Tag Archives: CCD

Basics of capital table and different capital instruments

The capital table is a reflection of the shareholding pattern of a company, shareholder names, percentage of shareholding.  This shareholding should ideally reflect the voting percentage in the company. But does it? What if the ESOP percentage has to be included while there is no voting on ESOP?

Founders should also consider the number of people on the capital table, though the maximum number in a private limited is 200, for various reasons including logistics of execution of documents, distribution of the annual accounts & annual report etc.

In this post, we have captured some of the key aspects to be considered while structuring the capital table.

At the time of Incorporation: It may be noted that the subscription of shares at the time of incorporation will be at face value and cannot be issued at a premium. The initial subscribers are usually the founders themselves.

The shareholding pattern amongst the founders is a function of many factors, such as roles and responsibilities and what each of them would bring to the table, whether investment is in cash or in terms of performance and service, for example, as a technical expert or a marketing expert. It certainly helps in decision making if one of the founders have majority shareholding. It is highly recommended that the founders enter into a founders’ agreement wherein the number of shares, percentage shareholding, future investment, vesting schedule, if any; roles and responsibilities of each founder, treatment of shares upon termination, etc. This would help in setting expectations as well as helpful in easing the founder terminations / resignations.

Employees Stock Option Pool (“ESOP”): A great team is instrumental and vital to the growth of an early stage company. However, the company may not have the finances to compensate with market salary to its employees at early stages (unless well funded). Thus, issuing stock options becomes very attractive – not only as compensation mechanism but also as building ownership and responsibility in the company. Stock options are notional unless they are exercised and shares are allotted. They represent a right to purchase a specified number of shares at a specific (exercise) price. When an employee exercises the Options and issued shares, then they became part owners in the company and can also sell the shares. Stock Options cannot be transferred or sold. Please see our previous post on Ten Frequently Asked Questions on Exercising Employee Stock Options in Private Limited Companies for more details in this regard.

Though Stock Options are not shares yet, it still forms a part of the capital table. External investments into the company, be it angel or institutional investment, are on a fully diluted basis. Ie. a shareholding pattern, as if all the outstanding share allotments regardless of vesting, assuming all stock options are converted, assuming all convertible securities are converted into common shares. Hence, Stock Options also form part of the capital table. In such a scenario, the percentage captured in the cap table is not necessarily the percentage of voting.

At the time of Investment: Whenever new investors subscribe to the shares of the company, the capital table undergoes a change. All the earlier shareholders’ percentage holding dilute, while the number of shares that they hold remains. If ESOP is set aside before the new investors coming in, then ESOP percentage dilutes, while the number of options set aside, remain the same.

Issuance to Advisors: Issuance of shares has to be at fair market value. Many a time, it is convenient for the founders to transfer their shares to the advisors. However, tax impact has to be evaluated for such transfers.

In India, we have different kinds of shares:
Equity share capital (common stock): (i) with voting (ii) with differential rights, such as dividend or voting. Founders typically have equity shares. ESOP is also typically granted as equity share class.

Preference share capital, which carry a preferential right over the equity shares to be paid dividend and a preference for repayment of capital in case of winding up. Investors typically have preference shares.

Preference shares can be:
Cumulative preference shares, which means that the holders are entitled to receive dividend even when a company does not make (adequate) profit, in which case the dividend is accumulated and paid when the company does have sufficient profits.
In Non-cumulative preference shares, the holders get the dividend only when a company makes sufficient profits, else the dividend lapses and cannot be carried forward.
Participating preference shares, means that the holders are eligible to receive surplus profits or dividends in addition to being entitled to their fixed dividend.
In Non-participating preference shares, the dividend paid is only to the extent of the agreed fixed dividend.
Convertible preference shares are those that are converted into equity within the maximum period of 20 years. Non-convertible preferences are those that do not get converted into equity shares.
Redeemable preference shares or optionally redeemable preference shares are those that have to be paid back within the maximum period of 20 years. We don’t have irredeemable preference shares.

The other form of investment is as debentures, which is primarily a debt. But the debt can convert into shares through the issuance of Compulsorily Convertible Debentures (CCD). You can read our post on CCD on the nuances related to its issuance. https://novojuris.com/2018/03/21/nuances-associated-with-issuance-of-compulsorily-convertible-debentures/

Investors also invest through CCD, especially when the valuation of the company is not clear. Here’s how it is done https://novojuris.com/2015/12/21/raising-of-funds-through-compulsorily-convertible-debentures/

You can share your thoughts or email your questions to relationships@novojuris.com

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Nuances associated with Issuance of Compulsorily Convertible Debentures

Compulsorily Convertible Debentures (CCDs) are considered to be hybrid instruments / and equity linked instrument, i.e. they are treated as debt till the time they are converted into equity. When they are issued it is a debt, after a period of time / milestone, it shall be compulsorily converted into shares. On the other hand, the Optionally Convertible Debentures are debt securities and interest is paid to the investors till maturity and repayment.

Under FDI guidelines, CCDs are treated as equity for the purposes of reporting to Reserve Bank of India.

 

The Companies Act, 2013 and the rules issued thereunder (the Act) provide the legal framework for the issue of Debentures[1] by Indian companies. The various kinds of Debentures are (i) Compulsorily Convertible Debentures; (ii) Optionally Convertible Debentures; and (iii) Redeemable Debentures. Section 71 of the Act states that a company could issue debentures with an option to convert into shares either wholly or partly at the time of redemption.

CCDs are considered to be convenient as it allows the investor to tap into the Company’s potential without diluting the founders shareholding percentage until the CCDs are converted into shares.

Here’s an article that we wrote way back in December 2015, which provides details on CCDs.

https://novojuris.com/2015/12/21/raising-of-funds-through-compulsorily-convertible-debentures/

In this post, we have analysed the nuances associated with the issuance of Compulsorily Convertible Debentures (CCDs).

Issuance of Securities:

Under the Act, the securities[2] could be issued in any of the following manner: (i) Private Placement Basis (section 42); (ii) Rights Issues (section 62(1)(a); (iii) Bonus Issue (section 63) and (iv) Sweat Equity (section 54).

Rights Issue: 

Section 62(1)(a) of the Act regulates the issuance of shares by way of a rights issue to the existing shareholders of the Company. Section 62 states that whenever a  company having share capital proposes to increase its subscribed capital by issue of further shares, then such shares shall be offered to persons who are holders of equity shares in the Company in proportion to their paid-up share capital.

Most of the practicing professionals opine that CCDs cannot be issued by way of rights issue since Section 62 (1) of the Act explicitly mentions issuance of “shares”. Whereas Section 42 states that a company may make a private placement of “securities”.  However, a few professionals opine that CCDs are a hybrid instrument which shall be compulsorily convertible into equity shares and therefore is considered as an equity-like instrument and they argue that the CCDs can be issued under rights issue.

Private Placement:

The rigour of following the Private Placement under section 42 is quite high, many nuances and high penalties for non-compliances.

Section 42 of the Act provides that the offer of securities or invitation to subscribe securities on a private placement basis shall be made to such number of persons not exceeding fifty or such higher number as may be prescribed, (excluding qualified institutional buyers and employees of the company being offered securities under a scheme of employees stock option), in a financial year and on such conditions (including the form and manner of private placement) as may be prescribed.

Every private placement of securities must be made with the prior approval of the shareholders of the Company by a special resolution approving the private placement offer letter. The utmost important condition under section 42 is the total face value of each kind of securities issued to each person shall be at least Rs. 20,000. The private placement offer letter is required to be accompanied by an application form addressed specifically to the person to whom the offer is being made. Additionally, the Act lays down the following requirements: (i) the offer has to be made only to those persons whose names are recorded by the company prior to the issue of the offer letter to subscribe to the securities; (ii) a complete record of offers has to be kept by the issuer in a prescribed manner, and (iii) complete information about the offer has to be filed with Registrar of Companies (the RoC) within 30 days of circulation of the offer letter.

Allotment in respect of private placement of securities (including CCDs) is required to be completed within 60 days from the date of receipt of application money. Additionally, the consideration so received towards issuance of securities (including CCDs) could be utilised only upon the securities been allotted and the return of allotment in this respect is filed with the RoC. In the event of non-allotment, the consideration so received is to be refunded to the subscribers within 15 days from the date of completion of 60 days. If the company fails to refund the consideration within the 15 days, it is liable to pay interest at the rate of 12% from the end of the 60th day.

Considering numerous disclosures, conditions and huge penalties associated with private placement basis, the practicing professionals always tends towards the rights issue mechanism which involves minimal disclosures etc.

Additional Compliance in case of Issuance of CCDs to non-residents

(a) CCDs as debt or equity instrument: It is also pertinent to note that the under the Foreign Exchange Management Act, 1999 and rules, regulations made thereunder (FEMA), any investment by any non-resident towards CCDs are considered as equity instrument under FDI guidelines. However, the investment by non-resident towards Optionally Convertible and Redeemable Debentures are considered as debt instruments and being construed as External Commercial Borrowings.

(b) Terms of Conversion of CCDs: The terms of conversion are to be decided upfront at the time of issuance of these CCDs. It is important to note that the price/conversion formula of convertible capital instruments should be determined upfront at the time of issue of the instruments and the price at the time of conversion should not, in any case, be lower than the fair value worked out, at the time of issuance of such instruments, in accordance with the provisions of FEMA. It may also be noted that there are no explicit restrictions on variation/change in terms of conversion either under the Act or under FEMA. However, the Reserve Bank of India (the RBI) has raised objections to such change in terms of conversions.

(d) Fair Market Valuation: The CCDs shall be issued at or above the fair market value as on the date of issuance of such CCDs. The valuation of CCDs shall be done as per any internationally accepted pricing methodology for valuation on an arm’s length basis duly certified by a Chartered Accountant or a Securities and Exchange Board of India registered Merchant Banker or a practicing Cost Accountant.

Closing remarks:

Considering nuances associated with the issuance of CCDs on private placement basis and the

statutory provisions with regard to issuance of CCDs on rights basis being silent, the method of issuance has become slightly ambiguous and lead to varied interpretations. A clarity to this effect from the Ministry of Corporate Affairs would help and aid all stakeholders to issue CCDs without resorting to various interpretations.

Author: Shruthi Shenoy, is an Associate with NovoJuris Legal

[1] Debenture is defined under 2(30) of the Companies Act 2013 as Debenture includes debenture stock, bonds or any other instrument of a company evidencing a debt, whether constituting a charge on the assets of the company or not.

Provided that: (a) the instruments referred to in Chapter III-D of the Reserve Bank of India Act, 1934; and (b) such other instrument, as may be prescribed by the Central Government in consultation with the Reserve Bank of India, issued by a company, shall not be treated as debenture;

[2] The term “securities” includes debentures.

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