Most of the corporate law firms have their core practice area in Investment law. A lot of startups and scale make the biggest mistake which is they start too late getting into the funding process. We should consider some questions before selecting an investor: did you research that if he/she is in there for their financial gain or their main motive is to get you off the market or support their business model? Generally, it has been seen that many of the startups and entrepreneurs make these decisions quite recklessly thereby not considering the impact on the growth and business plan in the long run. For entrepreneurs, investment needs no introduction. Investment is the lifeblood of a startup. Every business needs capital to start their operations and to expand their capital and raising finance for business is an inseparable part of a business. Some businesses are financed by their founders and sometimes they are started with meagre capital.
TYPES OF INVESTMENTS
Now let us first see the different types of investments that are made into a company and the commercial motive of every type of investor.
This type of investment is made with an expectation of financial return in the form of internal cash flow from the company in which the investment is being made. For Example: In a manufacturing mobile company if a Private Equity investor buys a stake the motive behind this is to just gain the profits from the dividend paid out by the investee company or appreciation of the stake over the time which the investor is buying now. This is a financial investment which is opposite from the strategic investment as they look something forward to it thereby strategic investors generally offers higher price as compared to financial investors. Venture Capitalists, angel investors and private equity investors are the financial investors whose sole motive is just to gain profit from the dividend which is paid out by Investee Company and appreciation of the value of shareholding over time.
In the case of financial investment, the investors are not interested in running the business till the company is earning profits and they return their expected financial returns. If the financial investors find that the promoter is not suitable then he has the authority to appoint different managers to run the company. The investors rely on existing management or if they find that the existing management is not capable enough to run the company then they appoint different professional managers but never take the charge of management to them. Due to this reason, they always want the continued presence of existing management and never provide the exit rights to the company or promoters/ founders. They are also not interested in controlling the stake which is above 50% normally. Most of the investors put their priority to invest in a company rather than providing the exit to the existing shareholders. Generally, they do not purchase the shares from the existing shareholders rather they buy the shares from the company which is freshly allotted so that they can invest the capital in the growth of the company which is better for the health of the company as compared to providing the exit to the existing shareholders. Investors have a particular amount of time during which they recover their investment amount and in addition to the profit which they recover from the dividend which is paid by the investee company and exit from the company. For example, Venture Capitalists want an exit from the company in 5 to 6 years. Financial Investors make investments in several companies some of which go into losses and some of which may do extremely well. They try to protect themselves from the losses in an initial stage of investment as far as possible and ask for various types of rights from the promoters/ founders like the pre-emptive right, right of the first offer so that they can hold a bigger amount of stake in a company if a company does well in the future.
This type of investment is made by cash-rich Giant corporations like Softbank to comparatively younger/ smaller companies due to their business synergies. Sometimes smaller/ younger companies end up buying bigger companies for strategic reasons as well. For Example: If a mobile manufacturing company buys the retail chain of electronic stores they profit themselves by positioning themselves closer to a consumer in a consumption chain. It may be able to assure them to pay less commission in selling and better visibility of their brand. Similarly, Google bought Motorola so that Google can significantly benefit from having its own mobile hardware company which can leverage Google’s existing software company and their empire. Now, it has been evident from this that the motive behind this is not just to earn profits from the financial returns from the investee company instead of it to use the investee company the increase the profit of the investor’s company or sometimes by using the resources of the investor company to increase the profits of the investee company.
Facebook investment in Instagram and Whatsapp is another example of strategic investment. Facebook’s motive is to gain benefit from the business synergy of Facebook, Instagram and WhatsApp. At the same time, Facebook does not want Twitter to buy Instagram. Strategic investments might be undertaken to pre-empt the competitors from achieving higher efficiency or business synergy by buying the target company.
In the case of strategic Investment, Investors want to have control in management and run the business and even if they cannot have immediate control in management they can have some indirect control. Investors always try to have the controlling stake which is above 50% or merge with the target company. These investors may keep the existing management in place, absorbed, phased out or even fired. They generally pay a premium price and this is possible if they reap rich benefits as compared to financial investors. Strategic investors may bring relationships, ties ups, crucial expertise and market share etc that may provide businesses with a competitive advantage. Strategic investors generally provide an exit to the founders and existing shareholders from the company.
Author(s) Name: Tanya Gupta (New Law College, Bharati Vidyapeeth University, Pune)