Issue of Securities on Private Placement Basis - Per the latest Amendment to Section 42 of the Companies Act, 2013

securities

A company shall require more capital for the growth apart from the founders or promoters’ contribution. In order to raise sufficient capital, the company may make a private offer to a select group of persons to subscribe to the securities of the company. The board of directors of the company shall identify such persons (‘identified persons’) to whom a private offer shall be made to participate in the share capital of the company and such an offer shall be made to a maximum of 50 people per each offer.

What is the maximum number of persons to whom the private offer shall be made?

The maximum number of persons to whom offer be made under private placement in a financial year is 200. Additionally, the restriction of 200 persons would be reckoned individually for each kind of security that is ‘equity shares’, ‘preference shares’ or ‘debentures’.

Note: In addition to the private placement offer being made to the identified persons, the private offer may also be made to a qualified institution buyer, or to the employees of the company pursuant to an ESOP scheme. The upper limit of making a private placement offer (i.e., 50 for a particular private placement offer and 200 in a financial year) shall be calculated excluding the qualified institution buyer or employees of the company.

What is private placement?

The term private placement is explained under the Companies Act, 2013 as “means any offer or invitation to subscribe or issue of securities to a select group of persons by a company (other than by way of public offer) through private placement offer-cum-application, which satisfies the conditions specified as per section 42 of the Companies Act, 2013”.

Who selects the identified persons for issue of shares on a private placement basis?

As per Section 179(3) of the Companies Act, 2013, the board of directors shall hold a meeting for issue of securities. Board of Directors may decide the list of identified persons to whom the securities shall be offered by passing of resolution in a board meeting.

Is the consent of shareholders necessary for issue of securities to identified persons?

The board of directors shall decide the list of identified persons to whom the securities shall be offered under a private placement offer. However, the board has to take consent of the shareholders of the company and pass a special resolution which states that the shareholders have given their consent to offer securities to the identified persons. The Companies (Prospectus and Allotment of Securities) Rules, 2014 mandates the filling of special resolution stated above with the RoC within 30 days from the date of passing the special resolution.

Note 1: The special resolution stated above shall be filed in Form MGT-14 with the RoC before offering shares to the identified persons or before giving the private placement offer-cum-application. This implies that the board cannot offer securities to any person without taking shareholders consent.

Note 2: The special resolution shall be substituted with a board resolution in case of issue of non-convertible debentures which are issued within the threshold limit (monetary threshold) prescribed under Section 180 of the Companies Act, 2013. The requirement of shareholders’ resolution under Section 42 of the Companies Act, 2013 is only applicable, in case the issuance of non-convertible debentures, when the threshold limit prescribed under Section 180(1)© of the Act is exceeded.

Note 3: In case a board resolution is passed as per Note 2, the board resolution shall be filed with the RoC on similar lines with the Special resolution.

Renouncing the RIGHT OF RENUNCIATION?

Section 42 states that only the identified persons shall have the right to subscribe to the securities offered by the company. This means that the Identified persons shall not have the right to renounce their right to subscribe in favour of another person. The aforesaid restriction was not provided in the erstwhile Section 42 of the Companies Act, 2013, but has been amended as such now with the amendments effective from 7th August 2018.

Is there any restriction on utilisation of the share application money?

Pursuant to issue of private placement offer cum application in Form PAS-4, the identified persons shall send the offer letter and the subscription money to the company. The subscription money shall be paid vide a cheque, demand draft or any other banking channel but not by cash.

The company shall not utilise the subscription amount/application amount unless the shares are allotted in the name of identified persons and a “Return of Allotment” in Form PAS-3 is filed with the RoC within 15 days from the date of allotment of shares. Additionally, the Companies Act, 2013 mandates for the company to allot the shares within 60 days from the date of receipt of application money and failure to allot the shares within the 60 days’ timeline shall result in a penalty to the company.

What is the minimum investment size for each individual in case of private placement of securities?

There is no minimum investment size in case of private placement of securities as per Section 42 of the Companies Act, 2013. Pursuant to an amendment by Ministry of Corporate Affairs, which shall be effective from 7 August 2018, there shall be no minimum investment size per person for issue of securities under private placement. Prior to the aforesaid amendment, there existed a restriction on the value of offer per person which was a minimum investment size of INR 20, 000 of face value of securities.

Anti-Dilution Rights - How to Work Around the FEMA (TISPRO) Regulations, 2017 for Non-Residents [Part 5 of the five-part series]

regulations

In order to avoid the ‘Pricing Guidelines’ [discussed previously in Part 4 of this story], the additional shares to be allotted to the original investor of the Indian startup company to comply with the Anti-Dilution Rights must be issued under the ‘rights issue’ mechanism under Section 62 (1) (a) of the Companies Act, 2013 instead of ‘preferential allotment’ mechanism under Section 62 (1) (c) of the Companies Act, 2013.

The FEMA (TISPRO) Regulation, 2017, under Regulation 6, clearly lays down the provisions governing the ‘acquisition of shares through a rights issue or a bonus issue’ to a ‘person resident outside India’. Regulation 6 (5), clearly lays down that, “In case of an unlisted Indian company, the rights issue to persons resident outside India shall not be at a price less than the price offered to persons resident in India.” This means that, under ‘rights issue’, the shares can be issued at any price (including price per share lower than the fair market value), provided the Indian company offers the shares under ‘rights issue’ to the other shareholders at the same price.

Generally, all investment agreements, which have Anti-Dilution Rights, have elements of shareholders agreements and are accordingly executed by all shareholders of the investee company (new shareholders of the investee company are inducted into such ‘investment agreement’ therein through addendum). Therefore, contractually, if one can bind the other shareholders of the investee company to reject such shares offered under ‘rights issue’, then the non-resident investor can exercise its ‘rights issue’ and subscribe to such number of shares that is required to comply with the Anti-Dilution provisions.

Anti-Dilution Rights – Exception for Non-Residents [Part 4 of the five-part series]

exception

Contravention of FEMA (TISPRO) Regulations, 2017

It is clear from the ‘Introduction’ [Part 1 of this story] that, if the Anti-Dilution Rights gets triggered, a startup company must issue additional shares to the investor exercising such Anti-Dilution Rights at no price or at a price lower than the value at which the fresh subscription has been made by the new investor.

This actually directly violates the ‘Pricing Guidelines’ under Regulation 11 of FEMA (TISPRO) Regulations, 2017, in the event the original investor is a ‘person resident outside India’ under FEMA (TISPRO) Regulations, 2017. As per the said Pricing Guidelines, no Indian unlisted company can issue shares to a ‘person resident outside India’, at a price lower than the fair market value, determined by a Chartered Accountant or a Securities and Exchange Board of India registered Merchant Banker or a practicing Cost Accountant.

Under the Companies Act, 2013, any fresh issue of securities to a new investor can be made only under Section 62 (1) ©of the Companies Act, 2013, and accordingly the Company within 30 days of such allotment must file a Return of Allotment under Form PAS-3 of the Company (Prospectus and Allotment of Securities) Rules, 2014. One of the mandatory conditions under Rule 12 (7) of the Company (Prospectus and Allotment of Securities) Rules, 2014 is that any shares issued under Section 62 (1) ©of the Companies Act, 2013, must attach a valuation report of a registered valuer (an independent SEBI Registered Merchant Banker or Chartered Accountant in practice having a minimum 10 years of experience) along with the Form PAS-3 filed for this.

Thus, any sale of additional shares by the Indian unlisted company, at no price or a cost below the fair market value determined by a registered valuer under Rule 12 (7) of the Company (Prospectus and Allotment of Securities) Rules, 2014, for the purpose of compliance with the Anti-Dilution Rights will contravene the ‘Pricing Guidelines’ under the FEMA (TISPRO). In the next part of this story, we shall discuss the work-around to this problem.

Anti-Dilution Rights — Weighted Average Method [Part 3 of the five-part series]

average

In Part 1 of the Anti-Dilution Rights story, we discussed the Anti-Dilution Rights in general, and identified that there are two mechanisms for Anti-Dilution Rights protection: i. Full Ratchet Method; and ii. Weighted Average Method.

In this Part 3, we will dig deeper into the Weighted Average Method.

The Weighted Average Method of calculation is used more extensively as this method gives importance to the proportionate relevance of the investments, made in both the rounds.

· Under this method, it is first assumed that all shares of the start-up company issued before the 1st round of investment were subscribed at the price per share similar to the price per share of the 1st round of investment (this is done to take into account the increase in valuation of the start-up company since incorporation to the time of 1st round of investment).

· Thereafter, the price per share at 1st investment is multiplied with the total shares in the start-up company after 1st investment (including the shares issued to the 1st investor).

· The result is then added with the 2nd round investment amount to arrive at the actual investment in the start-up company after the 2nd round investment.

· This is then divided with the total number of shares in the start-up company after the 2nd round investment.

· The result will be the weighted average price per share.

· Thereafter, the 1st round investment amount shall be divided by the weighted average price per share.

· The result will be the number of shares that the 1st investor would have received if the weighted average price per share was the price at which the 1st investment was made.

· This, when deducted by the shares actually received by the 1st investor, will determine the additional shares to be issued to the 1st investor under the Weighted Average Method.

As an example,

Total shares of start-up company before 1st round of investment = 800 shares (Shares before 1st investment)

Calculation:

{100 * (800 + 100)} + 5000} / (800+100+100) = 95

10000/95 = 105.2 shares (105 shares -rounded down)

105–100 = 05 (Additional Shares to be provided to 1st Investor under the Weighted Average Method)

Anti-Dilution Rights — Full Ratchet Method [Part 2 of the five-part series]

Ratchet

In Part 1 of the Anti-Dilution Rights story, we discussed the Anti-Dilution Rights in general, and identified that there are two mechanisms for Anti-Dilution Rights protection: i. Full Ratchet Method; and ii. Weighted Average Method.

In this Part 2, we will dig deeper into the Full Ratchet Method.

The Full Ratchet Method is a simpler method of calculating the number of additional shares that the start-up company needs to provide to the original investor in order to comply with the Anti-Dilution Rights. Under this method, the price at which the new investor has subscribed to the shares of the start-up company (“New Price”) is taken into consideration. Then, the number of shares, the original investor would have received, for his actual investment amount at the New Price is calculated. Thereafter, the number of shares actually received by the original investor in the first round of investment is deducted from the number of shares the investor would have received at the New Price. The result is the number of shares that must be allotted to the original investor in order to comply with the Anti-Dilution Rights.

Formula:

Original Investment/New Price = Shares 1st Investor would have got at New Price (New Price Shares)

New Price Shares — 1st Investor’s Shares = Shares to be allotted to Investor

Calculation:

10000/50 = 200

200–100 = 100 (Additional Shares to be provided to 1st Investor under Full Ratchet)

Anti-Dilution Rights — Introduction [Part 1 of the five-part series]

Contract

In India, the inclusion of ‘Anti-Dilution Rights’ in definitive agreements governing a startup or venture capital deal is quite common. These Anti-Dilution Rights provide protection to the investors against the dip in value of their newly purchased shares in the future event of subsequent investments in the startup company. This is actually quite fair in the case of startups because, at the time of any venture capital investment, startup companies are in a volatile stage and it is quite difficult to predict which way the valuation of the startup company will go in the subsequent rounds of investments.

Anti-Dilution Rights of the investors in a venture capital deal will trigger only when the subsequent rounds of investment in the startup company is made below the value paid by the investor in the original round of investment. Therefore, if the subsequent rounds of investments in a startup is made at a value more than the value at which the original investor had originally invested, then although the original investor’s shareholding in the startup company may get diluted, the value of his shares will actually increase in the market.

In the event the subsequent rounds of financing in the startup company is made at a price per share lower than the price per share paid by the original investor, the Anti-Dilution Rights of the investor gets triggered and accordingly the investor shall have the right to subscribe to additional shares of the startup company at no additional cost or at a significantly lower price. Thus, the original investor gets additional shares to compensate for the loss of value of the shares purchased by him originally. There are two mechanisms for Anti-Dilution Rights protection: i. Full Ratchet Method; and ii. Weighted Average Method. [these methods will be discussed in the coming parts to this story]