Tag Archives: valuation

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

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Fund raising and valuation: Company can choose the methodology

The recent ruling by the income tax appellate tribunal (“Appellate Tribunal”) of Jaipur dated 12 July 2018 in the case of Rameshwaram Strong Glass Private Limited v ITO has come as a significant relief for tax payers. In this matter, the Appellate Tribunal has held that the income tax laws in India gives an option to the assessee under rule 11UA of the Income Tax Rules, 1962 (“Rules”) to adopt either the break-up value method or the Discounted Free Cash Flow (“DCF”) method for valuation purposes.

Brief facts of the case: Rameshwaram Strong Glass Private Limited (the “Company”) incorporated on 31 January 2011, is a closely held company manufacturing toughened glass. There was no business conducted by the Company from assessment years 2011-2012 to 2013-2014 except for purchase of land. During the assessment year 2013-2014, the Company issued shares at a premium as per the valuation report prepared by a chartered accountant as per the DCF valuation method. The assessing officer (“AO”) claimed that the break-up value method was to be adopted by the Company instead of the DCF method for the purposes of valuation. As per the AO, since the DCF method was adopted instead of the break-up value method, the Company received additional money through the issue of these shares. Also, the AO claimed that the valuation report was incorrect and not justified and the actual premium of the shares should have been lower than what was mentioned in the valuation report. The Company submitted a revised valuation report to the commissioner of income tax, appeals (“First Appellate Authority”) in which a bona-fide error in the earlier report was corrected. The Company also contended that the amount of share premium is a commercial decision which does not require justification under law and the shareholders has the discretion to subscribe to the same. However, the First Appellate Authority directed the Company to prepare the valuation report based on the actual figures and not on estimates. Based on this revised report, the First Appellate Authority held that the earlier valuation report prepared was incorrect, based on imaginary figures and without any basis.

The Company appealed against the order of the First Appellate Authority to the Appellate Tribunal. One of the contentions of the Company was that the Rules allow the Company to choose between the DCF method or the break-up value method. The valuation method adopted by the Company cannot be challenged by the AO as long as it is a recognized method of valuation. Also, the Company contended that the requirement of the tax authority to give valuation report based on the actual figures and then comparing the same with the valuation report prepared through DCF method is not correct since the valuation under DCF method is based on future estimates based on revenue, expenses, investment, etc. The value is derived from the future profitability or cash flows of the Company. Also, since this is a newly formed company, the DCF valuation method had to be used as the capital base of the Company would be very less.

The Appellate Tribunal agreed with the contention of the Company stating that the assessee has the right to choose the method of valuation.  The Rules clearly provide an option to the assesse to follow either the DCF valuation method or the break-up value method. The only condition cast upon an assessee is that the valuation report has to be given by a merchant banker or a chartered accountant using the DCF method who have expertise in valuation of shares and securities. When a particular method of valuation is provided under law and when the assessee has chosen a particular method, directing the assessee to follow a particular method is beyond the powers of the income tax authority. The AO can scrutinize the valuation report if there are arithmetical errors and make necessary adjustments or alterations. However, if the assumptions made in the report are erroneous or contradictory, the authority may call for independent valuer’s report or invite his comments as the AO is not an expert. Also, the First Appellate Authority’s direction to the Company to give the valuation based on actual figures and then comparing such valuation report with that of the earlier report is contrary to the provisions of law since the DCF valuation method is based on future estimates. Therefore, the Appellate Tribunal held that the valuation report prepared by the chartered accountant using the DCF method was proper and the action of the AO and the First Appellate Authority was invalid.

It remains to be seen whether the judgment of the Appellate Tribunal goes up to the Supreme Court. However, as of now, this comes as a relief, in light of the many nuances that we discussed in our earlier post on Early Stage Valuations: Legislative Context and Continuing Saga of Angel Tax.

Note: The Board of Direct Taxes (CBDT) issued a notification on 24 May 2018, whereby the word “or an accountant” from Rule 11UA was omitted. Therefore, if a company is issuing equity shares to resident individuals, merchant banker valuation would be mandatory.

Author: Paul Albert