A private equity investor accepting an exit for a pre-agreed return on investment is the exit of last resort, that is, the bare minimum expectation of this investor. They want more, a lot more – as much as possible.
PEs provide permanent capital by buying equity into your business, therefore continuing to exist even after you may have achieved the goals for which you had raised this financing.
- By Anirudh A Damani
A recent Dun & Bradstreet survey indicated that 82 per cent of Indian MSMEs got negatively impacted by the disruptions caused by COVID-19. Even with the steep decline in the number of new COVID-19 cases, the psychological impact of the second wave will be more profound and broader than the first one, especially on MSME business owners. Last year, the Modi government had announced a Rs 50,000 crore Fund-of-Funds, with a Rs 10,000 crore investment by the government to facilitate the flow of equity to 25 lakh MSMEs. CII data credits MSMEs for 45 per cent of our exports and providing employment to over 12 crore people. Undoubtedly, ensuring their survival and success is a crucial element of the $5 trillion economic dreams promoted by the Prime Minister.
The Fund-of-Funds announcement was met with enthusiasm by all sections of the business diaspora. However, the government expected the remaining Rs 40,000 crores of equity capital to get invested by venture capital (VC) and private equity (PE) firms. Promoting external participation in a fund like this is a smart move as it ensures the professional and transparent disbursement of funds.
In an environment where MSMEs are perennially starved of any form of capital to fulfill their growth ambitions, MSME owners would be eager to bring in professional money. However, I wonder if MSME owners would appreciate the bells and whistles such capital brings with it. It is vastly different from the debt they might have received from a bank or an NBFC. This money has very different expectations.
For starters, banks or NBFCs provide “temporary capital” in the form of term loans, overdraft facilities or invoice discounting options, and so on. Once the goals for which you raised this money are met, you can return this capital with the pre-agreed interest rate and move on to bigger and better things. However, private equity investors provide permanent capital by buying equity into your business, therefore continuing to exist even after you may have achieved the goals for which you had raised this financing. A private equity investor accepting an exit for a pre-agreed return on investment is the exit of last resort, that is, the bare minimum expectation of this investor. They want more, a lot more – as much as possible.
Therefore, while we are as greedy as can be with our expectations of ROI, private equity investors bring a lot of good things to the table despite the dark and dubious picture I might have just painted of our kind. We (VCs and PEs) actively participate in growing your business and act as a sounding board for your business challenges. Besides, we bring in structures to professionalize the running of your business, and when required, we utilize our Rolodex to open doors for business or new rounds of financing. There is a whole lot of good, but not every company can accept our capital.
While we are co-owners in your business, we are not co-operators in your business (in most cases). Therefore, the introduction of our money in your balance sheet brings in the segregation of owners from the business managers. The manager reports to the owners even if the manager is sitting on both sides of the table. The manager could get removed but continue as an owner and enjoy the business’s profits despite not running it on a day-to-day basis. This segregation of the owners from the managers is a fundamental one since the introduction of venture capital. Still, it continues to confound entrepreneurs, even those that are on their fourth or fifth venture or what one would call a “serial entrepreneur”.
Not understanding the caveats brought on by external investors, however, does not allow you to ignore it. So here are some pointers on using this equity and how to prepare your business for private investment.
- Use private equity for chasing growth: Remember that this is the most expensive form of capital for your business. Using it in areas that will provide an ROI lower than the cost of this capital will be detrimental for your business. Invest this capital wisely and in the business verticals that would give higher returns than the cost of that capital.
- Institutionalise your operations: Every external shareholder of your company can question how you run your business. It could be a jarring experience for you if you or your business are not prepared. Instead, use this opportunity to bring in professional management, run the business on SOPs, KPIs, and KRAs. Create and empower a second line of leadership by creating reporting clear structures to showcase that you are not a one or two-person show.
- Transparent reporting: A common issue that irks private investors and keeps them from investing in MSMEs is their dubious recordkeeping. You must provide accurate and periodic reporting to your investors in a mutually agreeable format. The data is essential in our reporting to our investors (remember we manage third-party capital). Therefore, we stand to lose their faith in us if there is an error in your reporting. Also, it is practically impossible for us to provide accurate or honest guidance, feedback, or help if the numbers getting analysed are incorrect.
- Separate your personal expenses from your business expenses: When running the show independently and without external ownership, utilising a company asset for personal reasons was acceptable (even if not advisable). However, these activities must stop because company assets are co-owned by its shareholders. Using co-owned assets for personal use is not acceptable to private equity investors. Therefore, that car in the name of your company but is utilised for driving around your family, must go.
- Removing any conflicts of interest: A family-owned business will make certain concessions on its profits if it “sets up” an extended family member or friend to support their respective families. With external ownership, these relationships should be kept at arm’s length or should be reported to the investor when conducting their due diligence. Most private investors would not want to upset your business flow unless (in the investor’s eyes) the cozy relationship is significantly hurting your business. However, you must be open to make changes to the relationship or change the relationship if it becomes a tricky point between you and your investor(s).
Anirudh A Damani is the Managing Partner at Artha Venture Fund. Views expressed are the author’s own.