In the previous post ( read Part 4 here) , we discussed a few exit options. In this post we discuss about IPO, which is the preferred option in most investment deals. Many a time, even the early stage investment agreements capture quite a detail.

Negotiating Termsheets

As captured in the previous post, investors invest to exit with big returns and investment decisions are targeted towards startups which can create those great exits. Promoters on the other hand, may or may not have the same urge to ‘exit’ but the vision could be to create a long term successful organization. However, the investment agreements require the promoters to enable or provide exit to the investors, lest the investor may trigger its ‘default drag along right’.  It is very imperative to have clarity on the exit mechanism in the agreements including the timing of such exit or the decision tree (sequencing) of various exit options.

Tip: While one of the ways is detailing for all exit options to be provided in 5-7 years from investment date (IPO, trade sale, strategic third party sale, company buy-back), a smart way would be sequence the exit. Example IPO in 6 years, else provide for strategic third party sale after 6 years, beyond that time the investors can pressurize the promoters for a company buy-back at a pre-agreed IRR and only if nothing works, only then can the investors trigger their default drag along right. In one particular case, the company was not scaling up to the expectation and the investor after 2 years of investment, couched a drag along as a third party sale. The promoter did not make any money nor did he get a great salary during the investment (because it was a small series A round). 

Of the many exit options available, IPO (initial public offering/ listing of securities on stock exchange) is one of the most popular exit option, because when there are right market conditions, an IPO  option is likely to enable the investor to realize very high returns. However, as always, there is a flipside as well. The economic conditions for going public, is both the growth and scale of the company and very importantly external conditions which are not within the control of the promoters. There are very high costs involved in carrying out the IPO process, very high levels of information disclosures, strict regulatory requirements and restrictions. Another key point is that, the investors will exit when its shares are actually sold on the stock market, which might not happen concurrently with the IPO and accordingly the investor might be exposed to fluctuations and other market risks that are related after the IPO is carried out.

Tip: In order to protect a small IPO, which would enable investors to exit but may become burden-some for the promoters, it is a smart negotiation point to have a ‘qualified’ IPO, which provides for a total amount, which is sufficiently large to guarantee an IPO in major stock exchanges.

Given the importance of exits, even early stage investment deals capture IPO in detail. IPO can be either through issuance of new shares or offer of existing shares for public subscription. IPO can be either in India or outside of India. While there are many regulatory requirements that a company needs to ensure before getting into a scheme of an IPO, some of the eligibility criteria for a company to fulfill are, Net worth of Rs.1crore in each of the preceding 3 years. Net tangible assets of at least Rs. 3 Crores for each of the preceding 3 years along with track record for distributable profits for 3 out of immediately 5 preceding years. There are requirements of lock-in of promoter shares.  Hence, the clauses in the SHA, wherein the investors shall not be treated as promoters and not subject to lock-in requirements as per the listing guidelines.

While IPO on main stock exchanges is great, there are other platforms like SME Exchange. There are two basic criteria for determining the status of SME are capital and profits. Capital requirement is for a company to have minimum paid up capital of Rs. 1 crore and a maximum of Rs. 25 crore. Profit criterion is for a company to have distributable profits in two out of last three financial years. The amount that can be raised from the public is upto Rs. 25 crores. To facilitate the listing there are two platforms available in India BSE-SME Exchange and EMERGE –NSE.

A quick look at the other eligibility requirements for SME IPO:

Maximum Post Issue capital of Rs. 25 crores

  • Minimum number of members for a public issue is 50
  • Market making is mandatory for 3 years
  • Underwriting is required for 100% of the issue size (Merchant Bankers to underwrite 15% in its own account)
  • Issue lot size is dependent on the number of shares based on IPO price band
  • Trading lot size is multiples of Rs.1 lakh.
  • After listing the requirement of minimum number of members is not required to be continued.
  • Companies listed on SME Exchange can anytime migrate to the main Bombay Stock Exchange, provided shareholders’ approve.

While there certainly are benefits in SME listing, it might be a tad unappealing to investors who want bigger exits with greater liquidity on the markets.

Listing without IPO for SMEs:  SEBI’s new ‘Listing Of Specified Securities On Institutional Trading Platform) Regulations, 2013’ preamble states to provide easier exit options for informed investors like  Angel Investors, VCFs and PE  etc to provide better visibility, wider investor base and greater fund raising capabilities to such companies. These initiatives to help in greater exit opportunities and create liquidity for these investors. Further, SEBI has proposed to relax few norms for the ITP listing, where minimum amount for trading or investment on the ITP will be Rs 10 lakh and such companies would also be exempted from offering up to 25% of its shareholding to public through an offer document in order to get listed. There are further eligibility criteria that are listed by SEBI for availing the listing on ITP.

Further provisions are proposed where companies listed on the ITP will not have access to public money, can continue to have private placement rounds. Therefore, listing can be done without an IPO and the expenses associated with it. The biggest advantage is that it is economical and less procedural as compared to the IPO process.

Traditionally, the investment agreements have envisaged listing outside of India as well. Specially so, if the investment fund is not based in India.  So, clauses related to IPO in the USA with demand rights, piggy back rights etc. are captured. Piggyback rights entitle investors to register their shares when a company goes public. Whereas, demand rights requires the company to conduct a public offering and is a superior right compared to the piggyback rights.

Tip: Savvy promoters should negotiate for piggyback rights alone. We also understand that promoters can ask for the same right.

More often than not, during the early stage investment the promoters are keen on getting the investment and scaling businesses. Many a time, exits specially IPO looks like a distant dream and the focus on these clauses is usually less of a priority during negotiation.  We would love to see workshops/ seminars on ‘exit options’ and we could share our knowledge.

Our second customer at NovoJuris, Pennywise Solutions got acquired by Ogilvy and it is very satisfying to see these success stories. Even more satisfying is the squeaky clean due-diligence report of the company that Ogilvy was thrilled with. We’ll share this experience (‘sell-side experience’ as they call) pretty soon. Read article here.

Tip:  While there are termsheet level discussions for acquisitions that come by, many a time we have seen the deal fall through for non-compliances. We urge the promoters to take compliance seriously. It is boring but very important.

We would really love to hear your experiences and thoughts.

DisclaimerThis is not a legal opinion and should not be construed as one.  Please speak with your attorney for any advice.

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