The easing of restrictions on issuing DVR shares will benefit many startups with IPOs in the pipeline. However, the restriction on converting existing shares defeats the intent behind the recent amendments.
By Vaibhav Kakkar and Puneeth Nagaraj
The Ministry of Corporate Affairs (MCA) recently amended the Companies (Share Capital and Debentures) Rules, 2014 (SCAD Rules) to create an enabling environment for the issuance of shares with Differential Voting Rights (DVRs). The MCA move was long-awaited and follows closely on the heels of the Securities and Exchange Board of India (SEBI) amending the DVR framework applicable to listed entities. DVRs create two classes of shareholders, allowing founders/promoters to have a greater say over decision making with a minority shareholding. The call to introduce a workable DVR framework has grown louder in the recent past with many Indian startups looking to go public.
Led by founders with diluted equity (in exchange for venture capital/ private equity funding), these startups are looking to replicate a model most famously adopted by Facebook, Tesla and other successful startups in the recent past. Mark Zuckerberg reportedly retains control of the company despite owning less than a third of the company’s shares. However, DVRs have found few takers in India given the many restrictive conditions attached to issuing DVRs. The recent amendments ease many of these restrictions, most notably the requirement that a company should have distributable profits in the previous three years. This was a stiff obstacle for startups in particular, as they prioritize turnover over profits in their growth phase. Doing away with the profitability requirement hence is a big boost for startups. However, given the many restrictions attached to the revised DVR framework, there is a risk that the amendments may not provide sufficient incentives to popularize DVRs in the country.
The Need for DVRs
Though united in the purpose of giving life to a new idea, founders’ interest diverges as investors may look to take control of a company once the promoter/founder is on a weak footing with reduced equity. With founders diluting their equity in exchange for much-needed capital in the growth phase, their ability to call the shots when a bigger company comes calling or at the time of an Initial Public Offering (IPO) is limited. In such a scenario, founders/promoters may feel marginalised. Recent investor exits show that the balance between a founder and investors can quickly shift in the face of a lucrative exit option. In this context, the move to revamp the DVR framework is welcome.
Move Away from the Profitability Requirement
MCA’s amendments, notified last Friday, revise the existing DVR framework contained in the Companies Act, 2013 and the SCAD Rules. Though these rules have been in effect for a few years, DVRs have had few takers in India. This is highlighted by the fact that only four listed companies have issued DVRs due to the extremely restrictive conditions under which DVRs are permitted. Instances of such restrictions include the requirement to demonstrate distributable profits for three years and limiting shares with DVRs to 26 per cent of the total capital. The amendment to the SCAD Rules has dropped the profitability requirement and increased the limit to 74 per cent of the total voting power of all shares.
These changes are a welcome move for most startups as they would not meet the profitability requirement, especially at the point at which they would need to rely on DVRs. Similarly, there was no rational basis to limit DVRs to just 26 per cent of the total capital under the earlier rules. It has been reported that founders of many Indian unicorns have diluted their shareholding to single digits. Raising the cap to 74 per cent and linking it to voting rights rather than capital would allow startups to focus on growing the company, raising new investment without worrying over the control of the company.
Continuing Restriction on Conversion of Existing Shares
The easing of restrictions on issuing DVR shares will benefit many startups with IPOs in the pipeline. However, the restriction on converting existing shares defeats the intent behind the recent amendments. The inability to convert existing shares would make issuing DVRs virtually impossible for most startups. The SCAD Rules currently prohibit a company from converting its existing share capital into DVRs or vice versa. In the absence of a conducive environment to issue DVRs, startup founders/promoters have held most of their investment in the form of equity or equity-linked instruments. Hence, such promoters/founders may not have the necessary funds at their disposal to subscribe to fresh DVRs as required by the SCAD Rules, considering the number of DVRs that may be required, especially where companies have a large capital base and have attained unicorn status.
There is no clear rationale for why there is a bar on converting existing shares to DVRs. If the regulators are concerned about the founders/promoters exercising undue control, corporate governance safeguards in the SEBI framework can be introduced in the SCAD Rules. The recently amended SEBI Listing Obligations and Disclosure Requirements Regulations, 2018 identify important governance functions for which DVRs would carry the same voting rights as ordinary shares. These functions include amending the Articles of Association, appointment/removal of directors and winding up to name a few. Such restrictions would be far more effective than a bar on converting existing shares. More importantly, conversion of existing shares to DVRs is a common practice around the world and has been successful in the United States, Singapore, Canada and Hong Kong.
(Vaibhav Kakkar is a regulatory practice partner and Puneeth Nagaraj is an associate (Policy & Advisory) at L&L Partners. Views expressed are the authors’ own.)