Due Diligence Investment of India's Businesses

Arjun Sethi, An advisor and angel investor in early stage startups


The purpose of this paper is to examine what should be the due diligence for firms and investors that are seeking to invest in small and midsize companies in India. In the period from August 1991 through August 2007, foreign investors pumped some $56 billion worth of capital into the country. Within just the past year, the amount of capital invested in India from foreign entities and investors has totaled nearly $6.5 billion (Ministry of Commerce and Industry 2007, 1). It is quite clear that venture capitalists and private equity firms see strength in the future potential of the Indian economy and people. However, making any investment, even in a country where so many others are investing their resources, still requires due diligence to determine the appropriateness of the investment.

In order to examine what should be the due diligence process for firms seeking to invest in small and midsize firms in India, this paper will begin by looking at the proper due diligence process from a theoretical process. The information presented will examine the process that should be followed and why these processes of due diligence are so important. Following this discussion, information will be presented as to the actual due diligence process that is being used by venture capital and private equity investors in India. A comparison of the similarities and differences will also be presented to determine where these firms are following the entire due diligence process, as well as where they may be cutting corners in the name of making money.

The Theoretical Due Diligence Process

The first step in determining the appropriateness of a small or even midsized company in India for investment purposes is to actually determine if a company or entity is a rogue. This may seem odd, but Davies (2004, 157) notes that most small and midsized companies in India are run by well-intentioned individuals who are seeking to be able to fund growth through the acquisition of venture capital or private equity. However, there are those individuals who have other motives for finding investment dollars from outsiders. These individuals may set up a business entity and have the appearance of running a typical company. However, the reality is that these rogues are simply seeking to take money from others with no real intent to run the business properly.

Davies (2004, 158) notes that part of this step in the due diligence process calls for overcoming any initial charm that may be presented by a potential recipient of investment resources. Instead, the investor must investigate the people who are running the company, as well as the company itself. In order to overcome cultural differences between Western companies and those in India, this may require doing some cultural homework about how small and midsized businesses and business owners operate. This might even require gaining help from others who are more skilled in Indian business practices.

The next step in the due diligence process is really the beginning of the screening process to determine if further due diligence is necessary. Once potential investors have determined that a potential investment company is real and is in business for serious matters, it is time to actually assemble some basic information to determine if further due diligence is worth the time and effort. This initial screening process is really about quantitative data to make a decision about whether the potential investment shows any potential value based on what the investors desire in an investment (Dewan 2001, 90).

For example, investors might determine that they want a small company that has annual revenue of at least $2 million. If a company that is being considered for investment is found to have annual revenues of less than $2 million, then continuing with an in-depth due diligence process is not necessary. In addition, investors might want a potential investment to have been in business for a specific number of years or to have a certain level of sustain customers. Again, not meeting or exceeding these quantitative criteria would render further due diligence to be unimportant (Dewan 2001, 90).

Once the initial screening process has been completed and a potential investment has passed this process, then the true due diligence work begins. Whereas the initial screen process involved the collection of a small amount of quantitative data, the full due diligence process requires the collection of a large amount of data about the potential investment. First, investors should acquire a complete picture of the affairs of the company in terms of how the company has been run from its inception to the present (Committee on Negotiated Acquisitions 2005, 1.1).

It is important to realize that having a picture of the assets and liabilities of the potential investment is not enough. It is also necessary to know the location of the assets that are held by the company. Even more, it is important to completely understand the liabilities of the company. This means understanding the different type of liabilities that are present, such as loans or even legal actions. It also means understanding how much of the potential investment company's budget goes to paying for and handling liabilities, especially legal liabilities (Committee On Negotiated Acquisitions 2005, 1.1).

Aside from the information that might be found on a balance sheet or in legal documents, the due diligence process also requires the acquisition and investigation of public perceptions about the company in question. An understanding of how the company is viewed by the public, as well as the level of respect that is present for the company's products or services should be put together. At the same time, any existing relationships between the potential investment company and other entities or companies should be known. All of this information really points to potential future growth or operations that might be built off of existing operations and the background of the company in question (Committee on Negotiated Acquisitions 2005, 1.1).

The next step in the due diligence process is to use the information that has been obtained about the company and its products or services to determine if there is room for future growth. This part of the due diligence process requires both information about the existing technologies or services that are present and putting that together with a plan that would hopefully result in growth (Dutz 2007 177). This is where investors and company leaders must come together and make decisions about where the company is headed in the future. In addition, discussions and decisions about possible research and development into improving existing technology or services, or creating new technologies and services, must take place.

This is the point of the due diligence process where investors have to really take what they know about the company and its technologies or services and determine if they think that future growth is possible. Now, this part of the process requires listening to the goals and ideas of the business owner or owners. However, it also requires that the investors think about their positions within the company if they decide to invest financial resources. This is the part of the due diligence process where investors have to determine the level of commitment that is present on the part of the company's owners or operators to work with them if an investment deal goes forward (Millar & Chandramouli 1999, 327).

Investors should realize that a potential investment may pass all the steps of the due diligence process. However, if the current owners of the company do not have the proper attitude or desire to work with investors, then the potential value of the investment may be in jeopardy. The purpose of investing money in a company through venture capital or private equity is to reap returns on those investments. The owners of a company may not have the proper desire or attitude that is necessary to work with investors to create the largest potential growth for all parties involved. If this is the case, then the level of risk might actually increase because investing in the company in question might mean years of fighting and disagreements that could actually hurt any changes of growth.

Another part of this final step in the due diligence process is to make decisions if the structure of a potential investment is conducive for a potential investment. It is likely that many small businesses in India are going to be run by the individuals or families that started them. However, midsized companies might actually be at a stage where they have become decentralized from the original founders. This decentralization of power and authority in the company might make the transition from private ownership to having investors more difficult. At the same time, this decentralization of power could also mean differences in how the company attracts talented workers and the type of benefits or working environment that is present. All of these variables can play a factor in the potential future value of an investment (Millar 2006, 66).

In total, the theoretical discussion of how the due diligence process should work indicates that a lot of time and work goes into the investigation of a possible company in which to invest. While the discussion that has been presented might make it seem like the information that is needed for a full due diligence to take place can be acquired relatively fast and easily, this is not the case at all. It could actually take months to fully investigate a company and its products and structure. This might be especially true for a small company that may not have the same type of formal record keeping system as a larger company.

The entire process of due diligence is really about obtaining as much information as possible so that investors can make a decision about whether they believe a company's growth potential is large enough so that they reap the type of dividends desired from their investment. In this regard, due diligence is somewhat subjective in nature. While information and data are used to make the final investment decision, investors also have to determine if the conditions are such that they feel comfortable taking the risk of lending a small or midsized company in India what might be millions of dollars over a several year period.

The Practical Application of Due Diligence

As with so many things, there is a great difference between theory and practical application. This is true for the due diligence of investing in small and midsized companies in India. The previous section of this paper presented how the due diligence process should work and all of the steps that are involved. This section of the paper is going to present how venture capital firms and other private equity investors actually complete the due diligence process. Information from people in the industry, as well as actual due diligence guidelines from banks, legal advisors, and venture capital firms will be discussed.

One of the first steps that was mentioned in the theoretical discussion of the due diligence process was that an initial screening process takes place before the full due diligence occurs. Key Bank, which is a full service bank and financial company based in Cleveland, Ohio, states that their first step in the due diligence process is the initial screening of a potential investment (2008). The bank explains that the initial screening may occur in order to limit potential investments to certain areas, such as companies in the technology or construction sector. In addition, the screening process is to limit investments to companies that meet certain size or revenue criteria.

While the initial screening process is the same in practical application for a company like Key Bank, the actual due diligence differs. First, the bank explains that the actual gathering of in-depth information about a small or midsized company is often not possible. The reason for this, especially for a small company in India, is that there is simply not enough information for a true formal evaluation to take place. In addition, the bank states that the lack of formal information may actually make the formal evaluation of the potential investment not desirable (2008).

Key Bank does state that much of the due diligence evaluation is based on the actual owner or entrepreneur of the company in which an investment is being considered (2008). They look to see if they like the qualities of that person, such as leadership ability, ideas about the product or service, and certainly the business plan that the individual has put together for the future of the company. In this regard, the due diligence process is somewhat more subjective about how the investors feel about the person running the company and how they view his or her plans for the future and his or her ability to see those plans through to fruition.

As this explanation of the investment process shows, the reality of investing in a small business in India is that the decision of whether or not to invest is based much more on subjectivity than analyzing actual data. This is due to the fact that there may not be a lot of data to analyze. Instead, potential investors have to listen to the owner of the company and get to know his or her leadership and business skills. It is from these qualities that investors can truly determine if they feel comfortable making an investment in the company and if they think they will see a return on that investment.

Fenwick & West, LLP, a law firm providing legal services to investors and companies based in California, provides another means of seeing the differences between the theory and practical application of due diligence. They state that one of the criteria of determining if an investment in a small or midsized firm in India is appropriate is the ease of taking a company public as an exit strategy (2007, 1). What is being explained here is that the firm is concerned with their ability to exit as investors and to reap financial rewards in the form of an IPO for the company in which they have invested. If they think that an IPO is not going to be likely, then this is an important consideration that is potentially going to prevent an investment from taking place.

In fact, Fenwick & West state directly on their 2006 Update to Structuring Venture Capital and Other Investments in India that "exit valuation and ease of exit for investors are the most important considerations" (2006, 1). They are more concerned and advise their clients to look more closely as the ability to get out of the investment, as well as the value of the exit. In reality, this is not that surprising because venture capital and private equity investments, regardless of where they are made, are about obtaining returns for investors. In this regard, investors are likely to be more concerned with the returns they are going to see than with the actual product or service that is offered by the company.

Fenwick & West also states that another consideration for venture capital investments in India is the level of comfort that the investors have with the laws governing stock and shareholder rights in India (2007, 1). If a company is to go public in India, the investors must be comfortable with the laws that exist in that country and how they differ from laws in the United States. Specifically, they must be comfortable with how the Indian laws treat preference shares, or shares of stock that entitle the holder to a fixed rate of dividend payments that are made before payments to other stockholders (Marsh & Soulsby 2002, 255). Again, the idea is for investors to be comfortable with their ability to reap financial rewards from their investments in an Indian company.

Murali (2007) also explains that venture capitalists are often looking for higher rates of return because they are taking on riskier investments. With this in mind, it is explained that venture capitalists are usually seeking a product or service that has growth potential, not only in the product or service but also that it is targeted toward a growing sector of the country's economy. This might be an expanding area of consumer demand or an untapped market where there is very little competition. In either case, the idea is to find a company that is directing its product or service toward those consumers where a demand exists or is likely to exist.

At the same time, Murali (2007) does state that venture capitalists are also concerned about the leadership qualities of the owner, as well as the type of structure that is present in the company. The investors are interested in how the company functions as a team and how it brings innovation to the market. This does parallel with the theoretical side of due diligence because of the discussion of the importance of understanding whether a company is centralized or decentralized in leadership, as well as whether there is strong leadership to oversee the various internal functions of the organization.

The construction sector in India is one area in which the desire for strong growth can be seen. The real estate industry in India has received about $10 billion in investments from private equity firms within just the past year. Wachovia Bank, a bank and financial company in the United States, made a $57 million investment in a midsized real estate company in India within the past year. Part of the reason for this rush to invest in Indian real estate has to do with the 30% increase in real estate values within the past year (Hussain 2007). Investors from the private equity sector are seeing the potential for double-digit gains in a very short amount of time. Rather than seeking to invest in companies that might be in sectors that lack the current growth of the real estate market, investors are seeking to put their money in an area where growth is taking place at the present time.

Differences and Similarities in the Due Diligence Process

The discussion of how the due diligence process is carried out in practical application reveals both similarities and differences to how the process should work. First, there is very much a similarity to theory in the initial screening process of seeking out potential investments. Venture capital firms and private equity investors seek out companies in which to invest that meet certain criteria. These investors may only want companies that operate in the real estate and construction industries or the information technology industry. In addition, they may only want companies that have shown a certain level of revenue growth. Whatever the case may be, it does appear that most investors do take part in this initial screening to make choosing a potential investment easier and within their own comfort zones for investments.

Another similarity that exists between theory and practical application is the examination, at least in some part, of the qualities of leadership and innovation of the owner or entrepreneur that would be receiving the investment. It appears that investors want to know that the owner of the company has the skills and qualities that they feel are necessary for a company to grow and prosper. They also spend at least some time examining the internal structure of the organization and how the business is run and how innovation takes place.

However, there are several differences that exist between theory and practical application of the due diligence process. First, there appears to be less of a formal review of the financial data of companies that is suggested in theory. From a practical standpoint, many small businesses and even some midsized businesses in India simply do not have the background for a full and complete investigation of financial records to take place. Because of this, some investors do not take the time to search for information that may not be present or might not be completely accurate even if available.

Instead, they look more toward the potential financial outcomes of their investments in small and midsized companies in India. They plan for the ease at which they can exit an investment by helping to take a company public on the stock market in India. In addition, they also examine how their ownership in the company will transfer to the stock available in the publicly traded company, and how much preference they will have over other shareholders based on the financial laws of India.

In the end, the real difference between the theory of due diligence and the actual application really appears to lie in the importance of the rewards that are to be gained. The theory of the due diligence process seems to focus on finding a company with strong ideas and strong leadership. The reality of the process, however, is that investors are looking for companies that can grow in a relatively short amount of time and reap huge dividends. Investors are also looking for companies in which they will have a certain level of control and be able to exit as easily and hopefully efficiently as they entered the investment. They are looking more for a way to make money by taking advantage of a hot sector of the Indian economy or an untapped market much more than they are looking to see an innovate idea grow. Unless, of course, that innovate idea happens to be in the hot sector of the economy or be targeted toward those consumers in India with the financial means the desire to purchase the product or service in question.

Mr. Sethi is currently an advisor and angel investor in early stage startups. He is also a Strategic Advisor at Saset Healthcare, a start-up involved in the design and manufacture of high end ultrasound machines. Prior to Saset Mr. Sethi worked with the Carlyle Group. In 2002 Mr. Sethi co-founded Advanced Tuning Products, an ODM distributor for Garrett/Honeywell Aftermarket. He is the author of several Venture Capital and Private Equity articles, and writes regularly on his blog. Mr. Sethi holds a BA in History (Honors), from the University of Maryland College Park and BA in Liberal Studies (Honors), from Boston University.


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