SUGGESTION OVER SHARES WITH DIFFERENTIAL VOTING RIGHTS

Summary:

Today India is marching ahead on the path of promoting the entrepreneurship and Startups. More and more people are opting for self-employment and startups. India has witnessed many startups, which eventually became the prominent market leaders. Furthermore, these startups are mostly owner driven. In such a case, these owners prefer to maintain control of their startup, as the core idea had emanated from them. Further, they mostly wish to hold controlling interest in their startup along with raising funds. Raising funds for growth of startup requires divesting of founders equity and holding. Angel investors, FII, QIB, or any other fund houses (together hereinafter referred as “Angel Investors”) only invest if they get voting and management right in the startup organization.

In that case, it becomes difficult for the founders to hold control over their startups. Hence, they prefer shares with Fractional or Inferior rights (hereinafter referred as “Shares with Fractional or Inferior Rights – FR”) for the purpose of allotment to the Angel Investors. However, as correctly mentioned in the recommendation of DVR group, the Angel investors, on the other hand, wants to protect their investments, and want to minimize the risk by monitoring the activities of the startups. For this protective right the Angel Investors demands certain participation rights in the oversight board or management of the company. Such protective rights, as per current regime, can only be obtained through issuance of ordinary shares by company, which in turn again creates problem of divesting the holding percentage of the Founder and Promoter Group (hereinafter referred as “FPG”). Hence, to solve this dilemma, shares with differential voting rights (hereinafter referred as “DVR”) may be used. Shares with DVR can be Shares with Fractional or Inferior Rights – FR or Shares with Superior Rights – SR in comparison with Ordinary Shares issued by the company.

Suggestions:

Following are the suggestion in relation to the ““COMPANIES WHOSE EQUITY SHARES ARE PROPOSED TO BE LISTED – ISSUANCE OF SR SHARES” i.e. issuance of the Shares with DVR for the Startups and existing companies.

1.    First Issue of SR share:

In proposed recommendation for First Issue of SR Share i.e.

“SR Shares can be issued only to the promoters of a company by an unlisted company. An unlisted company where the promoters hold SR Shares shall be permitted to do an Initial Public Offer (“IPO”) of only ordinary equity shares provided the SR Shares are held by the promoters for more than one year prior to filing of the draft offer document with SEBI.”

there is no time limit specified until which the company could issue the SR shares to promoters. Further, it is menti0ned that the SR shares should be issued one year or more before filing for the IPO. Ideally, there should be a time limit specified until which the company should or can issue SR shares to the FPG. The rationale behind that is;

  1. The purpose of the introducing the permissibility for shares with DVR is to give the freedom to startups for owning there company along with protecting the rights of the Angel Investors. In such a case, to protect the rights of the Angel Investors and to protect the misuse of Shares with SR one should not issue shares with SR after huge investment done by the Angel Investors. And,
  • Further to maintain the transparency with respect to the accountability, structure of the company in regards to its decision making since inception.

Hence based on the above rationale following may be considered for the time limit for issuance of shares with SR;

“No company shall issue shares with Superior Voting rights after two years from its date of commencement of business or date of incorporation whichever is later.”

Further the provision contained in the Companies Act, 2013 i.e. “Pursuant to Rule 4(1)(d) of the Companies (Share Capital and Debenture) Rules, 2014, “the company must have a consistent track record of distributable profits for the last 3 years” in case it desires to issue DVR Shares,” should be reconsidered again with respect to the above suggested time limit provision for issuance of shares with SR as company might issue shares with DVR during inception or at later stage, considering the fact that the startups usually struggle to achieve profitable position in there initial years.

2.    Subsequent issue of FR Shares:

Further, pertaining to the Subsequent issue of FR Shares the group has recommended the following:

“A company whose SR Shares and ordinary equity shares are already listed shall be permitted to issue FR Shares in terms of the applicable provisions for issue of FR Shares by listed companies”.

In respect to this recommendation, it would be suggestive if the following changes may be made into that:

“A company whose SR Shares and ordinary equity shares are already listed on a stock exchange and has already issued SR shares to its Promoters or Founders shall be permitted to issue FR Shares in terms of the applicable provisions for issue of FR Shares by listed companies”.

Further, in respect to subsequent issue of FR Shares, following will be suggestive to adopt for better governance and transparency:

  1. A company only be allowed to issue FR shares when it has already issued SR shares in the past or has already issued ordinary shares to public and are listed on a stock exchange. The rationale behind this is if a company has issued ordinary shares to FPGand subsequent to that is only issuing shares with FR to normal public then such ordinary shares will in relative terms becomes shares with SR compared to shares with FR.
  1. It would be advisable if SR share should not be traded on stock exchange. As such shares are for the FPG for their governance of daily day to day operations. Such shares will carry huge responsibilities and rights. Hence in order to protect the interest of the public and the Angel Investors, no company should be allowed to list SR Shares on stock exchange.

3.      Lock-in of SR Shares:

Moreover, pertaining to the Lock-in of SR Shares, the group has made following recommendation:

“All SR Shares shall remain under a perpetual lock-in after the IPO.”

However, following changes are suggestive in nature for this:

“All SR Shares shall remain under a perpetual lock-in after the IPO subject to the transfers made to the legal heir or to spouse or to any or all of the dependent child(s).”

The reason behind such suggestion is to prevent the deadlock, in the case of death or any such scenario where the holder of SR share is not in position or take effective decisions which are required for daily operations and working of the company, in the governance or decision making of the company if such governance or decision-making is linked with SR shares.

4.      Coat-tail Provisions:

Under the point (g) of the Coat-tail Provisions it is mentioned that:

“Post-IPO, the SR Shares shall be treated as ordinary equity shares in terms of voting rights (i.e. one SR share one vote) in the following circumstances:

(g) extension of the validity of the SR Shares post completion of 5 years from date of listing of ordinary equity shares; and”

It would be advisable if the provision of the renewal of the validity of SR shares can be deleted i.e. by making them perpetually valid. The rationale behind this is today most of the startups are technology based. Technology changes fast with the time so it may happen that after 5 years the company is now require to adapt the change in technology. Further, as we already the know concept of the “Founder Knows Better” which states that the Founder has better knowledge of his idea, then in such a case only Founder will be in better position to protect the company from being rigid to such changes in the business environment.

Further as mentioned in the Sunset Clause i.e.

“The SR Shares shall get converted into ordinary equity shares on the 5th anniversary of the listing of the Ordinary Shares of the company i.e. they would lose their superior voting rights and each SR Share would carry an entitlement to a single vote as if it were an Ordinary Equity Share. The validity of the SR Shares can be extended by another 5 years with the approval shareholders by way of a special resolution in a general meeting where all members vote on one-share-one vote basis irrespective of the nature of their shareholding. The promoters, however, may do an accelerated conversion of their SR Shares into ordinary equity shares at any time prior to the 5th anniversary or such extended period.

The SR Shares shall get compulsorily converted into ordinary equity shares in the event of a merger or acquisition of the company or whenever these are sold by the identified promoters who hold such shares or in the case of demise of the promoter(s). Transfer of SR Shares amongst promoters or persons of the promoter group(s), even though they are inter-se transfers between persons acting in concert, shall not be permitted.”

It would be advisable if the provision for mandatory conversion can be removed, except the provision of sunset in case of merger or acquisition as currently mentioned, in light of earlier provided explanation. Further, it would also be advisable to include following sunset clause:

In case of dead or incapacitation, with respect to decision making linked with the SR shares, of any or all of the Founders of the company, the SR shares of all such founder shall shall get converted into ordinary equity shares after completion of 60 months from the date of such death of incapacitation i.e. they would lose their superior voting rights and each SR Share would carry an entitlement to a single vote as if it were an Ordinary Equity Share. The validity of the SR Shares can be extended by another 60 months with the prior approval shareholders by way of a special resolution in a general meeting, taken at least 3 months prior to completion of such 60 months period, where all members vote on one-share-one vote basis irrespective of the nature of their shareholding. The promoters, however, may do an accelerated conversion of their SR Shares into ordinary equity shares at any time.”

5.      Generic Suggestions:

  1. It would be advisable if the company is only allowed to list FR and Ordinary Shares on Stock exchange not FR shares.
    1. Further, it would be advisable if the proper definition, as to what construe as Superior Rights, Fractional Right and Differential Voting Right, should be provided in the Act.
    1. Furthermore, it would be advisable if the companies are mandate to mention the category of SR or FR shares in its AOA or MOA.
    1. Further, no companies should be allowed to issue multiple types SR shares or FR in terms of rights attached with such shares.     

For the detailed recommendation of the group on DVR refer the following link :
https://www.sebi.gov.in/reports/reports/mar-2019/consultation-paper-on-issuance-of-shares-with-differential-voting-rights_42432.html

You can access my recommendation in the PDF format from following link: https://drive.google.com/file/d/1sYL9rnOND4KlV6hbjEMlSbENMhhgD9oA/view?usp=sharing

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