The Value of a Promise

A private equity investment in an enterprise that does not trade in the stock market poses multiple challenges. These challenges multiply if the enterprise operates in a nascent industry that is still in its early stages of development, because there is very limited data to compare the investment deal with. 

Reaching a consensus on the value or price of equity is the first step in the equity investment process. Most often the valuation is based on the expected future returns to the equity investor. This usually involves forecasting future performance and an analysis of the business plan of the enterprise.  When the buyer and the seller agree that the forecasted performance reflects mutually acceptable and realistic expectations regarding returns, there is usually an agreement on the price of the equity share of the enterprise also.

In most cases where the equity value being asked is at a significant premium to the book value because of the future reward potential, the investor may not be comfortable in making the investment at one go. In such a case, the investor may demand a milestone linked investment schedule, spanning between six months to over two years. Till such time, the investment may rest within the enterprise as a convertible debt.

In situations where an existing equity holder sells her equity stake to an investor in an equity deal, the investor may put even more stringent conditions such as requiring that a significant part of the money being paid for the equity stake be kept in an escrow account maintained by the investor till such time that the company achieves certain pre-decided milestones particularly relating to sales and profits.

Investors view these as mechanisms to ensure that the existing owners as well as the management of the enterprise do not make exaggerated profitability forecasts in order to create a false impression of value. As most enterprises look for equity to fuel growth, they invariably project very high growth in the first few forecasted years. Given the “mystery” surrounding any early stage enterprise, it adds to investor comfort if these projections are beaten.

It would be an interesting research to examine investment terms and conditions in private equity deals in emerging economy contexts.