Enterprise technology companies: Raising capital in the private vs public market

Authored by Sandeep Gogia, Managing Director - Investment Banking, Equirus

The enterprise technology market in India has witnessed remarkable growth and has emerged as a thriving industry in recent years. With its robust technological infrastructure, skilled workforce, and conducive business environment, India has become a global destination for both technology services and product companies.

Technology services companies are typically cash-rich and do not generally need capital for their organic growth needs i.e., hiring a senior delivery professional or a senior business development executive or for working capital purposes. Product companies typically need to raise capital to support product development costs, carry out POCs, and market their product before they earn their first dollar of revenue. While the journey and the related challenges for both product and service companies typically differ, there comes a point in time wherein these companies struggle to scale beyond a certain threshold and/or the founders look to take some chips off the table by diluting their equity.

For an enterprise technology company founder willing to give up majority stake there is an option to go for an M&A and sell the company to a larger strategic player. Alternatively, the founder can dilute the stake to Private Equity and raise capital for acquisitions and/or grow aggressively organically by investing in an onsite sales team and funding the marketing initiatives.

CURRENT MARKET TRENDS

The funding winter that started in late 2021 continues wherein investors have become highly selective with their investments. Indian companies raised USD 3.8 billion in the first half of calendar year (CY) 2023, falling by a massive 36 per cent as compared to the fundraising in the first half of CY 2022. Investors are now keen on making investments in companies that are profitable. This has pushed investments into enterprise tech companies over companies with a B2C business model. B2C businesses require a lot of investment capital before they break even and hence are risky investments during a market downturn.

The public markets are robust as they are more forward-looking in nature as compared to the private markets. The Indian stock exchanges have globally witnessed the highest number of IPOs and stood eighth in terms of issue proceeds so far this year. So far in CY 2023, there have been 173 Public issuances (IPOs and FPOs) amounting to USD 6.5 billion in issue proceeds, whereas in the same period last year in 2022 there were only 108 Public issuances amounting to USD 6.0 billion. Moreover, there is a strong IPO pipeline with 13 companies filing DRHPs in Q2 CY2023.

FACTORS TO CONSIDER FOR PRIVATE VS PUBLIC EQUITY CAPITAL RAISE

Broadly the company has two main sources of Equity Capital:

1. IPO/Public Markets
2. Raise Capital from private funds: Venture Capital and Private Equity

Which source of equity capital is suitable depends on several factors. Some of these key factors are listed below:

1. Company Size: The company must be of a certain size and scale to be eligible for a public listing as the minimum post-issue paid-up capital must be at least Rs 10 crore and the minimum market capitalization of the company shall be Rs 25 crore. Also, typically institutional investors show interest at a market cap of at least Rs 2,000 crore. There is no such requirement for a private market transaction, every private investor has varying preferences for company scale and cheque size or ticket size of the investment.
2. Control: While post an IPO the company will have several minority public shareholders the promoter typically continues to call the shots and has reasonable control over the company’s strategy and daily operations. In the case of a large dilution to a private investor, the promoter ceases to have the same level of control over the company as the investor typically gets a board seat and is actively involved in the company’s strategy. Hence an IPO may be better suited for a promoter that wishes to stay in control.
3. Market Conditions and Investor Appetite: It is important to analyze the prevailing market conditions and investor appetite. Capital markets are influenced by economic conditions, market sentiment, and interest rates among other factors. Though private and public markets are typically impacted by the same factors there can be a disconnect in investor risk appetite between the two markets. Currently, we are witnessing a bull cycle in the public markets with several companies listing successfully whereas in the private markets, the funding winter continues.
4. Valuation: Typically, companies can fetch a higher valuation in the public markets given that the company’s valuation is decided basis its future prospects using a two-year forward price to earnings multiple. Also, a public listing ensures a higher degree of compliance and governance is in place along with regular reporting of financial performance which leads to greater investor confidence.
5. Flexibility of use of proceeds: A company going public is required to report the breakup of the use of the proceeds in the DRHP and ensure it does not deviate from the same. While a private investor may have some clear preferences in terms of the use of funds the requirement is not as stringent as in the case of a company going public.
6. Timeframe: Funds can be raised from a Private Equity Fund much faster as compared to going Public. Capital markets, especially IPOs, involve more extensive regulatory and compliance procedures, which can result in a longer timeline. Typically, an IPO process takes 6-8 months from the time a company hires Bankers and the Legal Counsel whereas a Private Equity Funding round can be completed in a matter of 3-5 Months.
7. Investor Expertise and Contribution: A Company must also consider the expertise and value-add that investors bring beyond capital. Even though a Private Equity fund is considered a financial investor it often provides industry-specific knowledge, operational expertise, and strategic guidance. Whereas institutional investors in an IPO are purely financial investors.
8. Regulatory and Compliance Requirements: The associated regulatory and compliance obligations vary significantly. Capital markets involve rigorous regulatory requirements and ongoing compliance obligations. It is key that the company has an in-house Company Secretary and Chief Financial Officer when undertaking an IPO. PE funds may have their own contractual requirements and detailed reporting obligations.
9. Transaction Costs: The cost involved in raising capital via the public markets is substantially higher, typically 6-8 per cent of the overall funds raised in the IPO. These costs include paying the Investment Banks, Lawyers, Regulatory authorities, Diligence agencies, regulatory advertisements, and stock exchange fees amongst others. Whereas the costs involved in raising capital in the private markets are generally 2-5 per cent depending on the amount of the capital raised and include only the fees of Investment Banks and Lawyers.
10. Tax Consideration: A promoter looking to dilute equity will incur different tax rates in the primary market vs the secondary market. In a private market transaction, the promoter will incur long-term capital gains tax at a rate of 20 per cent (plus applicable surcharge and cess) whereas when the promoter sells a stake via an OFS (Offer for Sale) transaction as part of an IPO the promoter will incur tax at a rate of 10% which is the applicable LTCG on listed equity shares.
11. Follow On Stake Sale: Post an IPO the promoter can dilute further stake by undertaking a block deal which is simply selling shares to institutional investors in the open market. These transactions can be executed easily without any contracts being executed or regulatory requirements. Whereas selling an additional stake in the Private market will require the promoter to comply with various terms such as pre-emptive rights of existing investors and negotiating a term sheet and binding agreement all over again with new and/or existing investors.

ROLE OF AN ADVISOR

Raising funds can be a tedious task to navigate without an advisor. It is important to have an advisor who represents the company’s and shareholder's interests and who can prepare the company and the shareholders for the process. For instance, the advisor will assess the important aspects of the investor fit and the market sentiment upfront and advise the company on narrowing down on the most beneficial form of capital. To ensure an efficient process and timely transaction completion, a specialized advisor is needed who can guide on the above points. An Advisor who can offer both Private Market Fundraising and Equity Capital Market services can provide unbiased guidance on what is most suitable for the company and the Founders and help navigate them through the process.

Disclaimer: The opinions expressed above are personal and may not reflect the views of DSIJ