bordia’s Notes: The ideology behind the law is the most important aspect. Though it seems slightly hard to comply with, it is instated to ensure that investors are protected (especially smaller investors coming in at the seed stage). It also prohibits a company from accepting too many such small tranches of investment to bypass the rules relating to acceptance of deposits.

 

 

 

Can we have a better understanding
of Private Placement?

Issuing capital in securities through Private Placement would require an in-depth understanding of the provisions laid out in the Companies Act, 2013 which mentions the manner, restrictions and provisions for Private Placement.

Ref: Section 42(2) of the Companies Act, 2013 read with rule 14(1) Companies Rules, 2014

We understand that a Private Placement as mentioned above is any offer of securities or invitation to subscribe to securities to 200 people or less in a financial year. The section requires that any such offer made is only through the issue of a Private Placement Offer letter and as per the prescribed conditions. This should be accompanied with an application form for the persons receiving the offer letter to indicate their acceptance.

Exception – 200 people or less does not include employees or institutional buyers.

Key procedural aspects
for a private placement

  1. Special Resolution needs to be passed approving the Private Placement terms
  2. A private placement offer letter needs to be created and circulated
  3. Offer should not be made to more than 200 people
  4. Only one kind of securities can be issued under one offer
  5. The subscription should not be for less than INR 20,000 face value
  6. The price should be based on the valuation conducted by a Registered Valuer
  7. Allotment of securities should happen within 60 days of the receipt of Application monies

 

What is the
documentation required?

A complete record of private placement offers in PAS 5, offer letter in form PAS 4, along with prescribed other details need to be filed with the RoC within 30 days. Form PAS 3, a return of allotment of securities, must be filed with the RoC within 30 days.

 

Key questions
that are on Founders’ minds?

What should the number of shares offered for a single round be?

The Offer size should be a minimum of INR 20,000 face value of the securities.

 

Dilip’s Notes: This means that if your authorized capital is INR 100,000, you will need to issue not less than 16.67% (20/120) of the capital of the company.

 

What should be the price? Can the securities be issued at any price?

The price of the securities should be based on a valuation certificate given by a Registered Valuer.

 

Nag’s Notes: A reasonably justified valuation is based on the exercise conducted by a valuer. There are no rules of thumb here. Simply speaking, a $ billion company may have an authorized capital of less than USD 100,000 also. What is important, is the valuation itself.

 

Is there a restriction on using the application money? When can I begin to use the proceeds?

The application money must be received in a separate bank account and cannot be utilized for any purpose other than for allotment of securities or repayment of monies. Further, any securities in relation to an offer made under private placement must be allotted within 60 days of receipt of the application money.

 

Roopa’s Notes: It is important to not utilize the money till the same has been issued and filed with the authorities. The maintenance of a separate bank account is also one of the most important aspects which can ensure that this does not happen.

 

What do I need to do? Do I need to obtain approval from shareholders?

A special resolution (not less than 75% of existing shareholders) has to be passed approving the private placement.

Bordia’s Notes: The simple logic for this is that any capital related transaction affects the shareholding of all the current promoters and investors. This provision protects all the shareholders from instances of future misunderstandings.

 

 

 

 

How different
is a Rights issue?

Rights Issue means offering shares to the existing shareholders (only) in proportion to their existing shareholding. Procedurally, there is no requirement for a valuation certificate for rights issue.

Roopa’s Notes: A particular existing shareholder can choose not to subscribe to the offer if he so wishes  to but each shareholder is granted with the same rights as everyone else.

 

What is the benefit
of taking the right Private Placement route?

Private Placement requires the price to be based on the valuation by a registered valuer thus the price is determined on a logical and justified basis. It also acts as an internal benchmarking exercise and helps outline the milestones.

Nag’s Notes: An investment done through Private Placement provides complete transparency of the entire transaction and reduces the complications during a Due Diligence at the times of subsequent rounds of funding/ investment.

 

On this document

 https://www.linkedin.com/in/pradyumnanag/  https://www.linkedin.com/in/rakeshbordia/  https://www.linkedin.com/in/roopakrishnamurthy/  https://www.linkedin.com/in/dilipraj/
PRADYUMNA NAG RAKESH BORDIA ROOPA MURTHY DILIP RAJ


Disclaimer: This paper is a property and copyright of Prequate™. No reader should act on the basis of any statement contained herein without seeking adequate professional advice. The authors and the company expressly disclaim all and any liability to any person who has read this paper, or otherwise, in respect of anything, and of consequences of anything done, or omitted to be done by any such person in reliance merely upon the contents of this paper.

 

Prequate works with organizations to help them understand their environment and do business in a leaner and smarter way. By helping businesses interpret their surroundings, Prequate helps amplify the impact of their strategies and executional strengths without worrying too much, or with a lot more clarity, as to how their environment may be respond.

A Critique on the 9 Crucial Factors for Successful Strategy Implementation using Dilbert

The success of a plan is not in the planning but in the execution. It is estimated that over 60% of strategies fail because they are not implemented. When asked about challenges, managers responded that their biggest concern is “It’s the successful implementation of a strategic plan” or “It’s getting your strategy done.”

With the number of management executives who are trained on building strategy plans and attend executive programs on various strategies, the one thing that needs to be emphasized is the ‘act of getting things done’ as outlined in the book ‘Execution:  The Discipline of Getting Things Done’  by Larry Bossidy and Ram Charan.

According to Larry Bossidy and Ram Charan, the heart of any Strategy Execution lies in 3 core processes: Strategy, People and Operations.

STRATEGY

1. STRATEGY FORMULATION

1The process of laying out the strategy is a significant factor, but not the only crucial factor. However, it defines all the other factors and how they can be achieved. As laid out in the paper, the central conclusion of research indicates the importance of procedural justice. All levels of the organization have different perceptions of strategy and interests in the formulation process. Unifying them is the task of the management function. Thus, unifying strategy must be consistent and accommodative.

 

2.ORGANIZATIONAL STRUCTURE

2Organizations are continuously thinking of adapting to times. Having a strongly thought out Strategy supported by an organizational structure is half the process in successful implementation. Further, different strategies require different organizational structures that can allow action items to flow down smoothly across levels. For example, executing a strategy to permeate leadership requires having a structure that allows more decentralisation of decision making activities. As pointed out by Olson, Slater and Hult (2005) four different combinations of structure/behaviour types of: management dominant, customer-centric innovators, customer-centric cost controllers and middle ground have to be matched with behaviours that best serve to facilitate the process of implementing a specific strategy.

PEOPLE

3.EXECUTORS

3

Organizations are made up of people. People in an organization take up responsibilities and become responsible for certain activities. According to the paper, enrolment of the top, middle and lower level management is essential for the purpose of rolling out a strategy. However, organizational structures are dynamically changing to become more flat so that they can be quicker and more responsive. While the hierarchical structures worked in the 20th century. In the 21st century organizations, people at various levels are required to take ownership of functions that work directly with the strategy as well.

Further, the most important part of the execution with relation to the executors will be the selection of the team of executors and arriving at how they need to be motivated to ensure that they work proactively for the success of the strategy.

 

4.COMMUNICATION

4While the strategy and team can be put in place in an organization, what makes the glue is establishing the right channel and mode of communication. Once the strategic plan is in motion, the organization needs to be brought into a single binding communication philosophy which ensures that right things are escalated as and when they become critical and avoiding failures due to inaction/ indecision. Further, organizations need to also be aware the importance in learning from one another to avoid future failures at the granular level. As put very beautifully by Alexander (1985), the content of such communications includes clearly explaining what new responsibilities, tasks, and duties need to be performed by the affected employees. It also includes the why behind changed job activities, and more fundamentally the reasons why the new strategic decision was made in the first place.

 

5.CONSENSUS

5Getting the buy-in from the organization and all levels is extremely important to ensure that the strategy is played out as envisioned. This can only happen when the organization feels that they are in on the decision making consensus. People care only about leadership that they have willingly provided, be it on strategies or on the leader itself. Further, a lack of consensus can lead to creation of obstacles in the implementation of a strategy.

As Floyd and Wooldridge argue, strong consensus exists when managers have both, a common understanding of, and a common commitment to their strategy.

 

6. COMMITMENT

6No amount of consensus can lead to execution unless supported by commitment.  As pointed out in the paper, strategy implementation efforts may fail if the strategy does not enjoy support and commitment by the majority of employees and middle management. This will hold true irrespective of whether or not consensus was achieved at each and every level of the planning. Commitment means that degree or extent to which each owner feels associated in order to support it without an immediate benefit accruing to him/ her. In flatter organizations, authority has no place. It’s all about accountability and ownership. Hence, commitment needs to be existent and permeating across the organization to ensure that the plan gets implemented.

OPERATIONS

7.RELATIONSHIP ACROSS FUNCTIONS AND LEVELS

7The relationship between corporate business units and inter-functional processes defines the functional competencies, allocation of resources, decision-making participation and influence, inter-functional conflict and coordination. As pointed out by Slater & Olson (2001), the relationships between different strategy levels also reflect the effect of relationships among different cross-organizational levels on strategy implementation (Slater & Olson, 2001). There is a significant trust required between functions in order to understand the long term implications of a strategy. If any lose sight of the end goals or get disheartened, the implementation may fail completely.

 

8.IMPLEMENTATION TACTICS

8The planners and executors both need to be a part of the implementation. The planners need to facilitate an environment that is conducive for the smooth implementation. Nutt (1986) identified four types of implementation tactics used by managers in making planned changes: intervention, participation, persuasion, and edict. In order for implementation to work, there must be sufficient direct and indirect motivational methods that need to be used as well as a certain sense of urgency to facilitate the change in thinking and direction of efforts.

 

9.ADMINISTRATIVE SYSTEMS

9While strategy is being implemented, the organization needs to have a strong enough review function that ensures that progress is monitored and managed. In the absence of review, there is absence of control over the manner in which the organization is carrying on implementation. Further, a strategy without accountability cannot be successful and monitoring systems are the only way to ensure accountability is taken seriously. In the absence of proper administrative systems, you cannot have cohesive and sustained implementation.

 

This document is a critique on the paper ‘Making Strategy Work: A Literature Review on the Factors Influencing Strategy Implementation’ (written in 2006 by Yang Li, Sun Guohui & Martin J. Eppler at the Business School, Central University of Finance and Economics, Beijing, China in collaboration with Institute of Corporate Communication, University of Lugano (USI), Lugano, Switzerland) which puts together a synopsis drawing out the nine most acknowledged crucial factors for a successful strategy implementation.
 

WHAT A CFO CAN DO FOR YOUR STARTUP?  

Business owners at the early stages of their startup are a jack-of-all-trades, trying to handle every aspect of their business for the simple reasons that they might be under-capitalized or trying to cut cost. When the business starts to grow organically, there arises a need to employ appropriate people for the various roles in the organization. The services of an accountant may be enough to provide support for recording the day-to-day financial transactions in the initial stages. Once the business moves into the growth stage, when the activities of the business are increasing, the need for strategic financial support is felt to consolidate data and provide the company with a strategic road map. This is where a CFO comes in.

The responsibilities of a CFO is no longer limited to financial reporting, audit and compliance, planning treasury and capital structure. It now encompasses the roles of corporate portfolio management, capital allocation, investor relations, performance management to name a few.

A CFO is not just a glorified book-keeper, he plays a number of important roles in a startup that are critical in providing a strong financial foundation for a growing business.

  • A CFO is like a steward to the business, working to protect the vital assets of the company, ensuring compliance with financial regulations and communicating value and risk issues to the board and the investors. The CFO will ensure that the business has important financial controls which include management of cash flows, establishing credit policies and implementing procedures to measure and evaluate optimal inventory levels.
  • As an operator, a CFO provides a variety of services such as financial planning and analysis, treasury, tax and other finance operations, to ensure the business is efficient and effective financially. An effective CFO handles projects that require significant quantitative and qualitative analysis in order to arrive at an understanding of the options that are available. Developing a company’s annual budget and interacting with the business owner and department managers to ensure that the final product accurately and objectively reflects the real requirements of the business will be the responsibility of the CFO. He might also conduct a thorough analysis of a company’s future capital investment requirements as a first step in securing additional financing.
  • CFOs take a seat as the strategist at planning table and help influence the future direction of the company. They are vital in providing financial leadership and aligning business and finance strategy to grow the business. In addition to M&A and capital market financing strategies, they can play an integral role in supporting other long-term investments of the company. . A CFO would also play a key role in any effort to seek investment from the public financial markets or to launch an initial public offering (IPO).
  • CFOs as catalysts can stimulate and drive the timely execution of change in the finance function or the enterprise. Using the power of their purse strings, they can selectively drive business improvement initiatives such as improved enterprise cost reduction, procurement, pricing execution and other process improvements and innovations that add value to the company.

Bringing in a skilled and expert personnel onto the board of the business will help give a strategic direction to the business. Outsourcing the financial support for the business will give the owners free time to focus on other aspects.

Cost Centres for Small Business

Managing your business costs and revenues is a challenge. To survive, you have to sell enough products/services, and collect money and manage your costs.  The latter can be more difficult than you think, particularly when you don’t have good breakdown of costs.

Without careful monitoring of costs, any business can find that costs can spiral out of control quite rapidly. This does not mean you spend hours and hours monitoring costs in minute details, but you should be able to get an overview of all costs at any time. One way to do this is to use cost centres in your accounting system.

What is a cost centre?

A cost centre some section/portion/unit of a business for which costs can be identified and someone is accountable for these cost.  Normally, a cost centre has a budget which includes all costs traceable to the cost centre. These cost could be anything from wages to telephone to motor expenses, once they can be traced to the cost centre

In a small business there may be only one or two cost centres.  Because you will be looking at small numbers of transactions, there is no need to split things up into smaller cost centres as costs can be more readily monitored against budgeted figures. However, for larger businesses, operating as a single cost centre is probably not good enough.  It is also not going to be an easy task to monitor whether those responsible for cost control are doing their job effectively.  A breakdown of costs down into each cost centre helps control cost of each cost centre and the business as a whole.

20140627-163257-59577785Identifying cost centres

Some businesses are easy to split into individual cost centres – for example, a manufacturing company with six factories, a head office and a distribution warehouse could be split into 6 individual cost centres for each factory, a head office cost centre and a separate distribution cost centre. A business may need to go into more detail to keep a tighter control of costs – for example, each manufacturing plant might make several different products, with several different machines/processes for each product. It would be possible to treat each machine or process as a costs centre in this case.  This would allow the business to keep a good eye of how profitable each product process is. Sometimes too, a business might treat support activities like human resources, finance and logistics as cost centres too. There is no end to how detailed cost centres can be, but remember to be a cost centre, it must be possible to trace costs directly and someone must be responsible for the costs.

PROACTIVENESS: The need of the Hour

In an ever-changing business environment businesses of all sizes face unexpected challenges. It is for the organization to decide how to face the unexpected. Would you want to wait for the crisis to come upon your business and then find a solution to it or have a cushion ready for the organization to fall safely upon? It is the preparedness of the organization which determines whether the business will make it through the storm or flounder under an unexpected wave.

Tsunami alarm systems across the globe help raise an alarm when there is tectonic movement under the sea-bed which could potentially cause a havoc wrecking tsunami. The alarm systems help take preventive actions to minimize destruction. Similarly a business may have systems in place that identify threats before they become serious problems, and highlight opportunities well in advance. These are signs of a proactive business. Business with robust and dependable systems have the flexibility to adjust to the new challenges and opportunities in a changing business landscape.

Stephen Covey’s book 7 Habits of Highly Effective People, was the first to popularize the term “proactive” in the business context. A reactive organization is controlled by external forces, whereas a proactive business are watching out for developing situations and uses them to control and exploit the situation for good, rather than being adversely affected by it.

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Building a Proactive organization

For a business to be proactive it is essential that the management fosters a culture to promote the same. Between proactive and reactive management there is a very thin line of difference Time. Time is an essential weapon. Time given to anticipate problems and devising plans is critical. Identifying tasks and responsibilities which are critical and helps prioritize and delay or delegate less important tasks. To ensure that this is followed across the organization offer guidance and explain how people can leverage time to get more done.

Processes are important in a proactive business. Dysfunctional or redundant processes can stall the proactiveness in an organization. A thorough review of all processes in the organization can help identify gaps or redundancies. Active involvement of team members in this task will help fill the gap as they are in a better position to tell you the difficulties arising out of each task and also help you anticipate and avoid future hiccups. Once you have managed to correct the processes and ensured robustness, you can move on to analyzing risk and managing them, starting with high probability and high impact ones.

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For people in an organization to be proactive, specific tasks must be assigned to them. Putting faith in their ability and giving responsibility helps boost the morale of the team. Everyone in the organization knows who holds the responsibility of each task and strive to perform better. A financial dashboard with the name of the person and the responsibility given to him, helps track performance. The dashboards allow all employees to see how the individuals are performing as well as how the company is doing.

Proactive businesses see trends in the business in response to the business environment without asking for the same. It is important for a business to record its past and present performance to forecast where it is headed in the future.

A proactive attitude provides numerous benefits to a business. It helps minimize malfunctions and increases the efficiency of teams. It ensures that the business in prepared for changes in the business environment and is ready to face the storm head strong.

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