Founders must not treat all investors in the same manner, and must remain dynamic in their approach towards them
Bharat Anand & Satish Padhi
Private equity investors and their portfolios do not always have aligned interests. Financial investors are concerned primarily with protecting investment value and realising returns on their investments. Portfolios, on the other hand, look at long-term continuity of business and freedom in operations, in addition to creating value. India’s economy has, for a large part of the past few decades, been positioned at the cusp of growth. However, regulations on foreign investment have been substantially relaxed only over the past few years.
The disparity between the rate of India’s economic growth and its regulatory evolution to support a free market has led to the demand for investment in Indian companies, especially early and growth stage investments, often exceeding the supply of willing investors. This market dynamic has encouraged investors in Indian markets to adopt protective, risk-averse positions, while finalising investment terms with early and mid-stage ventures. The investment documentation prevailing in today’s market largely reflects a considerable curtailment of founder freedom in operation and management of their ventures. The often times highly restrictive environment created for founders to run their ventures could force them to dedicate a significant portion of their time and attention to procuring exits for investors rather than the growth, longevity and diversification of their business.
This seemingly overbearing form of governance can be more pronounced and dangerous to the value generation potential of a venture when financial investors own significant holdings in a potentially competing venture. Such situations can present real and credible concerns to portfolios of a financial investor with the financial investor potentially playing ‘favourite’ by using its overarching governance and other rights in a manner that could be detrimental to one venture while benefiting another—where a clear value generation potential in the other venture can be identified, or that could force one venture to consolidate with the other, where there are considerable valuation gaps between the ventures.
The conflicting interests outlined above, in addition to restrictions that are placed on the operating freedom of founders, could contribute to distrust among founders and investors. Moving towards a more equitable realignment of interests: Founders of Indian companies are increasingly reconciled to two fundamental truths about the Indian investment market. First, a significant investor, though necessary to fuel growth and development, could be detrimental to long-term longevity and adaptability of a company’s business. Second, founders need to prioritise investors that are strategically aligned with the long-term vision of founders, than purely on the size of the cheque an investor is willing to cut.
A careful study of the current private equity market will show that founders are increasingly leaning towards recognising the investment philosophy of an investor as an important yardstick than only its ability to make financial commitments. This trend has also impacted the nature of rights founders are willing to grant investors. Founders must not treat all investors in the same manner, and must remain dynamic in their approach to investors. While the need for capital would perhaps be the leading factor for choosing to partner with one investor over another, it is important for founders to evaluate all potential investors and be well-advised of their varied natures and investment philosophies.
It is important to segregate investors that are perceived as being financially-aggressive and control-oriented from investors with track records of strategic alignment and support to founders. The investment documentation with such investors would also vary based on the above segregation. By minimising investor control, particularly negative control by a sole investor or a small group of investors, implementing a more democratic scheme of governance, and most importantly, retaining operational control of their ventures, founders can ensure they have the freedom to execute their visions for their respective ventures and work at generating value for all stakeholders involved (and not just their investors).
A softer consequence of founders taking an active interest in the protection of their operating freedom and resistance towards a single investor with unchecked discretion is the perception that forms about the resolve shown by founders in the protection of their business ideas. Implications for the Indian market: Recent trends described above should result in significant long-term benefits for Indian market. A focus on value generation and preservation should result in a healthy market and improve overall investment footprint in India.
A demarcation of rights between investors and founders should also ideally counterbalance the growing deregulation of foreign investment in India. From an investor’s perspective, although this practice ostensibly increases the immediate level of risk, long-term benefits that should accrue to ventures that are able to realise their full potential will likely incentivise investments. Rather, the focus of investors would be on backing founders with a certain pedigree and align their interests with those of the other stakeholders in their portfolios.
Bharat Anand is partner and Satish Padhi is associate, Khaitan & Co