Entrepreneurship is on the rise in India. Private Limited companies are now regulated by the Ministry of Corporate Affairs and created by a small number of shareholders. Herein, the want to invest in startup companies is on the verge. However, while we have heard of public investment, investing in private companies has limitations. As per regulations, investments in private companies are solely possible through SPVs, ETFs and mutual funds.
This article discusses how to invest in private companies and the different techniques to consider.
What are the different options for investment in private limited companies?
Investing in public forms is typical compared to private limited companies. The investment primarily depends on the development stage. Each phase of investment is referred to by different terms, which include:
- Angel Investing: It includes receiving funds from friends or family, wherein the company is called an angel firm.
- Venture capital: It includes a group of investors coming together to offer growth capital with good knowledge of operational assistance.
- Mezzanine investing: It includes equity and debt, where the debt is converted into equity if the company cannot meet the payment obligations.
- Private Equity: It includes prominent players with a significant turnover of around a trillion dollars.
How to Invest in Private Companies?
It is to be noted that no individual can directly invest in a private company. Instead, third-party investment in private companies is possible through different arrangements. It is carried out in three ways:
- Investing in startups where you are directly known to the founders
- Investing in mutual funds and exchange-traded funds (ETFs), the companies have themselves invested in private companies.
- Investing through private equity and investment firms tend to invest directly in private firms.
What are the options for third-party investment in private companies?
1. Investing through loans and advances
It includes investing through advances and loans, a secured form of investment that enables investors to get regular income via interest. The loan can be extended either by the company’s director or the director’s relatives. These include
2. Convertible Notes (CN)
Convertible Notes are debt instruments offered as loans. It is issued only by startups that are recognised and DPIIT registered. While they are initially issued by debt that can be repaid by the CN holder. The USP of CNs is that they are convertible into equity shares within five years from the date of issues. Only companies over 10 years and annual turnover of INR 100 Cr or minimum investment of INR 25 lakhs can issue CNs.
3. Investing through debentures
Debenture investments are a safe option for third parties to invest in a private company. People can either invest by converting debt into equity or in the form of non-convertible debenture, where it is impossible to convert equity from debt. These include:
4. Compulsorily Convertible Debentures (CCDs)
CCDs are securities (hybrid) that although issued in the form of debts are converted into equity shares by the issuing company. These are securities that can be issued by private limited companies but cannot be used as share capital. Herein, the shareholders do not hold any right to vote, enjoy interests until the conversion takes place and it can be issued to domestic and foreign investors.
5. Investing through shareholding
Third parties can raise capital in a private firm via personal connections with company members such as directors, promoters and others. These include:
6. Community Stock Option Pool (CSOP)
CSOP are financial rights such as equity shares without any voting rights. These are issued as contractual agreements between investor and startup to assist investors benefit from SARs (Stock Appreciation Rights) issued by the Startup (private limited company). They can be redeemed as cash buyouts or transformed into equity in case of merger and acquisition, secondary buyout or IPO. Additionally, it does not provide voting rights to investors nor dilutes shareholder’s existing ownership.
7. CCPs (Compulsory Convertible Preference Shares)
CCPs are defined as fixed dividends converted into equity shares within a predetermined event of not over 20 years. It is most preferred by investors as it enables paying dividend to preferred shareholders either common shareholders or senior to equity. In addition it also prioritizes the event of liquidation. Furthermore, CCPs do not dilute founder’s equity shareholding, can be issued to both foreign and domestic investors. Additionally, the dividends herein are fixed and paid to investors in priority with the company’s equity shareholder.
8. Investing in Stock Appreciation
Stock appreciation enables private companies to share bonuses with the management or employees if there is a rise in profit. In simple words, it allows employees to benefit from stock price appreciation.
9. Investing in Simple Agreement for Future Equity (SAFE)
It is an equity derivative contract to convert initial capital into future stock of the company as per contractual conditions and terms listed. It is often preferred by startups compared to CNs. In addition, it does not include any maturity date or date for conversion. Other USPs include zero interest or dividend rights, no voting rates for investors and neither does it dilute the ownership of existing shareholders. Additionally, the dividends can be paid only after the conversion.
Benefits of investing in private companies
- Investors investing in an established company enjoy the chance of getting higher returns compared to a startup firm.
- It allows investors not to pledge personal assets, make monthly payments, or compound interest.
- Private companies include a vast network of business owners who assist in solving business issues by building newer models, navigating economic issues and developing strategic alliances.
Prerequisites for Third party Investment in a Private Limited Company
Some of the prerequisites when investing in a private limited company include:
- The overall liability solely depends on the capital invested and the corresponding amount
- The investor cannot attach their personal property or assets while collecting debts from the firm
Essential Aspects of Investment in a Private Limited Company
Investors must consider the following points before investing in a private limited company. These include:
- Invest in a startup company heightens the risk of yielding lower returns
- Those who have invested through purchasing shares get the opportunity to control the operations and decisions based on the shares purchased
- Investing through debentures provides a higher chance of security for the principal amount
- It is essential to analyze the liquidity to convert it into cash
- Taking the assistance of a financial advisor enables in getting a better idea of different types of companies and investment techniques
Third-party investment in private companies is much easier now by getting accurate guidance regarding the various options. Good insight into the different investment options, their advantages and the points to consider before investment will assist in making wise and calculated decisions.
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