Disputes on Exit Strategy

Introduction

The startup world thrives on innovation and ambition, but these qualities need fuel to turn into reality.  Enter private equity (PE) and venture capital (VC) firms, the financial powerhouses that propel promising companies forward. These firms inject much-needed capital into businesses with high growth potential, acting as midwives to the next generation of industry leaders.  However, unlike traditional lenders, PE and VC firms aren’t simply interested in recouping their initial investment with interest.  They are playing a longer game, seeking a significant return on their investment through an “exit strategy.”

An exit refers to a circumstance in which the investor moves out of the company by parting with their investment in the company. It refers to clauses in a transaction document such as the Shareholder’s Agreement (SHA) which grants investors the contractual right to decide on the disposal of their securities and exit the Company. There are a few exit rights that the investor can use to facilitate the exit from the Company. These rights are exercised for numerous reasons including disagreements with company’s growth path, event of default and for booking profits. This article covers several aspects of exits and legal intricacies involved in such clauses.

Structure of Exit Clauses in a Transaction Document

Exit clauses are typically structured to require the promoters and/ or company (as negotiated) to provide an exit to the investors, generally within a period that has been contractually agreed by the parties.

There are two ways in which the investors prefer to draft the SHA:

Exit waterfall: In this case, a specific sequence is prescribed under the SHA which needs to be followed by the parties to give effect to the exit. For example, the clause may first require a company to launch an IPO, failing which to undertake a buyback, failing which to proceed with a third-party sale, and so on. While the prescription of a waterfall within the exit clause is beneficial for both parties, it tends to favor the investee company/ promoters, as it allows them to discharge their obligation in the order that has been negotiated. It also gives them enough opportunities to facilitate an exit before the investor triggers drag along rights under the transaction documents. Drag along rights in an SHA mean giving the majority shareholder the power to force minority shareholders to sell their shares along with them during a company buyout or merger.

Exit clauses without a waterfall: This is the converse of a waterfall clause and does not require the company/ promoters to exert their efforts at providing an exit in any particular sequence. This provides greater flexibility to the investors to decide and determine, at their sole discretion, which exit option they intend to trigger. For example, in case the markets do not seem ripe for a listing (which is commonly negotiated as the first exit mode by investors), they may opt for a buyback/third-party sale.

Exit Rights for Investors

• Initial Public Offer (IPO): An IPO is a process through which a company becomes publicly listed for the first time and puts its new shares in the stock market for the investor and trading communities to purchase it. The IPO exit strategy, for most private investors, rests on the principle of the company going public and its stock price rising favorably in the share market. This opens up several possibilities for the investor. Offloading a large chunk of stocks in a go, opting for a staggered or phase-wise sale of shares, or holding on in anticipation of a better price in the market price. Any of these strategies can be adopted based on the investors’ current financial situation and future goals. An exit by way of an initial public offering is seen to be ideal for Venture Capital and Private Equity funds.
• Buyback of shares: A buyback is an exit option where the company buys back from the investor at an agreed-upon price. This option can provide liquidity and certainty to the investor but it requires the company to have adequate financial resources. In a buyback, a company can either buy back all the shares or a portion of shares from the investor, thereby enabling the investor an exit from the company.
• Third-party sale and Secondary sale: This clause puts an obligation on the Founder/Promoter of the Company to facilitate the exit of an investor within a pre-determined time. The Founder is obligated to facilitate the sale of shares of the investors to a third party at a predetermined price. If at all there is no third party ready to purchase the shares of the investors the Founder/Promoter shall personally be obligated to acquire the investor’s shares at a predetermined price.

A secondary sale involves selling shares to another investor, often a private equity firm or another financial institution. This exit option can provide liquidity and flexibility for investors, but it may not offer the highest returns. In a secondary sale, the promoters of the company sell their shares to the new investor, who become the new shareholder.

• Drag-along rights: Drag-along rights provide the investor a right that requires other existing shareholders of the company to sell their shares to a third-party purchaser at the same price and on the same conditions at which the investor sold them. This clause protects the majority shareholder from the minority shareholder. Itgives them a right to drag minority shareholders along in case they try to obstruct their exit when a third-party purchaser tries to purchase a substantial portion of the Company. One of the key advantages of drag along right is that it increases the marketability of the investee business by delivering a target company with no minority interest.
• Tag along rights: Tag along rights help a minority shareholder to exit from the joint venture, when a majority shareholder is looking to sell its shares. It obliges the selling majority shareholder to procure that the third-party purchaser extends its offer to include the shares of minority shareholders on broadly the same terms. For a minority shareholder, a tag-along right provides a viable exit route as the minority shareholder runs the risk of being left behind when the majority shareholder liquidates his investment, hence the clause.
• Put Option Right: Put Option is a clause in an SHA that provides the investor the right to sell their shares at a pre-determined price within a specified time or on the occurrence of a defined event.

For example, a put options clause says that the investor has the right to sell their shares at a particular price if the company does not go public in the next 5 years. This mode of exit is a preferred way as it provides the investors the security of some form of return on the initial investment and also helps in regulatory approvals when a buyer is not present immediately.

Scope of the abovementioned clauses is wide and the Supreme Court in Vodafone International Holdings BV v. Union of India[1] has also recognized that “SHA also provides for matters such as restriction of transfer of shares i.e. right of first refusal (RoFR), right of first offer (RoFO), drag-along rights (DARs) and tag-along rights (TARs), pre-emption rights, call option, put option, subscription option, etc. SHA in a characteristic joint venture enterprise may regulate its affairs on the basis of various provisions enumerated above, because joint venture enterprise may deal with matters regulating the ownership and voting rights of shares in the company, control and manage the affairs of the company, and also may make provisions for resolution of disputes between the shareholders.”

An outlook on Disputes concerning Put Options

One of the preferred exit strategies is making use of put options. As upheld by the Hon’ble Bombay High Court, this strategy forms part of recent transactions. In the case of Banyan Tree Growth Capital LLC V. Axion Cordages Limited and Ors.[2] the Bombay High Court has granted interim reliefs in disputes involving the exercise of put options and not interfered with awards granting reliefs based on put options. This case dealt with the disputes regarding the exit clause of “Put Options” for investors. This is a landmark judgment on understanding the disputes that arise between investors and investee companies regarding their exit from the company.

To go into more detail, Banyan Tree Growth Capital LLC (Petitioner) and Respondent Nos. 2 and 3 entered into a Share Subscription Agreement (SSA) whereunder the Petitioner made an initial investment of USD 50 million in return of share equity and convertible debentures in Axion Cordages Limited (Respondent No. 1 Company). The parties also entered into a Put Option Deed on the same date whereunder Respondent Nos. 2 and 3 were required to buy the Petitioner’s shareholding in Respondent No. 1 Company (Put Securities) to secure its exit. However later, upon the exercise of the put option right by the Petitioner, Respondent Nos. 2 and 3 refused to purchase the Put Securities and stated that the Put option Deed is void ab initio under Indian law. The dispute was referred to arbitration at the Singapore International Arbitration Centre. The arbitral tribunal held the Put Option Deed to be a valid and legal contract under Indian law and awarded damages to the Petitioner based on the fair market value of the Put Securities, which remained uncontested by the Respondents (Award).

The Respondents opposed the petition for enforcement of the Award filed before the Bombay High Court (“Court”) and contended that the Award was against the public policy of India, and for the first time, raised an objection that the Put Option Deed was inadequately stamped.

On the issue whether the Put Option Deed is unenforceable under the Securities Contracts (Regulation) Act, 1956 (“SCRA”), the Court relying on Edelweiss Financial Services Ltd. v. Percept Finserve Pvt. Ltd[3] observed that a contract containing a put option cannot be termed as a contract in derivatives and is held to be illegal under Section 18A of the SCRA. Since the option in favor of the Petitioner was a buyback arrangement, it could neither be dealt with nor traded on the stock exchange and would not attract the SCRA.

The Court recognized that the Put Option Deed was governed by the SEBI notification dated 3 October 2013 (“SEBI Notification”), which provided statutory recognition to shareholders contracts for purchase or sale of securities, with a put option, even if entered prior to the issuance of the SEBI Notification. Therefore, the Put Option Deed was held to be permissible under the SCRA.

Conclusion

To sum up, investing in private companies, especially startups, involves significant risks. As a result, financial investors seek exit rights that allow them to exit the company with a favorable return on their investment. While strategic investors may have different goals, private equity and venture capital investors place great importance on their exit rights. Exit rights play a crucial role in investor protection and liquidity. Understanding these rights ensures that investors can make informed decisions and navigate the complex landscape of private company investments.

We hope you have found this information useful. For any queries/clarifications please write to us at insights@elp-in.com  or write to our authors:

Shailesh Poria, Partner, Email – shaileshporia@elp-in.com
Akash Manwani, Associate, Email – akashmanwani@elp-in.com

References:

[1] (2012) 6 SCC 613
[2] 2020 SCC Online Bom 781
[3] 2019 SCC OnLine Bom 732

Disclaimer: The information contained in this document is intended for informational purposes only and does not constitute legal opinion or advice. This document is not intended to address the circumstances of any individual or corporate body. Readers should not act on the information provided herein without appropriate professional advice after a thorough examination of the facts and circumstances of a situation. There can be no assurance that the judicial/quasi-judicial authorities may not take a position contrary to the views mentioned herein.