Zencap Case Study

PE Group 2:

Noel Enerio | Sayali Joshi | Adeline Limqueco | Suhas Narasimhan | Shrikant Patil | Ronaldo Recto | Noel Utanes | Carlos Valdes

To: R.K. Sharma

Founder and CEO

Surya Tutoring

Despite the higher valuation in Blackgem’s offer, our team recommends to accept ZenCap’s offer. In essence, it is due to the risk of losing the business, as stipulated in Blackgem’s term sheet, via the drag-along clause. Though ZenCap is the smaller firm, they bring with them shared market knowledge that allows them to make more informed operational decisions, as seen in their term sheet, where provisions for control are far more specific and customized to the business. Blackgem, in this regard, has not mentioned anything towards addressing issues of control. They won’t provide the additional guidance the business is looking for—maintaining the role of a passive investor.

Surya’s Business and Value as an Investment

Surya’s strengths reside in their team of professors. They are among the top institutes for IIT-JEE training. With the lack of credible training institutes in other regions of the country, Surya has a clear opportunity for geographic growth. At the same time, they’ve experienced a steady growth in number of enrolled students (at 20%). Technology has also opened up new modes of training, such as online classrooms.

Still, the business is present only in Kota. And their reputation is largely dependent on the capacity of their professors, who can easily leave the institute for competitive salaries. Growth can potentially be restricted due to obstructionist local policies and corrupt governing agencies, which must be handled with creativity and finesse. Lastly, there is intense competition in the tutoring industry.

Comparison of Offers from ZenCap and Blackgem

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A. Money

• Blackgem wants 25% of the company for 150 Crores, which is effectively a valuation of 16x for Surya, using Preferred stock. The preferred stock is noncumulative, with an 8% dividend rate, which is currently below the benchmark (5-year Treasury Bond) which is at 8.17%.
• While ZenCap offers a lower valuation of 12x for Surya, it wants a lower ownership at 12% for 44 Crores, through a combination of Compulsorily Convertible Preference Shares (CCPS), Common Stock, and Warrants.
• While ZenCap’s valuation is lower, it is still within the lower end of the 12x to 105x range of P/E multiples obtained from comparables. Furthermore, selling fewer equity initially could prove to be beneficial, as selling these equity in future rounds of funding would allow for higher share prices given Surya’s projected increase in earnings.

B. Control

• ZenCap’s basket of provisions allow them to exercise tighter control over the company’s operations and use of funds, compared to Blackgem’s provisions, which provide for more flexibility in running the company.
• Blackgem’s provisions allows them two seats on the board and one mutually appointed seat, as opposed to one seat for an Investor Director from ZenCap. However, ZenCap’s provisions augments their control of the board by requiring the Investor Director to be a member of all the subcommittees of the board.

C. Exit

• ZenCap’s provisions mandate an IPO on the 4th year, and if that does not occur, requires the CEO to facilitate a sale of ZenCap’s shares to a third party on the 5th year.
• Blackgem’s provisions allow them to simply hold the preferred shares until maturity wherein they could get the additional dividends of 4%. However, in this scenario, they would only attain an IRR of 11% on their investment which is considerably low. Hence it is most likely that Blackgem will convert their preferred shares to equity, and seek an exit through a public offer or a sale, which increases the likelihood of Blackgem exercising their Drag-Along Rights.

D. Other Aspects of the Offers

Additional value provided

• ZenCap has good connections with small and mid-level sized businesses. They align with the same Indian values and goals as Surya, and and has knowledge on the local business landscape
• It appears that Surya is not fully professionalized. They don’t even have a proper records system. ZenCap could help them operate in a more sophisticated manner.  
• Blackgem has strong international connections with established leaders in the education industry, and is internationally-recognized, which can further add credibility to Surya’s business.
• ZenCap being a small fund will be more involved in the investment.

Ownership allocation

• ZenCap has a provision which earmarks equity to be set aside for employees, friends, and family, while Blackgem has none. The clause provides freedom of equity distribution as long as the CEO adheres to the condition of 51% ownership.

Major concerns - onerous provisions

• ZenCap has a Full Ratchet Anti-Dilution provision, which protects the investors from downside risk at the expense of the founder. Coupled with the Minimum Holding provision requiring the founder to maintain an ownership of 51% for 7 years, and in the event that further funding rounds dilute ownership below 51%, these provisions could entail the founder to put in additional capital to satisfy the 51% ownership requirement.
• Blackgem has Drag-Along rights, which despite just having 25% ownership, would allow Blackgem to force the founder to sell his ownership in Surya regardless of whether he wants to or not.

Overall assessment

• Both the term sheets reflect each PE firm’s understanding of Surya’s business. An example of which is ZenCap’s provision for hiring a CFO and allocating shares for employee ownership. This indicates their understanding of the importance of managing Surya’s cashflows and retaining top teachers in order for the business to succeed. Furthermore, ZenCap’s exit provision for a third-party sale only requires the sale of ZenCap’s shares, which shows consideration for the founder’s desire to retain his ownership of Surya, which is a stark contrast to Blackgem’s Drag-Along rights. In comparison, Blackgem’s offer term sheet appears to be a standard cookie-cutter offer, with little indication of intent to add more than financial value to Surya.
• Considering Surya’s growth stage wherein the company is expanding, organizing the company’s structure and professionalizing the company would be an important objective. In this aspect, we believe that ZenCap would also be able to provide more value through their guidance and knowledge of the local business landscape in India.
• With all these factors considered, the group recommends that the CEO accept ZenCap’s term sheet.