In the life cycle of business, the promoters and founders face the puzzle of which path of fund raising is the suitable for them and their business. At the broad level, there are two ways- either debt or equity. The raising of debt has its own challenges and limitations. So, the preferred route comes to mind is equity. In case of equity, there are many options like IPOs, Private Equity or Venture Capital. In this article, let us explore the comparative analysis of these three paths and their suitability for a small and medium business enterprises:
Agenda of this article will follow as below:
- Basic understanding of these three paths
- Your business eligibility
- Cost of each path
- Control and dilution
- Time horizon
- Exit
- Suitable Path for you
Let us now explore in details:
1. Basic Understanding of Paths:
- SME IPO Path: SME IPO (Small and Medium Enterprises Initial Public Offering) is the path where your company’s shares will be listed on stock exchanges. On listing, the shares of your company will be purchased by the general public. As promoter, you will derive benefits on selling of your own shares at the market price and also there will be appreciation of the prices of your shares. There are dedicated exchanges like NSE Emerge and BSE SME enabling public to sell and purchase shares. You will be surprised that already about 700 SMEs are already listed. Any manufacturing, services, technology or infrastructure companies meeting the specified criteria can get their shares listed.
- Private Equity (PE): PEs are established intuitional investors who invest in companies with the cash flow positive business. They are basically big pension funds, sovereign wealth funds or High Net Worth individuals. They invest in the companies with a clear goal of certain percentage of Internal Rate of Return and plan for exit. In your business, they demand board seats and will decide major business decisions. Through contract, their rights are well protected. In case, you decide to follow this path, your freedom may be curtailed to a great extent.
- Venture Capital (VC): VCs are subset of broader PE set. They invest in early stage and growth stage companies. They search of companies with high potential but nil profitability at this stage. VCs are always seeking very high returns and their failure rate is very high. They invest in certain stages and with each stage, your stake gets diluted.
2. Eligibility of your business: First, you should evaluate own business profile:
- SME IPO:
- Minimum paid-up capital of your company Rs. 1 cr
- Business must be profitable for at least 2 years of the last 3 financial years
- Minimum 3 years of existence and operations.
- Private Equity:
- Revenue of Rs. 25 crores and more
- You should have strong EBITDA margin
- You business is scalable
- You have professional management team
- Defined exit time
- Venture Capital
- Your sector is high-growth technology or digital
- There is large addressable market
- Exponential growth is expected, even if present loss
- You have background and execution track record
3. Cost of each Path:
SME IPO: Explicit cost is anywhere between Rs. 50 lakhs to Rs. 1.5/ 2 crore. These costs relate to merchant banker, legal, exchange, registrar and advisors. There will also be annual compliance costs of Rs. 10-15 lakhs. The implicit cost will be your exposure to public scrutiny and quarterly disclosure and other governance issues.
PE: A PE fund has definite target of approximately 25% over say 5 years. They want their investment to grow to 3x over that period Their upfront cost is Rs. 25 to 50 lakhs mainly for the advisory.
Venture Capital: A VC fund needs around 30% IRR with 4X return. The VCs know that most of their investments turn into negative, so they demand maximum from the winners. This entails that your company must perform exceptionally well. The upfront cost is typically 10 lakh to 20 lakhs.
4. Control and Dilution:
SME IPO: You will still be holding dominant position after listing and will decide all important matters. You will appoint independent directors, quarterly disclose the required information and handle grievances of investors.
PE: You will enter into a Shareholders Agreement with PE. This agreement will have details of controls, the PE board seats, veto rights on defined matters, capex approvals etc. This will bind you in many ways. Your control and freedom is circumscribed. However, PE also brings their perspectives, networks, discipline etc.
VC: This funding path is the most restrictive for promoters. Each round of funding will bring new investor. The investors will decide most of the important things. They may even force you to sell your business to third party. There is intense pressure on the promoter to deliver the target returns.
5. Time Horizon:
Under SME Path, the timeline is mostly predictable from 6 months to 12 months. PE takes around 5 to 12 months assuming there is no hindrance in due diligence. VC route is highly vexing and unpredictable and takes around 6 to 18 months. Most of promoters time are consumed in the VC negotiation in this period.
6. Exit:
Under SME IPO, as a promoter, you remain in the company. Your wealth grows after listing. You remain focused on your business. In due course of time, you can sell shares in tranches, as per market prices. There is no need to retire or exit from your company.
In case of Private Equity path, the wealth is getting created for the funds. They decide to sell in secondary sale or strategic acquisition or through IPOs. You do not have control over the timeline or acquisition decisions.
In case of VC route, there is high risk. VCs decide timing for IPO or strategic acquisition. There is almost no say of promoters and they dictate the terms.
7. Suitable Path for you:
The answer for this question depends on you and your business
SME IPO: It is suitable besides fulfilling the eligibility criteria, your perspective on control and long-term wealth creation.
Private Equity: In case you need large capital for specific object and you are willing to accept the PE director’s involvement and defined exit plan, then this route is for you.
Venture Capital is suitable in case your business is at a very early stage in a high growth sector and you require capital to address the specific market requirements, then this route is suitable for you.
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In case you are at crossroad of deciding the funding path, have any concern and queries or need any support regarding fund raising, due diligence and valuation, you may like to contact us.
Abhinarayan Mishra, FCA, FCS, LLB, IP, RV; Partner, KPAM & Associates, Chartered Accountants, Dwarka, New Delhi; +9910744992, ca.abhimishra@gmail.com; www.youtube.com/@crossboradertaxindia
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