INTRODUCTION
There are numerous advantages of equity funding over debt funding for a business. It available in any difficult financial situation, in any amount with no requirement fixed, guaranteed, periodic repayments or no requirement of any security! They are based on the growth potential & merit of business!! But still debt funding is much more popular than equity funding in Indian business finance market. We typically see that apart from the founders & promoters, there is hardly any third-party equity funding in traditional SME businesses in our country. Private equity funding is a rage among the startups. Even if the failure rate of startups is as high as 95%, abundant private equity/ venture capital is available for them. Then, what is the reason that equity funding is not common among the long-established small and medium-sized business?
Equity funding for SMEs is an neglected area & they are many reasons why businesses remain stagnant for years, make losses, fail or even get liquidated but don’t approach the equity investors in time who can salvage the situation. Good profit making companies where internal accruals are insufficient can realize their fullest growth potential through equity funding. Companies that are intrinsically viable but which are defaulting, loss-making, NPA, insolvent, etc due to liquidity issue due to some misfortune or business error, can achieve a financial turnaround and again reach the past glory.
We can see that the equity funding market (for unlisted entities) is in rudimentary stage, especially in SME segment. Apohan is going to play a significant role in changing this scenario!!! We have analyzed for you the reasons why equity funding funding is not popular in India SMEs.
THREE TYPES OF BUSINESS PARTNERSHIP FAILURES
The lower degree of equity funding interest is due to three stages of possible failures which are given below. They are the measure reasons for lesser M&A activity in Indian business world. However, please note that these reasons are universal & not specific for SMEs.
Merger and acquisition deals can be said to have failed in three senses:
1. FAILURE OF DEAL CLOSURE:
In this type of failure, two highly synergistic businesses reach advanced stage of communication and negotiation for equity partnership. If the deal would have succeeded, it would have been a great venture. However, the parties fail to reach a successful M&A deal due to disagreement on a few aspects (of valuation or investment contract) and the possibility of their coming together ends. This is like pre-natal mortality.
2. FAILURE OF HARMONY BETWEEN MANAGEMENTS:
In this type of failure, the two companies come together and close a deal. The transaction ends successfully meeting the expectations of both the parties in terms of conditions of the contract as well as valuation. The investment is made by the investor. However, the two managements don’t gel together for the formation of an efficient and effective leadership. There is a conflict between the management representatives from the two pre-alliance companies. Thus, the companies that came together cannot take advantage of the synergies. The business loses value due to bickering in the top people. This is like infant mortality of a deal.
3. FAILURE OF MERGER INTEGRATION:
In this type of failure, the transaction closes successfully. The managements of the two companies come together effectively and efficiently with a great degree of harmony post alliance. However, the operational, manufacturing, technological, market access related, human resources related synergy that were expected by both the parties in the beginning do not get realised. The managements of the two companies might have gelled together very well, but the shop floor level staff would not, marketing teams would not & technologies and IP would be found not of much use and so on. Four & four adds to seven & half, not even eight; forget 10! This is like adolescent mortality.
Hence, it is important that strategic, long-term alliance is done carefully & with diligence to avoid all kinds of failures. Your M&A consultant must have that vision!
LACK OF AWARENESS OF THE ADVANTAGES OF EQUITY
Equity funding has several advantages once it is obtained. There is no regular payment of interest or any return. This leads to no burden on the cash flows of the companies and management of working capital. (Exception: cumulative dividend on preference share). There is no requirement of repayment of the capital. (Exception: Exit clause). The business has to share its fortunes with the equity investor. The equity investor bears all the risk and liabilities of the company in the same way as the original promoters bear. Equity investors provide the money based on the merit of the business and not any rule book like the banks. Equity funding is available even in the case of financial distress if the business is intrinsically viable upon turnaround. There is no limit on how much amount of equity can be made available; it depends upon the requirement of the new project or new initiatives. There is no requirement to provide any security or personal guarantees. There are many benefits of to businesses coming together exploring the synergies of each other such as marketing infrastructure. But unfortunately, many Indian small and medium enterprises are not aware of the multiple advantages of equity funding versus debt funding. On the other hand, they are aware of the procedural complexities and sharing of control. A company should systematically structure its capital to be a financial safe, profitable, table, sustainable organisation.
ABSENCE OF AN ORGANIZED EQUITY MARKET
One of the major reasons for very small number of deals in equity funding is lack of awareness of equity transactions among the SMEs. Most of the first generation or second generation businesses are simply not aware of institutional equity funding. The wave banks have physical presence and a wide network of branches, there is no similar market for equity funding. The deals happen in isolated pockets. Businessmen can’t approach equity providers like they can approach a bank for a loan. They only look at listed companies on stock exchange & think it is too complex (and the only?) a way of getting equity!
However, there is a very wide variety of equity investors for worthy private businesses! In fact, there is too much money chasing too few quality opportunities! Also, now a days, there are several platforms connecting investors & financial intermediaries and the experienced M&A professionals have a quick access to them.
LACK OF BUSINESS GROWTH APPETITE
Many Indian SMEs remain small for very long period of time and they don’t grow into very big multi-location, multi-product, multinational conglomerate listed companies. Many operate more like shops, contract manufacturers than sovereign businesses. Here, the promoters are typically first generation businessmen. They have very high technical & technology skills. They have deep product knowledge. They have very good operational knowledge for running the business functions. They have very wide network of suppliers and human resources, etc. They have a very wide client network. They know how to make & sell existing or new profitably.
Now, the market always throws open many new opportunities of growing the business. These businessmen are very much confident & capable of tapping those opportunities as they have all the relevant skills & client network. But capital is the problem! The internal accruals from the business are very limited. There is no possibility of additional loan from the banks as the amount of bank loan is dependent upon the existing wealth of a businessman to be given as security. So what happens? The opportunity is tapped by someone else. This results in formation & rise of a competitor in the market in the future & the business stagnates.
So long as expected return on investment can be generated, a business should take all possible resources of funds including equity fund to avoid creation of one’s own competitors.
INSIGNIFICANT & RISKY SEGMENT FOR PRESTIGIOUS M&A ADVISORY COMPANIES
The large or multinational strategic advisory companies/firms (Big 4) have their own filtering criteria in selection of equity business sellers. There, the small size of a business is a big hurdle. Again, small could mean a turnover of around INR 200 crore too! Note that the average deal size (not revenue!) in the organized M&A market is around INR 500 Cr! Their screening criteria are very very stringent. They do a rigorous risk assessment before engaging with the potential client . Hence, their services are not available for most small and medium enterprises. Their prices are very high and mostly unaffordable to SMEs. Equity funding can’t be provided on any online platform, it can only make connections; its process is in-person interaction intensive! Then, what is the solution for SMEs? There are many M&A professionals like CAs, CSes, business lawyers who provide services within their limited expertise & network which is generally not very satisfactory & successful.
However, there is rise in online media these days to fulfill this deficit. Apohan is one of very few integrated, custom, end-to-end, strategic M&A service provider for SMEs in India that serve SMEs.
LACK OF INVESTOR COMMUNITY ACCESS
Most of the first generation entrepreneurs are technocrats and have very poor (or none) network in the financial advisory industry or business investment industry. They are always occupied with finding new clients, managing operations. They are not aware of existence of a wide variety of equity investors. This leads them to believe that business capital is a rare commodity and there is no point in pursuing equity capital or business partnership because they themselves don’t know any suitable investor. So forget the organized market with valuation benchmarks, one gets an impression that there no buyer out there!
This lacunae can be filled in with engagement with expert, specialized consultants. There are around 25-30 main types of equity investors. They will networked with those in that specialization.
TOO MUCH ADVERTISING OF BUSINESS ALLIANCE FAILURES
One more reason for absence of prolific equity funding activity is the wide publicity given to failures of business partnerships, joint ventures, mergers and acquisitions and many other varieties of inter-corporate associations. What are the failures of business partnership their own reasons including absence of contract or poorly written contracts, the general market perception in India is that business partnership intrinsically is a difficult activity.
It is incorrect to blame the equity partnership concept for poor (or no) drafting of association contract!!!
CONFUSION IN CHOICE OF GROWTH & MANAGEMENT CONTROL
If we classify businesses based on their psychological orientation of the owners, we can see that there are two types of managements. One category of management is growth oriented and the other category of management is control oriented. The control oriented management chooses to remain stagnant, to grow slow and to remain introvert. The probability of suffering from a financial distress event of such businesses is very high. Except for the case where the majority from the other (or opposite?) shareholders’ group likely to take wrong strategic decisions in a stubborn way that would erode the value of the company, control of a business has only psychological value. The consultants to small and medium businesses are generally seen to be failing in explaining the accurate significance of control, leading to to many misconceptions. Growth oriented management would dilute its control but then simultaneously would achieve rapid inorganic growth. It is always wiser to eat a relative smaller fraction of a very very large pie than eating a substantial fraction of a very very small pie.
Apparently, there is no reason to believe that an equity partnership will destroy a business; basically because the parties have come together with the basic intention of growing together exploiting synergies of each other. There is another positive side to dilution of control as well. A lot of top management work, especially related to to financial management, can be delegated who is the director nominated by the investor making the life of technocrat businessman easier. It can be attributed only to the ignorance and misconceptions that businesses choose to remain unstable, small, and slow in growth rate without equity funding even if they have very very bright potential.
If proper, intelligent investment contract is in place, there is no reason why a business partnership should fail for management & corporate reasons!!!
REQUIREMENT OF DISCLOSURE OF CRITICAL BUSINESS INFORMATION
Another reason of lack of popularity of equity funding is requirement of disclosure of critical business information to the external parties which occasionally might be the competing companies. Indian businesses don’t seem to believe that mere signing of a non-disclosure agreement would guarantee security of the their confidential information.
SELLING BUSINESS – STIGMA NOTION
There is one more peculiar observation regarding mergers and acquisitions in Indian market among the small and medium businesses. Many businesses are found to see that availing equity funding is a kind of compromise with their image, reputation and ability to run a business. Having to sell a business, in full or part, due to financial distress (or to earn capital gains !!!) is seen as a weakness of a business. Also, many SME businesspersons take it below the dignity to answer the questions put forth by the investors during the process of due diligence, contract negotiation and valuation defense.
There is no difference in selling a product of a business & selling a business itself as a product on monetary front. And at least when it comes to developing a sense of stigma!!!
HECTIC DOCUMENTATION & INFORMATION COLLECTION
Equity funding requires hectic documentation and communication. And medium enterprises typically lack elaborate business plans, financial models, investor presentations, term-sheets, investment contract draft, etc. It might be a wonderful business with the wonderful management with wonderful growth potential, but how would an investor come to know all of this? Why will he be be convinced just because you claim so? Apart from the documentation for the process of mergers and acquisitions, accompany also must have all the internal documents of all its departments especially the key contracts. If a business is running in absence of well documented stakeholder contracts, an investor would perceive that the enforcement or continuation of the current terms and conditions may become difficult in the future. Another problem is that the business has to compile some new information by collecting widely scattered data in the company to answer the questions raised by the investor. Documentation is a serious hurdle in M&A initiatives.
But collection of information, compilation of documents, gathering data, etc also results in the company getting an insight about itself which was not though of seriously before the investor raised questions!!!
INTEGRITY OF ACCOUNTS
A lot of closely held private businesses always tend to show losses by manipulating the books of accounts save taxes or to keep away from the statutory requirements of compliances. This makes very difficult for the investor to buy the claims of high profitability or performance by the management.
We at Apohan, as a corporate policy, immediately close the relations if we come across any manipulation of accounts & siphoning of money during the course of interaction, document study or assignment.
POOR CONFIDENCE OR HOPE FOR GETTING EQUITY
One more interesting observation is made in case of Indian SME businesses. They do not seek equity funding because they think that the probability of getting equity funding is very very low or almost nil!!! Businesses witness that when a businessperson retires or resigns or exits from business life, the business is purchased by a similar business through a buyout agreement or share transfer agreement. The instances of dilution of control and ownership through issue an additional equity to unrelated third-parties is relatively rare phenomenon in India. Investment by financial investor, equity funds, foreign businesses for expansion of business is even more less.
There is wide variety of M&A transaction apart from 100% buyout, sellout & share transfer!!! Have a look at the wide variety of M&A solutions for different kinds of business aspirations & problems.
UNSUITABLE LEGAL FORM OF BUSINESS
Another reason for lesser popularity of equity funding is the constitutional setup of companies. Many proprietorship form of businesses see sudden growth opportunities and aspire to grow through equity funding. At this time, they are required to get converted to a private limited company. This has huge implications to continuation of experience, credentials, certifications, brand and stakeholder relations and contracts. A proprietorship technically cannot get converted into a private limited company. Hence, they have to obtain all the approvals, certifications, empanelments again in the new setup. Such kind of loss of legacy is not a very comfortable idea for any businessman. As if this was not enough, the assets of proprietorship are transferred to the private limited company are liable for payment of capital gains tax in the hands of the proprietor. If the proprietor is not able to give the transaction the form of a slump sale, the buyer private limited company would have to pay the GST on the entire current market value of the assets. This is a reason why mergers and acquisitions are not popular among the proprietorships.
The more the compliances, the more the varieties of investors you can tap!!! So get private. Understand the importance of strategic company secretary work!!
NO INDEPENDENT DIRECTORS & STAKEHOLDERS
In case of closely held or family owned private limited business, it becomes difficult for or a third party investor to trust the financials and past history of professional conduct of the company. Most of the Indian businesses to have very high resistance in inducting neutral, professional, competent, reputed, paid, third-party independent directors or professionals on their board. There is an absence of allocation of duties and performance measurement methods. A private limited business where the second shareholder and director is the spouse of the business person with no active role in the management or operations for decision making is treated as good as a proprietorship by an investor. The institutional private investors are required to be compliant with numerous types of regulations under various acts. If they are part of management of a family run one-man-show company, they would like that such director of the company does not create any problems after funding that would put the investment business itself in a danger. In many a case, this requirement of professional corporate conduct and fulfillment of compliance requirements is not happily greeted by small and medium enterprises. They want to keep it simple: make, sale, and earn profit!!!
An involvement of a third-part, neutral, integral individual in the management attracts investor interest!!!
INSUFFICIENT DEAL PREPARATION
A deal structure has several in elements: Corporate structure, contract structure, investment requirement, investment schedule, corporate process, mechanism of allocation, selection of instrument, valuation, type of contract, rights and liabilities, applications, approvals, opinions of stakeholders, tax structure, etc. Many a time, the directors of private limited company have not made sufficient preparation for how the the proceeds of the equity funding will be utilised for growth initiatives and new projects. The deal can’t evolve sitting with the investor. It has to have prior defined shape & practical options along with boundaries of terms of negotiations.
An investor will show serious interest only if a complete, consistent, well-studied, meaningful, practical offer is made!!! This is where there is importance of role of Apohan. We explain the business everything about M&A process right in the beginning removing his uncertainty stress.
RELIANCE ON AUDIT & TAX PROFESSIONALS FOR M&A WORK
The small and medium enterprises rely on their Chartered Accountants for many strategic financial decisions in which they have little orientation. Unfortunately, in India, the chartered accountants don’t act as a CFO of their client company. They carry out a postmortem role: Accounting, audit, taxation, compliances, reporting, filing, etc. They have lesser orientation in understanding the financial standing and financial potential of the business. Their role is limited to basic minimum compliances. On the other hand, many businessmen don’t tend to give strategic financing assignments to Chartered Accountants who are highly competent strategic finance to save consulting charges. The compliance charges are very low due to saturated market & they can’t be compared to risk based, success based expert work. Further, many Chartered Accountants don’t have all the requisite skills (legal, corporate, market, technical, to carry out their role in merger and acquisition transactions.
Only dedicated M&A companies with 360 degree M&A expertise & a wide network of investors should be hired!!!
LACK OF TIME WITH SME MANAGEMENT
Merger and acquisition is a hectic activity. It has a lot of documentation, information, data collection work. Apart from this, it involves a lot of meetings and communication. It involves lot many decision making exercises when several option are available or competing, similar offers are made by the counterparty. In most of the small and medium enterprises, a lot of work is done only by the promoters who do not find adequate time to to address the requirements of the rigorous merger and acquisition process. There is no second level managerial staff to support the directors in hectic, critical & intelligent work.
Merger and acquisition is not a process which you can initiate and letter ignore due to paucity of time.
COMPLEX CHAIN OF BROKERS & NO DIRECT ENGAGEMENT WITH M&A CONSULTANTS
Many SME businesses mistake the deal brokers for merger and acquisition consultants. Brokers are not able to carry out any scope of work in the hectic process of M&A. They have an invisible expectation of success fee (as a percentage of deal size) instead of finding fee or referral fee (a few thousand rupees). This increases the cost of M&A transaction if an agreement with them is made & that too exclusive! Further, brokers delay the process by engaging in prolonged negotiations for their own fees with M&A consultants, investment banker, investor representatives & investment institutions. Many a time, the chain of brokers, M&A Consultants, representatives of buyer companies and investors becomes so long and complex that they can’t reach an agreement on how they will share the Consulting charges and fees charged to the investor to the business. We have seen a chain of 12 people interested in brokerage/consulting pie which obviously couldn’t work! They have no standard templates of contracts and no principles governing sharing of scope and fees. Many are newbies & learn during transaction creating time gaps & mis-communications! Most of these brokers are knowing only one or two investors who might not be interested in the deal. Thus completely halting the process. Brokers look attractive problem solvers to SMEs as they agree for a “completely” success based contract with the business even for small size of investment. Since they have no role other than attending a few meetings, they are never at a loss. However, this leads the business person to believe that the merger and acquisition consultants seeking retainership fees are off-market, pricey and unaffordable. When brokers don’t solve problem for months together, businessman develops despair on utility of equity funding efforts.
The brokers increase cost of deal, they increase resentment among professionals who do all actual hardwork, they take wild profit for virtually no work & they delay (just don’t let it happen) the deals by increasing the number parties, their contracts, communications, etc!!! So check the competencies, credentials, expertise & network first before hiring brokers. Pay them fixed referral fees and don’t let it exclusive mandate.
NO SINGLE WINDOW M&A SOLUTION COMPANIES FOR SMES IN THE MARKET
The mergers and acquisitions consulting business require multiple kinds of skills: MBA finance professionals to lead all the activities, evolve a strategy, arrive at a deal structure; MBA marketing professionals who would understand the market, the marketing ability of the company, the client network of the company, and the marketing infrastructure of the company; chartered accountants who will carry out the accounting, taxation, compliances, valuations, financial models; company secretaries who will carry out the process of board approvals, shareholder approvals, corporate process; business lawyers who would carry out the process of obtaining Court approvals, legal due diligence, study of key contracts, investment contract; certified valuers could carry out valuations for tax purposes and from government perspective; engineers or technocrats or sector experts who understand the plant, machinery, process to name a few. Typically, in very large deals, a single agency carries out many types of roles. But, in the SMEs, the businessperson gets bogged down by sudden involvement of so many variety of experts hired by investors & or by himself. In India, it is not a practice followed by the consultants to explain the entire process in detail to the businessman right at the outset. Hence, something that is very common ordinary for the investors or consultants is a burdensome surprise for the businessman. Small and medium enterprises do not have sufficient manpower to coordinate scopes and outputs of all these kinds of experts. Unlike M&A consultants, the professionals have to paid entirely on work basis.
Always engage a full M&A solution company & not CA firm or CS firm or legal firm as the principle M&A consultants. Statutory works & strategic works don’t go together all that well!!! Hence, the a lot of work should be done by internal staff, CAs, CSes, lawyers, etc. The scope should be given carefully only after review by the M&A consultant. Fortunately, the cost of all this work is relatively very less as the strategy is done by M&A consultant only statutory part is to be done by the certified professionals Apohan would be a good choice where we not only have in-house experts but also we are associated with many M&A professional services firms. Preferably turnkey assignment should be given.
M&A COMMUNICATION IS DIFFICULT & COMPLEX
Mergers and acquisitions are very communication intensive. This kind of activity happens only once in the life of a business (hence difficult) and at the same time it is the routine course of life for an institutional investor. Every communication acts as good as a legal document.
M&A needs highly professional, legal & sensitive communication!!! You should consult the advisors before sharing documents or making commitments or agreeing to contract terms.
NOTION OF INFERIOR SIDE
Also, it is not necessary that the first attempt to approach an investor would be successful even if careful profiling is done. A business might have to approach a few investors to get a good deal. Experiences with the initial investors may set in certain kind of misconceptions in the mind of the businesspersons, especially psychological ones. Businesses seeking investment behave as if the transaction is between two unequal parties. Asking for money or seeking money his perceived inferior side of the table for absolutely no reason. This is not a very good example to cite but the investment seeking businessman acts as the “typical” Indian wedding host from the bride’s side though both the parties are equal in all ways. This also results in premature death of many deals, and more prominent more so where businesses are seeking turnaround finance.
You should take pride in selling a business at attractive price & terms!!! Need is equal for the investors & the businesses!!!
HIGHER TRANSACTION COST
Merger and acquisition consulting fees is generally perceived to be much higher than bank loan processing fees. There is standard set-up in banks. There is no custom study of business. Also, they take “the higher part of transaction fees” in the form of interest itself during the pendency of the loan. In M&A, a custom business study is needed to be done in the beginning itself. The work is entirely different for different businesses & different deals. There is no payment after the transaction is settled in any form such as interest on loan. Whatever cost has to be recovered by the consultants has to be by the end of transaction & hence it looks more. Also, the bank documentation is extremely standard whereas the documentation created by the M&A consultants is highly customised. SME businesses are put off when they hear the success fee levels of of equity transactions.
Also, a loan is like a friendship, it it easy to make & break. Relatively, equity funding is like a (Indian) marriage, hence the entry is very very careful & diligent. There is no recourse later! Exit is difficult & all risks have to be shared. Hence, the transaction study, documentation, time & cost is higher.
Businesses fail to appreciate that the bank does not collect all its processing costs as processing charges. A lot of processing & management cost is also built into the interest & there no such interest in equity.
RESISTANCE FOR ISSUING CONSULTING MANDATE
While the bank provides the capital as well as the documentation, the merger and acquisition consultants provide only consulting service and no capital (except merchant bankers). In absence of a M&A consulting mandate, it is impossible for M&A consultant to discuss investment proposal with the investor, forget arranging meeting & letter of interest. On the other hand, many SMEs unfamiliar with M&A business simply refuse to provide written mandate to M&A consultants unless they meet the relevant investor. It is impossible to get a relevant investor at the discussion stage as not many details of the deal are known! It becomes chicken & egg story. Business asks M&A consultant to first share the details of the investor & investor asks for the M&A consulting mandate. Nothing happens further.
Timely issue of consulting mandate is very crucial, especially in NPA & distress conditions. The companies which would have easily got equity in early stage of default becomes serious when the owners loses a lot of value in the business or when insolvency process starts in NCLT. This should be avoided.
NO APPRECIATION OF TIME-FRAME
M&A time-frame is 4-9 months depending upon complexity of the case & length of negotiations. Many SMEs want the M&A consultants to get the money in the company within 2-3 months. We have seen cases where wanted money in as short-time frame as 15 days!!! At the most, an in-principle okay is possible this much time-frame. Further, the time-frame for assignment is reduced by delaying the consulting mandate making it virtually impossible.
Time is essence. More time for M&A deal finds better partner. It gets higher valuation as well.
UNREASONABLE EXPECTATION OF VALUATION
A private limited business is a highly illiquid asset, even more illiquid than real estate. There is no standard market where the value of a business can be checked. Even if highly expert people are deployed, business valuation is highly debatable, contentious, subjective matter. A valuation can be done based on future cash flows, replacement value, valuation of comparable market asset, asset valuation, and multiple of financial performance parameters. Many businesses have no clue about the value of their business or the method how it is calculated. Valuation made for tax purpose or impromptu valuation is of no use. A proper financial model should be made.
The expectation of valuation of the business should be reasonable and rational. A deal should not broken for a minor valuation difference today, one should more focus on the greater value to be created in the future. The value of synergies & future advantages is way higher than minor valuation differences arrived by different methods & perspectives.
UNCLEAR EQUITY CONTRACT CONDITIONS
On a lot of occasions, a competent M&A consultant is hired successfully. The investor is identified, and both the parties seriously like the transaction proposition. Also agree upon the valuation, amount of investment, phasing of investment, extent of dilution of control, roles of the parties, etc. The deal gets stuck or fails altogether only because the parties cannot agree the rights and obligations under the investment contract.
A contract has to be equal & equitable with all rational & practical expectation. Also, one must bear in mind that business partnerships fail due to incomplete, inadequate & unprofessional investment contracts.
Author- Arun Joshi, Chairman & Managing Director, Apohan Corporate Consultants Pvt. Ltd., E-mail: arun.joshi@apohanconsultants.com
Author Bio
