Classification of M&A activity based on type of the financial investor:
The main classification of investors is strategic investors who are businesses themselves and are not any finance companies or organisations. The rest are the financial investors. However, the financial investors come in a wide variety. It depends upon what is the legal nature of the organisation, what is their governing regulation, from whom they collect (and can collect) the money, what is their selection criteria for a target, what is their investment criteria, what is their risk appetite, what is their expected rate of return on the investment, how much they want to interfere they in (or assist) the management, what is the complexity of their investment process, how long they want to keep invested, etc.
Following is the classification of various types of financial investors. (There is a lot of redundancy in this classification and the types are not necessarily mutually exclusive.)
Friends, relatives & family:
An investment from friends and family on very liberal terms is very helpful in the initial stage of a business. A businessman should keep very good personal relationships with its social circle. Relationships come handy in the most difficult times. The friends and relatives are typically not aware of the terms of business investment. A businessman on his own should offer transparent and fair terms of investment in the form of written down contracts. He should apprise his friends of the risks of his business. It is a good idea in these turbulent and unpredictable times of the employment market to take along close friends even in the management of the company as directors if they can develop requisite skills in due course of time.
Sweat equity (executive directors and key professionals):
It is the equity issued to the the employees and executive directors of a company in lieu of of their work for the company. It is the reward for contribution to the development of a company in non-cash form. In many cases members of a company contribute capital for the growth whereas others are spending time for the growth. Sweat equity has equal value as cash equity by distributing stocks or other forms of equity. As a businessman, if you are able to convince high cost employees or executive directors about the growth story of the company, they can wait to get rewarded. This provides sufficient liquidity to the company. It is very important for a business to have a talent pool at the top to manage the complex operations of the business, the complex relationships with stakeholders and the complex external business environment. If a businessman does not recruit or associate with competent professionals or does not associate with them because they do not have money to invest, he might have made a major error. Lack of sufficient top-level resources delays the fulfilment of various business activities and may have impact on viability of the business itself. In the issue of sweat equity, devaluation of efforts and time needs to be made. A proper contract needs to be signed retailing all the aspects of participative ownership.
ESOPs (employees):
The employee stock option plan is a form of sweat equity. The difference is that it is not a definitive issue but an option to participate in the ownership. In the initial stages of a business, money is required for creating infrastructure. To attract good talent and to retain it, it is necessary to compensate them with good salaries. This is not possible in the beginning. Hence, an employee given an option to acquire the equity of a company at a future point of at a discounted rate. An employee is paid a cash salary out of the total remuneration for basic subsistence. And the rest of the incentive is in the form of ESOPs. This way the business can turn its employees themselves as the investors in the company.
Seed investors:
As the name suggests, seed investment is provided when the business is at the seed stage or before the proof of concept. Seed money is used to fund the earliest stages of a new business, potentially up to the point of launching the product. It can be in the equity form or debt form. The amount of seed funding is usually very small. Money can be used for market survey, feasibility study , detailed project report, membership of associations, obtaining approvals and licences, preparation of contracts with the key stakeholders, incorporation of the company, design and development of the product, etc.
Angle investors:
An angel investor is a high net worth individual who provides financial backing to SMEs typically in exchange for ownership or equity in the company. The investor is called an angel investor because the stringent eligibility criteria are not applied by them and investor takes a lot of risk in terms of losing the capital. They do basic due diligence, but largely they trust your ability to create a viable business. The funding is provided by them even before generation of revenues or even before it is established that a business can generate revenues (forget profitably or not). The amount of angel fund typically ranges from 1 crore to 5 crore. But they want to multiply the investment hundred times or thousand times and they do achieve this target if any one of their investments succeeds.
Simple agreement for future equity (SAFE) investors:
A SAFE is an agreement, a mechanism of equity capital provision, that is be used between for a company in the formation stage.
When is SAFE used? A private limited company, cannot take loans from individuals according to the laws of India. The process to take loan from ordinary individuals involves a complex RBI approval route which is generally not explored. So the only way left is to to get equity funding. But, in the initial years/stages of the company, either the valuation of the company is not done or it is not possible to do the valuation in a sensible and meaningful way because just too many things are unclear. As the time passes, the potential of the company becomes visible and the range of valuation can be estimated with more accuracy. So the problem arises: How much control and ownership should be offered to the investors whose capital contribution in proportion of the promoters capital is very substantial today what is going to be hardly any amount when compared to the future valuation of the company after its Idea succeeds? A SAFE is the perfect solution to this. It is considered as a better solution than the preference share in such circumstances.
What is the process? In exchange for the money, with a SAFE, the investor receives the right to purchase equity in a future round (trigger). SAFEs are not debt instruments and there is no risk of insolvency. It is a simple legal contract and the corporate process also it simple. The trigger is the investment round issuing preferred shares by the company. Investors and the company agree the mechanism of participation in the next investment round without any valuation as of the moment. There may be a valuation cap in terms of the total amount or there may be a discount with respect to the price offered to the third parties in terms of a percentage.
The unknown, unmet general citizen investor (Crowdfunding):
In the era of internet, it has become very easy to get connected with potential investors on various social media platforms. One need not run around meeting every person individually and understand his investment orientation only to discover that it was simple wastage of time. The solution to this is crowdsourcing. Crowdfunding refers to collection of funds from multiple investors through the web-based platforms or social networking sites for business investment. The relatively small financial contributions from a number of persons cumulatively do fulfil the fund requirements of the businessmen. Crowdfunding provides a new mode of financing for the SME sector.
When two raise equity capital through crowdsourcing? It is a handy resource of capital when the personal social network is either small or not rich enough to provide capital. It is also a good tool when typically Indian banks ask a businessman to wait for minimum 3 years from the year of incorporation to be eligible to apply for loan. Crowdsourcing raises funds at relatively lower costs. There is no rigorous corporate procedures.
What is the process of equity crowdsourcing? The operators of a crowdfunding platform carry out the basic due diligence of projects to be included on their website basically to maintain the reputation of the website. The funds from the crowd are available in several variants. The promoters have to provide proposed business plan, intended fund usage, audited financial statements, management details etc.
What are the conditions for equity outsourcing in India? The business must be less than 2 years old. The retail investor can contribute between INR 20,000 to INR 60,000 only. The maximum number of retail investors can be 200. This limits the retail investment to 1.2 crore rupees. Only “Accredited Investors” can invest without much restrictions. The Qualified Institutional Buyers (QIBs) can hold maximum 5% of issued securities. As per the SEBI norms, issuers can raise only up to total Rs 10 crore by issuing equity shares. No single investor shall hold more than 25% stake in a company. The promoters should have a minimum of 5% equity stake in the company for at least 3 years. These conditions are very unfair to the Indian businessman especially in the light of highly efficient financial intermediaries in the legacy market.
Following are the types of mechanism of crowdsourcing:
Donation Crowdfunding:
Donation crowdfunding denotes solicitation of funds for social, artistic, philanthropic or other similar purposes, and not in exchange for anything of tangible value.
Pre-order Crowdfunding:
The investors contribute today with the objective of receiving a product later (may be at discount with respect to future market price) if it is an advance payment. The investors receive the product of the company if it is successfully designed and developed. This manner of capital funding not only provides capital but also creates a market.
Reward Crowdfunding:
In this type, funds are given with the objective to receive a tangible reward. So if you invest in business of a gym, you may get a free membership or a discounted membership.
Debt Crowdfunding (P2P lending):
This is a form of Peer-to-Peer lending. Apohan has covered it here only for the completeness sake.
Equity based Crowdfunding:
It refers to raising equity through crowdsourcing. You may have noticed that most other mechanisms are either for marketing or for debt. Technically, equity crowdfunding can be Deemed to be illegal in India unless carried out with the prescribed rules. The reason for this is that it can make the stock markets, the initial public offers and SEBI irrelevant and investor protection can go for a toss.
Venture capital fund (VC Investors):
The term ‘venture capital’ represents financial investment in a highly risky project with the objective of earning a high rate of return. Venture capital is a form of equity financing especially designed for funding high risk and high reward projects. Typically, the investment ranges from INR 5 crore to around INR 100 cr. This investment is available when a business start making revenue i.e. The proof of concept (POC) is achieved. The term of investment is around 5 to 10 years. The instrument is preferably in the form of convertible preference shares.
A venture capital funds invest in:
1. Ventures promoted by technically or professionally qualified but unproven entrepreneurs, or
2. Ventures seeking to harness commercially unproven technology, or
3. High risk, high reward ventures.
Private equity fund (PE investors):
Private Equity firms are the investment funds that invest in the capital of the enterprise so as to acquire a strategic stake in it, once it is set up as a successful unit. Private equity funding is available at a very advanced stage of a business. Investors get attracted when the business starts making profits, has crossed the break even point of investment and the growth in the revenues is very fast. The amount of investment available is very large, typically more than 500 crore rupees. This money is utilised for rapid capacity expansion and acquisitions of companies.
How is a private equity fund organised?
Private equity fund is an alternative investment fund. It operates on the lines of a liability partnership. It raises a very large capital pool from pension funds, high net-worth investors, and a wide variety of investment funds. Its general partner plays the role of the fund manager. It plans the portfolio of investments. It manages the limited partner’s capital commitment and capital calls whenever an investment opportunity arises. A limited partner can be a retail and institutional investor such as an angel investor, a pension fund, a charitable trust, a bank, an insurance company, etc.
Family offices (The rich family investors):
Family offices are the consulting firms that represent the rich families. Rich family could be a family of a big businessman for the family of a great artist for a sports person, etc. Family office is a generic term and it is not a type of a legal entity. They are into private wealth management and investment banking operations. They can be legal or informal organisations that manage investments for high-net worth and ultra-high net worth families. They provide a wide variety of financial consultancy to the family. They employ their wealth to make investments on behalf of the family. Their (family’s) source of money is sale of a business, inheritance of shares, sale of ancestral property, progress in personal career, top level jobs in very rich companies, etc. The families other than the business families are not expected to have financial investment awareness. However, they would be interested in having some or other say in how their money is being invested. Hence, their personal investment philosophy, personal attachment for a certain cause or a location, transparency and openness in the business proposition, etc need to be taken into account while approaching them. While the family office managers themselves might be very busy, the members of of high net worth families might be even more busy. Another important aspect is sensitivities of different members of the the family itself. Unlike the offices of the family office, the members of the ultra high net worth family may not have knowledge of the rational concepts of business investment. One must also understand the difference between high networth individuals and high net-worth families. While the decision making power in the family maybe widely scattered, it is fully concentrated in case of high networth individuals. They have a relatively longer investment horizon which is good for raising long-term capital. The business expertise of the the family offices of the businessmen, having run successful businesses themselves, may come handy. Family offices allocate the highest fraction of their portfolio for a direct investment in a private business. They also provide capital to the private equity funds and other type of equity funds for ultimate investment in private businesses.
The family offices are divided into two types:
Single family office (SFO):
It is the personal wealth management firm of a very wealthy families. It only serves a single family.
Multi-family office (MFO):
It is an independent investment consulting firm aur financial advisory firm which specialises in to management of the the financial aspects of rich families.
High net worth individual (HNI) Investors:
Network means the difference between market value of assets (or total wealth) and liabilities, including liabilities of personal expenses in this context. High net worth individuals have much more personal wealth than they need (for expenditure purpose). There is no standard definition of HNIs in the market. The criteria can be net worth or the investible surplus or assets under advise or any similar parameter. The word investible implies that the majority shareholding in one’s own business cannot be added. However, a small fraction of shareholding company with liquidity on stock market (such that it doesn’t affect the price of the share much due to sale in a short span) can be treated as part of networth.
How do high net worth individuals invest? There are two modes in which HNIs invest. Direct equity investment means an investment without involving any financial intermediary. It is risky & time-consuming process in which HNIs have to do all the M&A consultant’s work. In the indirect equity investment mode, they invest in equity with the services of portfolio management companies or stock advisory firms. Here, their simple role is to bring in the capital and perusal of the dashboard.
Following are the three types of high networth individuals:
Emerging HNIs:
Individuals with Investible surplus of Rs.25 lac – Rs.2 crores are considered as Emerging HNI.
Normal HNIs:
Individuals who have more than 2 crores investible capital are considered HNI or HNWI
Ultra-high net worth individuals (UHNIs):
Individuals who have more than Rs.25 crore investible surplus are called ultra-HNIs.
Non-resident Indian (NRI) Investors:
Non-Resident Indians invest in an Indian private limited company. NRIs can make a direct investments in a private limited Indian company without needing an approval from the Reserve Bank of India or MCA. NRI investment in an Indian private limited company is a growing trend. They can also act as founders and promoters right before the incorporation. The non resident Indians (NRIs), Persons of Indian Origin (PIOs), and Overseas Citizen of India (OCIs) are allowed to become the directors of a private limited company at any later stage. In case there are too many foreign resident Indians are on the board of directors, it is mandatory that least one investor should be resident in India. The small and medium enterprises in India can play the role of resident Indian director and join hands with these capital rich entities.
Asset Management Companies (Mutual Funds):
A Mutual Fund collect money from general public and many other types of investors by launching schemes from time to time. They invest this money into a variety of instruments. They provide high risk high return diversify investment portfolio in the context of equity investment. A number of mutual funds invest in private companies. Mutual funds also invest in initial public offerings (IPOS) if their bylaws permit.
What are the restrictions on mutual funds for investment in private business? No mutual fund scheme can make any investment in the unlisted shares of an associate company or a group company of its sponsor. They cannot invest in the shares issued by way of private placement by such companies. Even in case of listed companies, they can invest maximum 25% of the net assets. When it comes to unrelated companies, a mutual fund cannot invest for more than 10% of any company’s shares. They can not invest more than 5%-10% of the scheme’s NAV in a single unlisted equity for the open ended and closed ended schemes respectively.
In our context, there are two types of mutual funds important from the perspective of equity investment:
Equity mutual funds:
They are the mutual funds that invest only and only in equity.
Hybrid Mutual Funds
They are the mutual funds that invest in equities and other types of securities.
The various taxpayers as Investors:
Shares of a Private Limited Company can be issued to any of the following legal persons:
An individual;
Hindu undivided family (HUF);
A company;
A Limited Liability Partnership;
Any other Body Corporate;
An association of Persons; or
A body of Individuals
A minor (only through his/her guardian)
Investment trusts as Investors (REITs & InvITs):
REITs, a globally known investment vehicle, are beneficial to both investors and real estate industry. It provides an opportunity for investors to invest in properties which they would be unable to be invest otherwise. The investors stand to earn from both dividends (from rental income of the property) and capital appreciation.
How do investment trusts invest? They have to invest in at least 2 projects. Who can invest maximum 60% of value of assets in one project. Minimum 80% of their assets are commissioned and revenue generating properties. They can invest maximum 20% value in developmental properties, mortgage backed securities, listed/ unlisted debt of companies, equity shares of listed companies in the real estate or infrastructure sector.
How does investment trust function? An infrastructure investment trust is formed under the Trusts Act and registered under the Registration Act. A trust is basically an obligation or duty (under trust in its ordinary sense) attached for entrusting the ownership of property. An obligation is created by the author of a trust, accepted by the now owners (trustees) of property and owed to the beneficiaries. All this is captured in its constitutional document or trust Deed. In the context of an InvIT or REIT, the trust is created by the sponsor (source investor), the ownership of the property vests in the trustees and the beneficiaries of the trust are the unit holders. They are governed by SEBI regulations.
There are two types of investment trusts:
Real estate investment trusts (REITs):
They invest in real estate sector.
Infrastructure investment trusts (InvITs):
They invest in infrastructure sector such as transport infrastructure, urban infrastructure, rural infrastructure, health infrastructure, social infrastructure, etc. Largely the term infrastructure means a very heavy focus on civil engineering.
Investment bankers as the Investors:
Essentially, investment bankers are corporate financial advisors.
What Is Investment Banking? Investment banking is a specific division of financial services business regulated by SEBI related to the creation of capital for other companies, governments and other entities. They assist in large, complicated financial transactions. Investment banks’ clients include governments, companies, funds, banks, etc. The services they provide include Private Placements, Mergers and Acquisitions, sales & trading services, fairness opinions, structured finance, securitization, risk management, merchant banking, Public Trading of Debt and Equity Securities, Equity Research, asset Management, Security Analysis, Wealth Management, Alternative Investments advisory, Public / Government Finance advisory, International Investment banking.
What is underwriting? In the course of arranging capital markets financing for their clients, investment bankers typically undertake the underwriting of the deals. This means that they manage the risk inherent in the process by buying the securities from the issuers and selling them to the public or institutional buyers with a markup.
There are generally three types of an underwriting:
Firm Commitment Underwriting:
The underwriter agrees to buy the entire issue and assume full financial responsibility for any unsold shares.
Best Efforts Underwriting:
Underwriter commits to selling as much of the issue as possible at the agreed-upon offering price but can return any unsold shares to the issuer without financial responsibility.
All-or-None Underwriting:
If the entire issue cannot be sold at the offering price, the deal is called off and the issuing company receives nothing.
Qualified institutional buyers (QIBs) as Investors:
Qualified Institutional Buyers are the institutional investors who are generally perceived to possess expertise and the financial muscle to evaluate and invest in the capital markets. These institutional purchasers of securities are deemed financially sophisticated and are legally recognised by exchange boards to need less protection from the issuing companies than most public investors who invest directly. The listed companies raise funds by placing securities with QIBs complying minimum public shareholding norms in the form of equity shares or other forms convertible into equity (except warrants). They are not registered with SEBI as QIBs but are governed by its regulations. The mode for listed companies to raise funds from these investors is called Qualifies Institutions Placement (QIP).
Following investor are classified as qualified institutional buyers:
Mutual funds;
Foreign institutional investor registered with SEBI;
Multilateral and bilateral development financial institutions;
Venture capital funds registered with SEBI.
Foreign Venture capital investors registered with SEBI;
State Industrial Development Corporations;
Insurance Companies registered with the Insurance Regulatory and Development Authority (IRDA);
Provident Funds with minimum corpus of Rs.25 crores;
Pension Funds with minimum corpus of Rs. 25 crores;
Public financial institutions such as SIDBI;
NBFC core investment company (CIC) Investor:
The other variants of nbfcs are not permitted to carry out any kind of equity investment. CIC concept was promoted to avoid requirements of RBI compliances by the NBFCs formed for business group investments. Core Investment Companies, (CIC) are those companies which have their assets predominantly as investments in shares for holding stake in group companies but not for trading, and also do not carry on any other financial activity. They hold at least 90% of its net total assets on the balance sheet in the form of investment in equity shares, preference shares, bonds, debentures, debt or loans in the group companies. Their investments in the equity shares in group companies and investment trusts is more than 60% of its net assets. They can’t trade their investments except through block deals for dilution. They can undertake an investment in bonds or debentures issued by group companies, loans to group companies and issuing guarantees on behalf of group companies. Here, a group companies means the companies that can exercise at least 26% voting rights or appoint 50% or more directors in each other, directly or indirectly.
Hedge Fund Investors:
A hedge fund (or an investment safety fund) uses the funds collected from accredited investors like banks, insurance firms, High Net-Worth Individuals (HNIs), business families, and endowments funds, pension funds. Their per investor minimum investment requirement is INR 1 crore in India and USD 1 million in the Western markets. They have initial lock-in periods and monthly or quarterly withdrawl facility. They function as overseas investment corporations or private investment partnerships. They do not need to be registered with SEBI but they are regulated by SEBI and have compliance requirements similar to Foreign Institutional Investors(FIIs). They need not disclose their NAV periodically. They can invest directly in Indian stocks. Hedge funds are a type of alternative investment funds with a large initial investment. Hedge funds are classified as category III AIFs as per SEBI regulations. They are managed by fund managers whose fees is around 1% of the fund value per annum. Their managers tend to invest their own money along with the investors. Hedge funds can invest in long term and short term instruments. Income accruing to them is taxed at the fund level. Only to accredited investors can invest in them. They are not required to maintain very high degree of liquidity. They invest in a very wide variety of assets. Their investment strategy in equity is called long/short equity in which they go long and short on two competing companies in the same industry. A version of hedge funds, i.e. Distressed Hedge Funds are involved in capital restructurings for financial turnaround of companies.
Sovereign wealth fund (SWF):
An SWF is an investment fund which is primarily owned by the central government of a country. It sources it corpus from balance of payments surpluses, foreign currency operations, proceeds of privatizations, governmental transfer payments, fiscal surpluses, resource exports, etc. These funds invest in many financial instruments including equity in businesses in the home country or abroad. Sovereign wealth funds are typically applied for stabilization of the economy, projects for future generations of the country, payment of pension, investment in strategic foreign assets, acquisition of foreign companies, nationalisation of domestic companies, etc.
National Investment and Infrastructure Fund (NIIF) is India’s first & only sovereign wealth fund for infrastructure investment in commercially viable projects.
It has three entities:
NIIF Master Fund:
The Master Fund is an infrastructure fund with the objective of primarily investing in operating assets in the core infrastructure sectors such as roads, ports, airports, power, etc.
NIIF Fund of Funds:
The Fund of Funds invests in the various other funds managed by various other fund managers who have good track records in infrastructure and associated sectors in India.
NIIF Strategic Investment Fund:
Strategic Investment Fund invests in equity and equity-linked instruments in the core infrastructure sectors such as steel & cement.
Pension Funds
Pension funds are created out of the pension contributions employee and employers. They need good investment avenues to ensure that retirees receive promised retirement benefits. The rules governing their investment are highly restrictive. For many years this meant that funds were limited to investing primarily in government securities, investment-grade bonds, and blue-chip stocks. The percentage of the fun they can invest in equity instruments is very small. However, this is expected to change over time. Liberal investment norms for at least private pension funds are expected.
Fund of Funds:
As the name suggests, this fund is a combination of various Alternative Investment Funds. The investment strategy of the fund is to invest in a portfolio of other AIFs rather than making its own portfolio or deciding what specific sector to invest in. However, it should be kept in mind that Fund of Funds under AIFs cannot issue units of fund publicly.
Alternative investment funds (AIF):
The term alternative investment fund is used to contrast them with the mainstream investment funds. The mainstream investment funds such as stocks, debt securities, etc receive investments from ordinary individuals whose knowledge of financial investment and the risk involved in them is relatively poor. They need a lot of protection in the form of stringent laws governing their receipt and application. On the other hand, alternative investment funds source their investment from the entities that are deeply educated in financial investment. They need relatively lower degree of regulation when it comes to how they invest the funds.
How do alternative investment funds operate? AIF can be established in the form of a company or a corporate body or a trust or a Limited Liability Partnership (LLP). Private equity (PE) and venture capital (VC) are the most popular AIF followed by real estate funds; hedge funds come as distant fourth. They are categorised in three types by law.
Following is the classification of alternative investment funds:
Category I AIF:
Funds which invest in StartUps, Small and Medium Enterprises (SMEs) and new businesses which have high growth potential and are considered socially and economically viable, are part of this category. The government promotes and incentivises investment in these projects as they have a multiplier effect on the economy in terms of growth and job creation.
Following are the types of category I AIF:
Venture Capital Fund (VCF)
Infrastructure Fund(IF)
Angel Fund
Social Venture Fund
Category II AIF:
Funds investing in various equity securities and debt securities come under this category. All those funds that are not described under category I and III by SEBI, fall under category II. No incentive or concession is given by the government on investment in these funds.
Following are the types of category I AIF:
Private Equity (PE) Fund
Debt Fund
Fund of Funds
Category III AIF:
Funds which aim at short term returns fall under this category. They employ various complex and diverse trading strategies to achieve their goal of short term capital appreciation. There is no specific incentive or concession given by the government on investment on these funds as well.
Hedge Fund
Private Investment in Public Equity Fund (PIPE)
Foreign direct investor (FDI):
All these varieties of funds for investment entities can be of foreign origin for foreign registration. Investment by them in a Indian company is called foreign direct investment.
There is a specific reason why Apohan has listed all these type of investors exhaustively here. A typical small and medium enterprise owner always thinks that there is a great shortage of capital. He is in despair after not getting good quality response from the bank. Apohan believes that a technocrat businessman should prepare a viable business plan without an assumption of capital constraints. They should focus on the core business of generating value. There is a wide variety of investors in the market to Cater to almost all kinds of needs. Apohan carries out professional, end-to-end, customized consultancy services as it understands the investment philosophy & process of all of these types of investor M&A deals. Apohan manages the transaction right from the problem identification phase, to the closure of deal with perfection.