Tag Archives: Convertible debentures

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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Anti-dilution protection in shareholders agreement – Implementation under Indian laws

Anti-dilution protection is one term which is present in almost every investment transaction. From the perspective of the founders, especially in case of a start-up or an early stage company, it is very important to understand the implications of having such a provision in the shareholders agreement (SHA). Founders generally tend to agree to so-called “standard” terms in the SHA, when in dire need of the investment. An anti-dilution provision has to be reviewed closely in order to ensure it is not too harsh on the founders and also since the transaction documents set precedents for the subsequent round of investments. This article discusses some of the main methods of anti-dilution protection usually seen in transactions in India and some of the difficulties associated with actual implementation of such anti-dilution provisions.

What is Anti-Dilution Protection?

Before moving to anti-dilution, we need to understand the concept of dilution. Dilution is the decrease in the shareholding percentage of a shareholder in a company due to increase in the number of outstanding shares. For example, when a company receives subsequent round of investment, the shareholding percentage of the existing investors gets diluted. It is good to have the value of a company increase in subsequent rounds of funding. However, there might be situations when a company may not perform or grow as expected due to which the value of the share decreases. In such a scenario, anti-dilution protection is triggered by the existing investors to maintain their shareholding percentage in the company to a certain extent (which is explained below).

Essentially, anti-dilution protection is such protection given to the existing investors of the company when new shares are issued in a subsequent round at a price per share which is lower than the price paid by the existing investors. It is pertinent to note that anti-dilution protection is applicable only when shares are issued at a price per share which is lower than the price paid by the existing investors and not for every subsequent issue of shares. The reason being that, if shares are being offered to subsequent investors at a price per share which is higher than the price per share paid by the existing investors, even though their percentage shareholding in the company reduces, the value of the shares held by them increases.

Anti-Dilution Protection and its Variants

In India, the two commonly used forms of anti-dilution protection are: (a) Full Ratchet and (b) Broad Based Weighted Average.

Full Ratchet: Under this method, if shares are issued at a subsequent round of investment at a price per share that is lower than the price per share paid by the existing investors of the company, then the price of the shares/ conversion price of the existing investors will be revised to the price at which the new shares being issued. In such scenario, either additional shares will be issued to the existing investors for the surplus consideration after such price adjustment without the existing investors making any further payments or conversion price would be revised to the price of such shares being issued. Thus, the full-ratchet method does not consider the number of shares held by the existing investors or the number of shares being issued in the subsequent investment round, but only considers the price at which the new shares are being issued and the new price will be applied to all the shares held by the existing shareholders. Thus, the full ratchet method of anti-dilution protection is very harsh on the Company and the Founders as compared to the broad based weighted average method. Also, the shareholding percentage of the founders may get diluted to a very large extent if a full ratchet provision is implemented.

Broad Based Weighted Average: As compared to full ratchet mechanism, broad based weighted average method uses a formula which considers the number of shares issued in a subsequent round of investment and the number of shares held by the existing investors. Therefore, the broad based weighted average method is fair to the founders as well as to the investors and is adopted more frequently in investment transactions. The weighted average formula used in the transaction documents describe how the weighted average price is determined by taking into the consideration the existing price or the conversion price of the shares, number of outstanding shares prior to the new issuance, the number of shares to be issued and the purchase consideration to be received by the company with respect to such issuance.

Implications of Anti-Dilution Provision 

Pricing Guidelines under Indian Laws:

Any further issuance of shares by a Company registered in India shall adhere to various provisions of the Companies Act, 2013 (the “Act”), Foreign Exchange Management Act, 1999 including rules and regulations notified thereunder, regulations prescribed by Securities Exchange Board of India (“SEBI”) (if applicable) and Income Tax Act, 1961 (the “IT Act”).

In India, implementation of anti-dilution protection is complex considering the existing laws. For instance, shares issued to foreign investors need to be in compliance with the pricing guidelines as provided in Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017 (“FDI Regulations”). As per the pricing guidelines, capital instruments which are issued or transferred to a foreign resident has to be priced as per any internationally accepted pricing methodology for valuation on an arm’s length basis duly certified by a chartered accountant or a SEBI registered merchant banker or a practicing cost accountant in case of an unlisted company.

Convertible Instruments: Additionally, in case of convertible instruments, the price/ conversion formula of the instrument should be determined upfront at the time of issue of the instrument 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 FDI Regulations. Therefore, even adjusting the conversion ratio of a convertible instrument can pose complexities.

Considering aforementioned guidelines, enforcement of anti-dilution provisions and issue of shares pursuant to the same, especially to non-residents will be very difficult. Also, implementation of anti-dilution which results in issuance of new shares for no consideration, would not be allowed under the Act (which is applicable for both resident and non-resident investors).

Tax: Further, there is a complication which has to be examined under tax laws. As per section 56 (2) (x) (c) of the IT Act, when any person receives shares for a consideration which is less than the aggregate fair market value (FMV) by an amount exceeding fifty thousand rupees, the aggregate FMV of such property as exceeds such consideration is taxable as ‘income from other sources’ in the hands of the person receiving such shares.

Our thoughts:

Considering the nuances associated with the issuance of shares at a price below FMV or for no consideration, the actual implementation of anti-dilution provisions poses a lot of difficulties. Unless certain exceptions are brought in the existing laws, actual implementation could be a challenge in India, especially with respect to foreign investors.

Authors:  Mr. Paul Albert and Mr. Ashwin Bhat

Amendments to Companies Act and some relief to Permitted Startups

With the ability to modify the guidelines quick and fast, Companies Act has become dynamic. On 19 July 2016, the Ministry of Corporate Affairs notified the Companies (Share Capital and Debentures) Third Amendment Rules 2016 (Amendment) to amend certain provisions of the Companies (Share Capital and Debentures) Rules 2014 (Rules). These Rules contain the procedures for issuance of shares and debentures and disclosures to be made.
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Notes of the Amendments made:

1. Relaxation of preferential allotment process:
Earlier to these amendments, any securities issued through the ‘private placement’ process had to be fully paid up at the time of allotment. This infact was an anomaly, because, if the company chose a ‘right issue’ process, then it was possible to issue partly paid shares. The amendment now seeks to set this anomaly right and made it possible to issue partly-paid shares even through private placement process.

2. Determination of conversion price:
Earlier to these amendments, a company issuing convertible securities had to determine the conversion price at the time of issuance. This is true for any foreign direct investment as well. Now, companies may either determine the conversion price (a) upfront at the time of offering the convertible securities, or (b) not later than 30 days prior to the date the holder of convertible securities becomes entitled to convert such convertible securities, based on a valuation report of a registered valuer issued not later than 60 days prior to such date. The change in the foreign direct investment guidelines is still the same and it has to be notified to RBI at the time of issuance.

3. Issue of secured debentures:
Earlier to these amendments, a company could provide only its own assets and properties as a security for issuance of secured debentures. Now, the companies can issue secured debentures by creating a charge on the assets and properties of its subsidiaries, holding company or associate companies. The amendment expressly permits companies intending to redeem their debentures prematurely to transfer such amounts in excess of the limits specified under the Rules as may be necessary to the Debenture Redemption Reserve.

4. Issue of equity shares with differential rights:
Earlier, companies could not issue equity shares with differential rights if they defaulted in (a) the payment of dividends on preference shares, (b) the repayment of a term loan (or interest thereon) from specified institutions, (c) the payment of statutory dues relating to employees, or (d) crediting prescribed amounts in the Investor Education and Protection Fund. Now, such defaulting companies to issue equity shares with differential rights after 5 years from the end of the financial year in which they make good the default. It would have been nice, that a company could issue such shares immediately upon compliance.

5. Sweat equity shares by Permitted Start-ups:
Start-ups (as defined in notification number GSR 180(E) dated 17 February 2016 issued by the Department of Industrial Policy and Promotion, Ministry of Commerce and Industry, Government of India – “Permitted Startups”) are now permitted to issue sweat equity shares up to 50% of their paid-up capital for the first 5 years from the date of their incorporation. For other companies, this limit continues to be 25%.

6. Stock options to promoters and shareholder-directors of the Permitted Start-ups:
Permitted Start-ups can issue stock options to their promoters and to directors who hold more than 10% of the start-up’s equity shares for the first 5 years from the date of their incorporation. The restriction on issuing stock options to promoters and such directors continues for all other companies, who are not Permitted Startups.

7. Form SH-7 by companies not having share capital:
The Amendment requires that Form SH-7, for intimating any alteration of a company’s authorised share capital, be filed by companies that do not have share capital in case of an increase in the number of members.

Author: Venkatesh Vempati, works as an Associate with the Compliance Team