private placement & venture capital

7/29/2019 Private Placement & Venture Capital

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PRIVATE PLACEMENT

1.1 Concept and background of private placement:

According to the Dictionary of Banking and Finance, 'Private placement is the act of

placing a new issue of shares with a group of selected financial institutions' .

Bloomberg defines a private placement as the transferring of securities to a small

group of investors. The sale of a bond or other security directly to a limited

number of investors an institutional investor likes an insurance company

antithesis of public offering.

Private placement is the method of fund raising from the capital market, when public

issue is not feasible option. It can be made both by companies that have already gone

public in the past (listed companies) and by those that have not (unlisted companies).

In the Indian capital market, private placements do not require issue of a prospectus

and regulatory clearances for the issue of securities. However, if such securities are

subsequently proposed to be listed in a stock exchange (NSE or BSE), they would need

to be compliant with the Listing regulations of the respective stock exchange.

Though the intention behind a private placement is fund raising, sometimes they are

also made not with a. fund raising intention but to accommodate certain strategic

objectives. These could be,

(a) Consolidation of stakes of promoters,

(b) Induct a strategic investor or a joint venture partner,

(c) Provide management stakes to working directors and senior management,

(d) Implement an employee stock option plan,

(e) Reward shareholders with bonus issues and such other objectives.


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1.2. Types of private placement:

1.3. Assessment of Private Placement:

From an issuer's perspective, private placement provides faster access to funds, less

market uncertainties and a more cost effective way of raising funds as compared to

public offers. The effectiveness of private placement would however, depend on the

maturity of this market in respective countries. Floatation costs would also depend on

the type of investors being targeted, size of the offer and the desirable distribution of

securities. Private placements are therefore more cost efficient for larger floatation if a

widespread distribution is required. There is also lesser paperwork and administrative

pressure on the issuer company in satisfying process requirements.

Even under the debt category, private placements offer an efficient mechanism for

raising capital. The lack of illiquidity is seemingly compensated by higher levels of

accessibility for the investors to the issuer company. In addition most privately placed

debt is rated and only instruments with investment grade rating get placed eventually

Private placement

B. Private Placements Made

with a Fund Raising Objective

Early Stage Venture Capital

Later Stage Private Equity

Other Institutional Investors

Non-institutional investors

International Capital Markets

A. Private Issues Made with a

Strategic Objective

Promoters and Promoter Group

Employees and Senior

Management

Bonus Issues

Introduction of Strategic Investor


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with institutional investors. Therefore, it can be stated that private placement of debt is

as efficient as a public issue of similar instruments from an issuer's perspective.

From an investor's perspective, private placement provides lesser transparency and is

therefore suitable more for informed institutional and HNI investors than retail investors.

A balancing factor though is the opportunity for investors to interact with the issuer

company's management on a one-to-one basis and assess investment prospects in the

proposal. If private placed securities are also listed on the stock exchange, they would

combine the advantages of publicly offered securities as well by providing liquidity and

price validation on a continuous basis to investors.

1.4. Market Segments for Privately Placed Debt:

A) The PSU bond market consists of debt securities issued by public sector

corporations set up under separate statutes, government companies

incorporated under the Companies Act, local authorities and municipal bodies

that float debt securities for raising funds. Many well-known names such as the

NTPC, Power Finance Corporation, Konkan Railway Corporation, Sardar

Sarovar Narmada Nigam, Rural Electrification Corporation and other Central and

State Government undertakings had raised funds through private placement

route.

Private placement of debt securities

PSU bonds Bonds from banks

and institutions

Corporate debt

securities


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The essential difference between PSU bonds and other corporate debt is the

constitution of the PSUs. In many of them, the government being the main

shareholder provides credit enhancements including a financial guarantee. For

example, the bond issue made by Krishna Bhagya Jala Nigam Ltd was

guaranteed by the State Government of Karnataka. This kind of a structure not

only helps the PSU to raise funds but raise them at competitive rates as well.

B) The institutional bond segment consists of all India and state level financial

institutions and commercial banks that raise funds through issue of SLR and

non-SLR bonds. SLR bonds are called so since they fulfill the requirements of

the statutory liquidity ratio.

SLR bonds constitute an inter-bank offering whereby the bonds issued by a

financial institution or a bank are subscribed to by other banks. Financial

institutions do not subscribe to SLR bonds since they do not have to maintain

any statutory liquidity ratio. The non-SLR bonds are issued to other investors

mainly to augment the fund base of the financial institutions and banks. They

serve as an alternative to raising funds from deposits.

C) The corporate debt securities market consists of private sector companies

that issue privately placed debentures to financial institutions, banks and other

investors to raise funds through the debt route as a substitute for long-term

borrowings through term loans. These debentures offer better advantages to

corporate, since these are easy to float and if these are rated, they become an

easier option to raise funds than through term loans that go through long drawn

appraisals.

Since many of these debentures, are placed with select investors, suitable credit

enhancements can be made to get a good rating for the structured obligation and

thereby place them at finer coupon rates.


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1.5. Market Segments for Privately Placed Equity:

The main investors in the private market are qualified institutional buyers such as

banks, insurance companies, mutual funds, registered venture capital funds, foreign

institutional investors and others. Unregistered foreign private equity investors also from

a significant part of the investing community in privately placed equity. In the privately

placed debt market, the dominant investors are mutual funds, banks and insurance

companies. To lesser extent foreign institutional investors, HUFs, private trusts etc

comprise the bottom layer of the investment community.

A) VENTURE CAPITAL:

Concept and introduction:

'Venture Capital' is an important source of finance for those small and medium-sized

firms, which have very few avenues for raising funds. Although such a business firm

may possess a huge potential for earning large profits in the future and establish itself

into a larger enterprise. But the common investors are generally unwilling to invest their

funds in them due to risk involved in these types of investments.

In order to provide financial support to such entrepreneurial talent and business skills,

the concept of venture capital emerged. In a way, venture capital is a commitment of

Private placement of equity

Venture capital Institutional private

equity

Placement to others

QIBs and non

institutional investors


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capital, or shareholdings, for the formation and setting up of small scale enterprises at

the early stages of their life cycle.

Bloomberg defines it as 'An investment in a start-up business that is perceived to have

excellent growth prospects but does not have access to capital markets. Type of

financing sought by early-stage companies seeking to grow rapidly'. Some of the

famous companies of today such as Netscape Communications, Apple Computer,

Cisco Systems, Compaq (since merged with HP), Network General, Yahoo, e-Bay etc

were all start-up companies financed through venture capital. The Indian examples of

successful venture backed companies include Biocon, i-Flex Solutions,Sasken,

Geometric Software, Mastek Global etc.

Venture financing involves significant risk-taking on the part of the venture capitalist

since young businesses are subject to high rates of mortality and the venture investor

could stand to lose the investment made in the company.

The venture capital recognizes different stages of financing, namely:

1. Early stage financing - This is the first stage financing when the firm is undertaking

production and need additional funds for selling its products. It involves seed/ initial

finance for supporting a concept or idea of an entrepreneur. The capital is provided

for product development, R&D and initial marketing.

2. Expansion financing - This is the second stage financing for working capital and

expansion of a business. It involves development financing so as to facilitate the

public issue.

3. Acquisition/ buyout financing - This later stage involves:

Acquisition financing in order to acquire another firm for further growth.

Management buyout financing so as to enable the operating groups/ investors for

acquiring an existing product line or business and

Turnaround financing in order to revitalize and revive the sick enterprises.


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Venture capital is not meant for any type of start up business. A venture capital backed

business requires certain characteristics in the business model and financing structure

of the company. Some of the usual features are furnished in below:

Structure of a venture capital backed start up business

Business structure:

1. Generally associated with a technology venture or a knowledge intensive or

innovation driven business model.

2. Venture to be backed by technology that has been created or is to be created.

3. Requires product development / technology and / or market validation.

4.Product has to be successful at lab scale / prototype level (beta version) before it is

commercially launched.

5. Test marketing or phased marketing is required since concept selling is

involved.

6. Cash flow model requires to be established.

7. Business to be ramped up in phase.

8.Business risks are taken in phases. Investment monitoring by the VC is more of

mentoring, with the VC appointing its nominees on the board of the company to

bring in significant value addition apart from protecting its interests.

Financial structure:

1.Starts up firms go through rounds of financing starting from the seed stage to pre-

IPO stage. Financing is generally linked to pre set milestone either in terms of

financial projections or strategic achievements.


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2.Financial risk is taken in phases. The highest risk reward relationship is at the seed

stage and the risks and rewards go down progressively as the business gets de-

risked in each subsequent round of financing.

3.Promoters may or may not have sufficient financial resources. Their technology is

valued and allowed to be capitalized as stock. Alternatively, investors are prepared

to pay a high premium on their stock. Promoters equity is more in intellectual capital

and stock options than in hard cash.

4.More suitable for financing through equity since the business model may not be able

to support debt financing. Some part of the financing could be a convertible or a soft

loan to prevent excessive dilution of promoters equity.

5.Tangible asset creation would be less there is a high component of intellectual

property valuation. VCs are open to financing soft costs in the business plan that

does not result in creating tangible assets. In other words they are not security

oriented in the financing structuring. No collateral security needs to be created for

VC financing unlike in bank borrowing.

6.Involves significant amount of cash burn in terms of product development and

validation expenditure and seed marketing expenses. No restriction is placed onallocation of funds for working capital.

7.The business model should have the potential for very high returns to investors

since the risk level is also very high. The risks are clearly understood through a due

diligence process and assumed by the investors.

A venture capitalist normally looks for some of the following type of attributes in abusiness plan before deciding to invest:

An industry or space that is currently a sunrise sector that promises to be creating a

paradigm shift.

An exciting concept that has the potential for an uninhibited market.


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A concept that significantly improves existing processes or applications and therefore

find a vast replacement market.

A business or idea that has potential for spin off businesses or revenue streams or

significant possibilities for future scale up.

A start-up business that has the potential to become an attractive proposition for

strategic acquisition in future by a market leader.

A firm that has the caliber to become an industry leader in due course with the right

inputs.

A business that is in a cutting edge technology that could become an industry

benchmark.

A company that has sufficient technology and management bandwidth to reach and

sustain the leadership position that it promises to attain.

A business or technology that has a first mover advantage which can be harnessed

adequately before competition catches up.

A business that has significant entry barriers for the competition either in technology

or in business variables that can largely be sustained.

A firm that has an unfair advantage to begin with which could remain long enough

before it is diluted by competition or regulation.

A firm that offers possibilities for multiple exit options.

There are many other types of start up firms that do not qualify for venture capital as

they do satisfy the investment criteria of VC investors. These could be more of

commercial ventures in manufacturing, trading and services that either address a

commodity or a mass market, small scale market, or engaged in the business of

volumes with thin value addition or in a generic product or service market with little

technology or innovation. Such businesses do not find favour with VC investors and

would therefore need to be financed differently.


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Regulatory framework of Venture Capital in India:

Venture Capital in India governs by the SEBI Act, 1992 and SEBI (Venture Capital

Fund) Regulations, 1996. According to which, any company or trust proposing to carry

on activity of a Venture Capital Fund shall get a grant of certificate from SEBI. However,

registration of Foreign Venture Capital Investors (FVCI) is not obligatory under the FVCI

regulations. Venture Capital funds and Foreign Venture Capital Investors are also

covered by Securities Contract (Regulation) Act, 1956, SEBI (Substantial Acquisition of

Shares & Takeover) Regulations, 1997, SEBI (Disclosure of Investor Protection)

Guidelines, 2000.

Guidelines for the Venture Capital Funds:

For the Venture Capital Funds, it is required that Memorandum of Association or Trust

Deed must have main objective to carry on action of Venture Capital Fund including

prohibition by Memorandum of Association & Article of Association for making an

invitation to the public to subscribe to its securities.

Further, it is required that Director or Principal Officer or Employee or Trustee is not

caught up in any litigation connected with the securities market and has not at any time

been convicted of any offence involving moral turpitude or any economic offence. Also,

in case of, body corporate, it must have been set up under Central or State legislations

and applicant has not been refused certificate by SEBI.

A Venture Capital Funds may generate investment from any investor (Indian, Foreign or

Non-resident Indian) by means of issue of units and no Venture Capital Fund shall

admit any investment from any investor which is less than five Lakhs. Employees or

principal officer or directors or trustee of the VCF or the employees of the fund manager

or Asset Management Company (AMC) are only exempted. It is also mandatory that

VCF shall have firm commitment of at least five Crores from the Investors before the


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start of functions by the VCF. Disclosure of investment strategy to SEBI before

registration, no investment in associated companies and duration of the life cycle of the

fund is compulsorily being done. It shall not invest more than twenty five percent of the

funds in one Venture Capital Undertaking. Also, minimum 66.67% of the investible

funds shall be utilized in unlisted equity shares or equity linked instruments of Venture

Capital Undertaking.

It is also mandatory that not more than 33.33% of the investible funds may be invested

by way of following as stated below:

1.Subscription to IPO of a Venture Capital Undertaking (VCU).

2. Debt or debt instrument of a VCU in which VCF has already made an investment by

way of equity.

3. Preferential allotment of equity shares of a listed company subject to lock in period of

one year.

4. The equity shares or equity linked instruments of a monetarily weak company or a

sick industrial company whose shares are listed.

5. SPV (special purpose vehicles) which are created by VCF for the purpose of making

possible investment.

RBI and Investment Criteria:

A foreign venture capital investor proposing to carry on venture capital activity in India

may register with the Securities and Exchange Board of India (SEBI), subject to

fulfilling the eligibility criteria and other requirements contained in the SEBI Foreign

Venture Capital Investor Regulations. The SEBI Foreign Venture Capital Investor

Regulations prescribe the following investment guidelines, which can impact overall

financing plans of foreign venture capital funds.

a) The foreign venture capital investor must disclose its investment strategy and life


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cycle to SEBI, and it must achieve the investment conditions by the end of its life cycle.

b) At least 66.67 per cent of the investible funds must be invested in unlisted equity

shares or equity linked instruments.

c) Not more than 33.33 per cent of the investible funds may be invested by way of:

Subscription to initial public offer of a venture capital undertaking, whose shares are

proposed to be listed.

Debt or debt instrument of a venture capital undertaking in which the foreign venture

capital investor has already made an investment, by way of equity.

Preferential allotment of equity shares of a listed company, subject to a lock-in period

of one year.

The equity shares or equity linked instruments of a financially weak or a sick industrial

company (as explained in the SEBI FVCI Regulations) whose shares are listed.

A foreign venture capital investor may invest its total corpus into one venture capital

fund.

Tax Matters related to Venture Capital Funds:

Indian Venture Capital Funds are allowed to tax payback under Section 10(23FB) of the

Income Tax Act, 1961. Any income earned by an SEBI registered Venture Capital Fund

(established either in the form of a trust or a company) set up to raise funds for

investment in a Venture Capital Undertaking is exempt from tax[16]. It will also be

extensive to domestic VCFs and VCCs which draw overseas venture capital

investments provided these VCFs/VCCs be conventional to the guidelines pertinent for

domestic VCFs/VCCs. On the other hand, if the Venture Capital Fund is prepared to


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forego the tax exemptions available under Section 10(23F) of the Income Tax Act, it

would be within its rights to invest in any sector

B) INSTITUTIONAL PRIVATE EQUITY

The private placement market for equity is quite large and consists of several types of

institutional and non-institutional investors. The term 'private equity' is commonly

associated with the institutional investors that cater to the requirement of equity capital

by companies otherwise than through public offers.

Venture capital is all about identifying early stage investment opportunities, while

private equity is large and as companies grow and mature, they require more of equity

capital through private sources. Thus, private equity is associated with those companies

that have crossed the venture stage in their life cycle.

Thus, Private equity can be termed as 'later stage financing' as compared to venture

capital, which is all about early stage financing. Private equity financing is thus a distinct

model of making direct equity investments wherein investors identify good investment

opportunities in well performing companies, some of them even listed, either for

financing their growth or for acquisitions and buyouts.

Private equity funds cater to larger deal sizes and do not normally look at transaction

values less than a minimum threshold. This is quite in contrast to venture capital

wherein, since the risk is significantly higher, the venture capitalist looks to gradual

infusion of capital to minimize risk.

Private equity investors also have a relatively moderate return expectation as compared

to venture capitalists who have exponential return expectations. Therefore, it may be


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said that private equity market is all about investors who invest later, invest more, prefer

reasonable stakes and moderate risk entailed returns.

Private equity investors showed interest even in project financing, an area dominated

by large banks and specialized financial institutions. Private equity investments extend

over later stage unlisted companies and many a time, in listed companies as well, a

phenomenon known as PIPE in the US markets.

Private investment in Public Equity (PIPE):

According to Bloomberg, 'Private Investment in Public Equity (PIPE) occurs when

private investors take a sizable investment in publicly traded corporations. This usually

occurs when equity valuations have fallen and the company is looking for new sources

of capital'. From the above definition, it is clear that when private equity is infused into a

listed company it would be classified as a PIPE investment.

Character of PIPE:

A) Private- A PIPE is a private placement transaction between a limited group of

investors and a listed company. The private placement of securities is made possibleonly to the extent permitted by regulations governing issue of securities by listed

companies, such as the SEBI regulations in India and the SEC regulations in USA.

B) Investment- A PIPE is a direct investment in a company. Unlike securities of a

listed company purchased from other investors in the secondary market, a PIPE

involves the purchase of securities in the primary market. In a PIPE, securities are

issued directly by an issuer company, and the proceeds from such investment go to

that company.

C) Public- A PIPE is used by a listed company to raise capital. These have to be

differentiated from private equity raised by unlisted companies due to the fact that

there are several regulatory restrictions on PIPE financings as compared to private

investments in private companies. The way, in which these regulations and laws are


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interpreted, make PIPEs a discrete financing alternative, distinct from other forms of

private and public investments.

D) Equity- A PIPE is an equity or equity-linked investment, i.e. securities that

involve an equity component, and securities that are convertible or exchangeableinto equity.

C) PRIVATE PLACEMENTS WITH OTHER DOMESTIC INVESTORS

Apart from institutional equity in the nature of venture capital or private equity that is

raised from dedicated equity funds, there are other sources to raise equity in the private

placement route. The QIB sources for private placements are mutual funds, foreign

institutional investors, insurance and pension funds, banks and financial institutions.

The non-institutional sources for private placements include family sources or

associates of promoters, private high net worth investors (called HNIs), early stage

investors (also called angel' investors), financial and investment companies, other

corporate investors, stock broking companies, portfolio funds and non-residents.

If equity is raised from any of the above sources without a public offer, it is simply

referred to as a private placement as distinguished from venture capital or private

equity. Private placements to non-institutional investors are more informal processes

than to institutional investors and normally do not entail elaborate disclosures and due

diligence.


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Regulatory aspect of private placement:

Point 2003 Rules 2011 Rules

Special Resolution The issue of shares can be only

made, if

The AOA of the company

authorizes to do so and

A special resolution is

passed at the general

meeting authorizing the

allotment.

The special resolution has

to act upon within a

period of 12 months.

The Additional Requirements

includes:

The company has to make

disclosures in the offer

document as prescribed.

The offer document has to be

approved by way of a special

resolution.

Both the copy of the special

resolution and the offer

document has to be filed with

the ROC.

Condition for the

issue of Private

Placement

Does not prescribe any such

condition.

The following conditions are

prescribed:

Not more than 30 day gap

between opening and closing

of the issue.


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Minimum 60 days gap

between two issues.

Any financial instrument which

is convertible into equity

shares at a later date and

resulting into a cumulative

amount of Rs. 5 Crores or

more will require the prior

approval of the central

government.

After the issue, the company

has to file a return of allotment

with the ROC within 30 days.Dematerialization of

Securities

No such requirement All securities issued under

preferential allotment or private

placement has to be kept in a

demate form.Compliance

Certificate

A Similar audit certificate was

only required to be placed before

the shareholders.

The compliance certificate has to

be filed with the ROC.

Disclosures in the

offer document

Not applicable. However

disclosures are to be made in

the explanatory statement to the

notice for the general meeting.

The 2003 rules only prescribed

that the object of the issue had to

be disclosed. The 2011 rules

require disclosures with regard to

the object of the issue, brief detail

of the project and statutory

clearances required and obtained

for the project. Apart from this the

two rules are more or less the

same in this regard.


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1.7. Guidelines of the private placement:

1. All placements of securities must be done through an independent placement agent

(a merchant bank or a stock broking company), except where,

The securities are to be issued to the directors or substantial shareholders of the

issuing company;

2. Time Frame for Placements

Securities must be placed out to places within a period of 5 market days from the price-

fixing date of the placement.

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