Fund raising is an intrinsic part of a startup’s journey, to scale up or diversify its operations. The fear of losing control of one’s company due to dilution of their equity stake is a concern for promoters too. That’s why startups have been demanding a relaxed regime to issue shares with differential voting rights. Their timing has been good.
The Indian government is keen to ensure the country is viewed as an attractive destination for startups, not just as a market for them to do business but as a place where they are domiciled. Last week, the government allowed startups to issue shares with differential voting rights (DVR), amounting to 74 percent of the total paid-up share capital from the earlier 26 percent through an amendment of the Companies (Share Capital & Debentures) Rules under the Companies Act.
Earlier, the Securities Exchange Board of India had allowed listed tech companies to issue superior voting rights to promoters and founders up to a maximum of 74 percent of the company’s paid-up capital. The modification in company law will mean that unlisted companies too can issue DVRs and if they decide to list the company, they can do so without the DVR structure blocking the listing, as long as the company meets the requirements under the Sebi regulations.
This will provide a boost for startup founders who can retain management control in their companies even when they raise equity funding. Besides, the requirement of distributable profit for three years for a company to be eligible for issuing DVRs has been removed. To add to that, the government has doubled the tenure of employee stock options (ESOPs) to 10 years from five years.
The change in DVR norms will not only help startup founders retain control, but will also ensure financial investors have limited control and access to the innovations and technology that these companies develop, the government said in a statement.
But, things are not be as simple as they might seem especially for startups that are planning to list. According to decisions taken by the SEBI board on June 27, only tech companies – as defined by SEBI under innovators growth platform – will be able to issue DVRs to the founders and promoters whose collective networth should not exceed Rs 500 crore.
DVRs will have to be converted into ordinary equity shares within a specified timeline of five years after the company’s initial public offering. This can be extended for five more years if the company passes a resolution. The startups, however, had asked the period of this sunset clause to be 15-20 years citing practices in the US market.
The sunset clause could be seen as a deterrent, especially by the companies that are solely dependent on technology innovations and require multiple rounds of heavy funding. Besides, promoters or the founders of the company will not be able to sell or pledge these DVRs until they convert these shares into ordinary equity shares. The US market has a more relaxed regulatory structure, especially for the technology firms.
Also, the DVRs will be treated as ordinary shares, for the purpose of voting, in instances such as appointment of independent directors, related-party transactions, voluntary winding up of a company or initiation of resolution plan under the Insolvency and Bankruptcy Code (IBC), among others. This is to ensure that DVRs don’t distort corporate governance standards or become a hindrance during the insolvency process.
To better govern startups, Sebi prescribed that companies with DVRs will need to have half of the Board members who are independent directors. Also, two-third of the committees (as prescribed under SEBI (LODR) Regulations, 2015) should comprise of independent directors.
These are checks and balances that ensure the rights of minority shareholders is also protected, while founders can raise funds without the fear of losing control. But, it will lower the chance of a hostile takeover and that could affect valuations.
At a time when India is struggling to deal with unemployment being at a 45-year high in 2017-18, DVR shares is a good move by the government. This is simply because funds help startups to grow and with growth creates more jobs. Will the opening up of the DVR share route unleash a wave of fund-raising by startups and shake up ownership structures in the Indian startup world? Keep watching this space.Subscribe to Moneycontrol Pro and gain access to curated markets data, trading recommendations, equity analysis, investment ideas, insights from market gurus and much more. Get Moneycontrol PRO for 1 year at price of 3 months at 289. Use code FREEDOM.