Growth Equity: Minority Capital Into a Scaling Business

Growth equity is a minority investment in a company that is already working, usually subscribed for new shares so the money goes into the business rather than to a departing shareholder. A minority holder cannot make the company do anything. A minority holder can stop a listed set of decisions, can ask about everything else, and before signing can walk away.

A minority holder's whole position rests on one contract, and that contract has a date. Before the date the holder can require almost anything. The alternative is that the money never arrives. After the date the money has arrived and cannot be pulled back out, so the holder has exactly what the document says and nothing more. Every practical rule about minority investing is a consequence of that single asymmetry, including the rule that a wish is worth nothing and a condition is worth everything.

The shape of this is familiar from ordinary life. Before the deposit on a rented flat is handed over, the tenant can ask for the leaking tap to be fixed, the lock to be changed and the walls to be painted, and the landlord has a reason to say yes to all three. The morning after the money is paid and the tenant has moved in, the same three sentences are requests. Nothing about the tenant's case got weaker overnight. The tenant no longer holds the one thing the other side wanted.

Every figure in this guide belongs to Nilgiri Growth Partners Fund II, an invented closed-end growth and buyout fund managed by Nilgiri Alternatives Advisors Private Limited. The fund is settled as a trust, with Nilgiri Trusteeship Services Private Limited as trustee and Nilgiri Financial Holdings Private Limited as sponsor. In this arrangement the role that the imported global vocabulary calls the general partner is discharged by the manager and the trustee between them, and the contract is a trust deed and a contribution agreement rather than a partnership agreement. The fund made nine investments. Four are control positions and five are minority ones, and the worked case throughout is holding 4, Bhavani Speciality Chemicals Private Limited. Every figure for the fund is stated as at its record date, the end of Fund II Year 9 Quarter 2, 8.50 years after its final close.

What is growth equity, and how is it different from a buyout?

Two things at once, and both have to hold. The first is the stage of the company: it is already trading, it already has customers paying it money, and it is growing. The second is the size of the stake: the investor takes a minority positionA stake carrying less than half the votes, so it cannot carry a decision alone., meaning less than half the votes, so it cannot carry a decision on its own. Drop either condition and the transaction has a different name and a different set of problems.

Consider a sweet shop at the end of a street. The shop has three branches, a queue outside each one at six in the evening, and a proprietor who knows that a fourth branch would work but cannot fund the deposit and the equipment out of what the first three throw off. Money into that shop, in return for less than half of it, is the shape of growth equity. Money into a shop that exists only as a drawing and a licence application is a different subject, covered separately, and buying the whole shop from the proprietor so that the buyer decides what happens next is a third.

Notice what is not in the definition. Nothing about the size of the cheque, nothing about the industry, and nothing about how fast the company is growing. Those vary. Two things do not vary. The company works before the money arrives, and the investor cannot outvote anybody after it arrives.

Where does the money actually go, into the company or to a shareholder?

The question is one a reader most often never thinks to ask, and it has two completely different answers that look identical on a schedule listing what a fund paid. Money can be paid to the company in exchange for shares the company issues for the occasion, a primary subscriptionBuying newly issued shares, so the money goes into the company itself.. Or money can be paid to somebody who already holds shares, in exchange for those shares. In the first the company is richer by the amount. In the second the company has exactly the same bank balance it had the day before and a different name on the register. Both are called an investment and only one of them funds anything.

A tea stall has an owner, and there are two ways to put a lakh of rupees into it. The lakh can buy out the owner's cousin, who holds half and wants out; the cousin walks away with the money and the stall still has the one kettle it had yesterday. Or it can pay for a second kettle, a second counter and a boy to run them, in return for a share of the stall; nobody walks away with anything and the stall can now serve twice as many people. Same lakh, same word for it, opposite consequence for the stall.

The worked fund shows both, in the same period of its own life. In Fund II Year 2 Q4 it paid Rs 50,00,00,000 for holding 4, and that amount was subscribed for new shares issued by Bhavani Speciality Chemicals Private Limited. All of it reached the company. Not one rupee reached any shareholder. In Fund II Year 1 Q3 it paid Rs 55,00,00,000 for holding 1, and that amount bought existing shares from the founding shareholders of Sahyadri Diagnostics Private Limited. All of it reached those shareholders. Not one rupee reached the company.

Growth equity usually looks like the first, and the reason is the whole purpose of growth equity: the company has somewhere to put the money and cannot get there without it. A buyout usually looks like the second, and the purpose of a buyout is to change who holds the company. Usually is doing real work in both sentences. A single transaction can carry a primary tranche and a secondary tranche together, and the only way to know is to read where the documents send the cash rather than to infer it from the label on the deal.

What can a minority holder actually make happen?

Nothing. Nothing at all is the whole answer, and it is worth sitting with. Almost every reader arrives expecting a smaller version of control rather than a different thing entirely. A minority holder has three lists. The list of what it can make happen is empty. The list of what it can stop is seven items long and every item on it is named in writing. The list of what it can ask about is everything. The most important of the three lists is the empty one. A reader who does not see that it is empty will misread every clause of the agreement that follows.

Think of a household where five adults pool their earnings and four of them vote the same way on where the money goes. The fifth can say the roof needs work at every single meeting, for years, with better reasons each time, and the roof still does not get done. The fifth adult can, if the household ever wrote it down, say that the house may not be sold or mortgaged without written agreement. A veto over a sale is a different kind of power, and it is the only kind a minority holder has.

What can this fund stop, and where is that written down?

A reserved matterSomething a company may not do without a named shareholder's written agreement. is something a company may not do without the written agreement of a named shareholder. Nilgiri Growth Partners Fund II's shareholders agreements each carry seven of them, and the same seven appear at every one of its nine holdings, the four control ones and the five minority ones alike. Seven reserved matters at every holding is this invented arrangement's own contracted term, not a standard, not a usual number and not anything required of anybody.

Now read the list a second time and read what is not on it. Who gets hired. What the company charges. Which customers it chases and which it lets go. What it builds next. Who it buys from. How it closes its books each month. Where it opens and where it shuts. How it markets itself. None of that is reserved, at any of the nine holdings, and the fund's director can argue about every item of it and be outvoted on every item of it. A veto is enumerated, and an enumerated veto does not spread.

The reader who has met a term sheet before is most at risk at exactly this point. A reserved matters schedule looks like a general power of approval when it is skimmed. Feld and Mendelson, in Venture Deals, make the same point about reading an investment agreement clause by clause rather than by its overall impression, and it holds exactly here: the schedule is a list, the list has an end, and the end of the list is where the company's freedom starts again.

Why do the reserved matters sit in a shareholders agreement rather than at the board?

Because a board decides by counting and a contract decides by consent, and only one of those survives being outnumbered. Every one of this fund's portfolio companies has a board of five. If the seven matters lived at the board, the fund's single director at holding 4 would lose all seven of them four votes to one, every time, and the schedule would be worth nothing. Sitting in the shareholders agreement instead, they do not get voted on at all. The company simply may not do the thing unless the named shareholder has agreed to it in writing. A reserved matter is a veto held under a contract and a board seat is a vote held in a room, and merging the two is the most expensive reading error in this subject.

The two instruments even use different verbs, which is the fastest way to keep them apart. A board seat is about carrying: a director proposes a thing, the votes are counted, and with enough of them the thing happens. A reserved matter is about stopping: nobody counts anything, and the thing does not happen. Carrying needs a majority. Stopping needs only that the holder's name is in the clause.

There is a crossing the slider never reaches, and it is worth saying so plainly. Reserved matters are added one named item at a time, and ordinary company decisions are not on the list at any setting, so the lower list does not empty at seven or at any other setting. At nought the holder can stop nothing. At three it can stop new shares, a sale and borrowing above the limit. At five the two senior officer appointments come in. At seven, the setting where holding 4 actually sits, it can stop seven things and the other eight happen exactly as they did at nought. The count only ever adds named items and never converts the unnamed ones, so protection does not scale with the count.

What does one director of five actually do when the vote is already lost?

At holding 4 the fund appoints one of the five directors. At each of its four control holdings it appoints three of the five. One seat and three seats are not two points on a scale of influence. Three of five is an instrument that carries resolutions; one of five is an instrument that does not, and no amount of preparation, persuasion or being right converts the second into the first. The difference between one seat and three is not how much influence the fund has but whether a resolution the fund wants can be carried at all.

So what is the seat for? Four things, and all four are real. Presence puts somebody in the room asking the question. A record survives the meeting, and a director's objection goes into the minutes and stays there. Information arrives whole, and a director sees the pack, the papers and the arguments rather than the summary. And notice arrives early, so a director learns that something is being contemplated at the point it is contemplated rather than at the point it is done. None of the four is an outcome, and a reader who expects the seat to produce outcomes has bought the wrong instrument.

When is a minority holder's leverage at its highest?

On the day before completion, and it is not close. Up to that moment the fund holds the one thing the company wants, the money, and the company holds nothing the fund needs. After completion the money has gone across, the shares have come back, and what the fund holds is whatever the documents say it holds. Leverage does not decay gently after completion; it steps down at completion, on one day, by contract.

The instrument that converts leverage into an outcome is the completion conditionSomething that must be done before the money moves, so it happens or the transaction does not.: something that must be done before the money moves. Not a request. Not a suggestion written into a report. Not an action point for the first board meeting. A condition. If it is not done, completion does not happen and the cash stays where it is. The completion condition is the entire mechanism, and it is available exactly once.

Which is why every finding that comes out of diligence faces a fork with only two exits. A finding becomes a condition of completion, or it becomes a sentence in a report that somebody may raise later. The fork is taken before the money moves and it cannot be taken again. After completion the fund holds seven named vetoes and one seat of five, and there is no route from either of those to a thing that is not on the list.

What did the four diligence workstreams find on holding 4?

A diligence workstreamOne line of enquiry into a company before an investment, each with its own question. is one line of enquiry into a company before an investment, with its own question. On the transaction that became holding 4 there were four of them, and each produced a different kind of finding. Four separate enquiries exist for that reason rather than one long checklist.

The commercial workstream asked whether the demand is real and the position defensible, and found the largest customer at 31.0 per cent of revenue on a contract with fourteen months left to run. The financial workstream asked whether the numbers say what the seller says, and found that Rs 2,40,00,000 of the reported earnings before interest, tax, depreciation and amortisation was a one-off recovery, so the run rateWhat a figure would be once the one-off items inside it are taken out. was lower than the headline. The legal workstream asked what is owed, what is held and what is disputed, and found an unregistered chargeSecurity over a company's assets that has not been recorded where it should be., cleared before completion. The operational workstream asked whether the business can be run and whether the fund can be a shareholder in it, and found no month-end close discipline and no second signatory on payments.

And here is the move the whole argument turns on: the fund made both operational findings conditions of completion. Neither a monthly close nor a payment authority is one of the seven reserved matters, and neither can be carried by one director of five. The day before completion was therefore the only day on which the fund could require either of them at all, and it used that day.

Two notes belong here. The first is that the record marks what happened to the legal and operational findings and does not say what the fund did with the commercial and financial ones. The second is a caution. Operational diligence is also the name of an exercise an investor runs on the manager before committing to a fund, a different exercise carrying the same name. The four workstreams set out above are the first of the two.

What did holding 4 look like from entry to the record date?

Set out end to end, the invented transaction reads like this, and every line reconciles against every other line.

Two cautions on that last row. The holding is unsold, so Rs 1,08,00,00,000 is an estimate of what a position is worth rather than a sum anybody has paid, and how such an estimate is arrived at is covered separately. And the 1.80 times is Nilgiri Growth Partners Fund II's own carrying multiple on one invented holding as at the end of its Year 9 Quarter 2, a statement about that holding on that date and nothing else.

What information does a minority holder actually get, and how?

Contractually, and on a timetable. A minority holder that has to ask nicely for numbers is a minority holder that will get them late. At this fund's portfolio companies the arrangement runs to five items: a monthly pack within fifteen business days of month end; a board meeting each quarter; audited annual accounts; an annual budget, itself one of the seven reserved matters; and immediate notice of anything falling inside any of the other six. Information is the one thing a minority holder gets in full measure, and it is the reason the position is worth holding at all rather than being held blind.

The five items are this invented arrangement's own contracted terms rather than usual, required or standard ones. Company reporting is also worth keeping apart from what an investor of the fund receives from the fund, a different list on a different timetable that is covered separately. One is the company reporting up to the fund. The other is the fund reporting up to its investors.

What does a minority holder do when it disagrees and cannot win?

A minority holder has the disagreement recorded, and that is genuinely most of what is available. The fund's director says the thing, asks for the objection to be minuted, and the minute stays in the company's books whatever happens next. The fund can also ask in writing and keep the answer, use the information rights to test what it was told, and, where the matter falls inside the seven, simply not give its consent. The holder cannot make the company act. A minority holder with seven vetoes can stop a great deal and can compel nothing, and that asymmetry is the position itself.

Recording an objection sounds like a consolation prize and it is not. A decision taken over a written objection is a decision somebody has to own later, so a recorded objection changes what the other four directors have to be comfortable with. The minute also changes what an eventual buyer of the position reads. And it is the only thing on the list that costs the fund nothing and is available every single quarter.

What does this fund's own record say about minority against control?

Here are the two figures a reader will want, followed immediately by the arithmetic that empties them. Printing the first pair without the second would mislead. At Nilgiri Growth Partners Fund II's record date at the end of its Year 9 Quarter 2, the four control holdings show Rs 4,34,00,00,000 of total value on Rs 2,10,00,00,000 of cost, being 2.07 times, and the five minority holdings show Rs 2,86,00,00,000 on Rs 1,90,00,00,000, being 1.51 times.

Now take one holding out of each side. Remove holding 1 from the control group and the remaining three show Rs 2,31,00,00,000 on Rs 1,40,00,00,000, or 1.65 times. Remove holding 4 from the minority group and the remaining four show Rs 1,78,00,00,000 on Rs 1,30,00,00,000, or 1.37 times. Removing a single holding from either side moves that side by more than the gap between the two sides. The gap was never measuring what a reader wanted it to measure.

Four holdings against five, one invented manager, one invented fund, one period, and five of the nine still unsold so that most of the value on both sides is an estimate rather than a receipt. Nothing about control as an approach and nothing about minority investing as an approach follows from either number. Holdings 6 and 7 inside the minority group make the same point. Each cost exactly Rs 30,00,00,000, and the two sit Rs 18,00,00,000 apart in carrying value at the same record date.