Boost for start-ups

Several key amendments in the Shares and Debentures Rules of the Companies Act, 2013, including a hike in the limits for the issue of shares with differential voting rights (DVR), could energise the start-up ecosystem. Tech start-ups now have the option of issuing DVR shares for up to 74 per cent of their paid-up capital. Moreover, they need not show distribution of profits for three years in doing so. They may also continue to issue employee stock options (Esops) for up to 10 years to executives even after listing.

This aligns with requests from the start-up community, which has also received a huge retrospective relief from the so-called “angel tax” enquiries by the Income-Tax Department. Under the new regulations, entrepreneurs launching tech start-ups should be able to raise capital, while retaining operational control. This should also embolden new concerns to list in India rather than seeking listings abroad.

DVRs are a standard instrument in many hi-tech environments such as Silicon Valley. Tech start-ups often raise several rounds of venture capital financing, diluting the stakes of the original entrepreneurs. This can lead to the investors taking control of operations even before the company’s listing and, later, it leaves the company vulnerable to hostile takeover bids.

One way around this is to issue DVR shares. In such cases, some shares have superior rights (SR) in terms of voting rights, while in other respects, the rights of shareholders remain equal. Indeed, DVRs can be structured so as to give owners of shares lower voting rights, and higher dividend payouts as compensation. 

Until the recent amendments, corporates seeking to list in India could not issue DVR shares, nor could they launch an IPO until they had demonstrated three years of distributable profits. This forced Indian entrepreneurs to seek capital abroad, and to go abroad for listing. This, in turn, meant that ordinary Indian investors could not participate in the wealth creation process, by buying shares at an IPO, or off the secondary market. Moreover, Esops could only be issued for a period of five years after an IPO.

The new amendments allow issues of DVRs where the SR shares hold between twice and 10 times the voting rights by ratio. Corporates also need not have demonstrated distributable profits. This is a big relief because many tech companies endure years of loss before establishing themselves.

There is an upper limit to net worth in that holders of SR shares must be from the core promoter group, and not possess a collective net worth of above Rs 500 crore. Also SR shares cannot be pledged or transferred. The SRs must be held for at least six months before the issue of a draft red herring prospectus for an IPO. Eventually, a sunset clause should kick in wherein the SR shares revert to normal voting rights.

These changes should encourage listings in India because they make the processes of raising capital and listing easier. In turn, start-up activity should attract more capital and, thus, lift sentiment. One caveat is that it will be more difficult for investors to seek redress by ousting founders in cases of gross mismanagement. But this possibility is outweighed by the practical need for entrepreneurs to raise capital while retaining operational control.

Business Standard is now on Telegram.
For insightful reports and views on business, markets, politics and other issues, subscribe to our official Telegram channel