In recent years, there has been increasing clamour and debate around implementing a framework for enabling issuance of shares with Differential Voting Rights (“DVRs”) where listed companies are concerned. In a move that is bound to significantly change the way certain transactions are structured, the Securities and Exchange Board of India (“SEBI”) approved the Framework for Issuance of Differential Voting Rights Shares (“Framework”) on June 27, 2019.
As the name suggests, DVRs deviate from the standard one person-one vote principle. DVRs can be issued either in the form of shares carrying superior rights or shares carrying inferior rights. Superior Rights shares (“SR Shares”) offer multiple votes on an ordinary equity share and inferior or Fractional Rights Shares (“FR Shares”) offer a fraction of the voting rights on an ordinary equity share. FR Shares offer higher dividend compared to ordinary shares in lieu of the voting rights taken away. The Companies Act, 2013 permits a company limited by shares to issue shares with differential rights[i].
Before the enactment of the Framework, SEBI had prohibited listed companies from issuing DVRs with superior rights. However, SEBI, had permitted the issuance of FR Shares, which as has been noted below, has been amended under the new Framework. The rationale for not allowing the issuance of SR Shares was the potential of misuse of the same by promoters in a manner detrimental to the interests of the minority shareholders.
Pertinently, many startups in India witness crucial promoter involvement holding comparatively low shareholding and such promoters may wish to retain controlling interest in the company disproportionate to their economic ownership. DVRs, therefore, become the mechanism through which promoters are able to keep a hold on the decision making process even after subsequent rounds of funding. Keeping the same in mind, SEBI, via the Framework, has permitted Initial Public Offering (“IPO”) of unlisted companies with shares carrying superior voting rights.
The key proposals under the Framework as approved by SEBI are as follows:
- Eligibility – A company with SR Shares will be permitted to make an IPO of only ordinary equity shares, subject to fulfilment of existing SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 and the following conditions:
- Issuer company should be a tech company (as defined in the Innovator Growth Program) i.e. intensive in the use of technology, information technology, intellectual property, data analytics, bio-technology or nano-technology to provide products, services or business platforms with substantial value addition.
- The SR shareholder should be issued to only promoters/founders holding an executive position in the company and should be part of the promoter group whose collective net worth does not exceed INR 500 Crores.
- SR shares should have been held for a period of 6 (six) months prior to the filing of Red Herring Prospectus.
- SR Shares should have voting rights in the ratio of a minimum of 2:1 to a maximum of 10:1 as compared to ordinary equity shares.
- Listing and Lock-In – SR Shares are to be listed on the stock exchanges after the issuer company makes a public issue and such shares shall be subject to a lock-in after the IPO until conversion into ordinary equity shares. Transfer of SR Shares among promoters is not allowed under the Framework and pledge / lien also not permitted.
- Rights of SR Shares – SR Shares are to be treated at par with ordinary equity shares in every respect, including dividends, except in case of voting on resolutions. Total voting rights of superior rights shareholders are not to exceed 74% (seventy four percent) after listing of the IPO.
- Enhanced Corporate Governance – Companies issuing SR Shares shall have to comply with a higher threshold of corporate governance. At least ½ of the Board and 2/3rd of Committees as prescribed under SEBI (LODR) Regulations, 2015 shall comprise of Independent Directors and the Audit Committee shall be comprised of only Independent Directors.
- Coat-Tail Provisions – SR Shares shall be treated as ordinary equity shares in terms of voting rights (i.e. one share one vote) under various circumstances including appointment or removal of independent directors and/or auditor, related party transactions under SEBI (LODR) Regulations, 2015 involving SR shareholder, voluntary winding up of the company, initiation of voluntary resolution under IBC, utilisation of funds for purposes other than business, changes in the company’s articles of association or memorandum – except a change affecting the SR instrument, etc.
- Sunset Clauses – The conversion of SR Shares into ordinary equity shares as envisaged under this mechanism shall be either time based or event based. In case of a time based conversion, SR Shares shall be converted into ordinary shares 5 (five) years post-listing. An event based conversion shall transpire on the occurrence of certain events such as demise, resignation of superior rights shareholders, merger/acquisition where control no longer resides with the SR shareholder, etc.
- Fractional Rights Shares – Issue of fractional rights shares by existing listed companies shall not be permitted.
Consequently, SEBI has also expanded the scope of ‘encumbrance’ as defined under the SEBI Takeover Code, 2011, to include ‘any restriction on the free and marketable title to shares’, thus ensuring that no lien or pledge may be created over SR Shares issued in accordance with the new framework.
A scrutiny of the Framework highlights the balance sought to be maintained by SEBI in allowing the issuance of SR Shares. However, there are a few places where removal of ambiguity would be welcome, such as:
- It has not yet been clarified what would constitute as ‘intensive’ use of technology in order to meet the eligibility criteria specified in the Framework.
- The Framework has not set in place a timeline or coherent structure for companies with existing FR Shares. It is interesting to note that while the consultation paper issued by SEBI on the matter of DVRs had contained a detailed regime for both SR Shares and FR Shares, the mechanism for FR Shares was not incorporated into the approved Framework.
- Under the Framework, tech companies are also required to comply with the eligibility criterion mentioned in the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018, which stipulates profit based measures of eligibility. This provision may potentially constitute a hurdle in the way of effective implementation of the new Framework. The reason behind the same is best highlighted by a recent report by the Reserve Bank of India (RBI), Expert Committee on Micro, Small and Medium Enterprises, which also hinted at a dual class share structure.However, the panel on MSMEs suggested that most technology or high-grow the startups are often loss making, which is why there should be no profitability requirement to list.
Apart from the positive impact expected on the stakeholders explicitly covered under the Framework, a dual class share structure may also encourage highly valued startups to list on the domestic stock exchanges rather than the exchanges overseas. SEBI has taken a bold step in attempting to make the tech startup space more attractive. On the heels of and in concomitance with the Framework, the government has also announced that it shall review restrictions on shares with DVRs in the Companies Act 2013 to make it easier for promoters of startups to raise equity capital without losing control of the issuing company[ii].