Voting rights ushering in a new era of capital raising

Published: August 26, 2019 12:56:40 AM

Differential voting rights allow for more Silicon Valley inspired investment structuring and negotiations, and could have avoided the debacle of a public Indigo fallout or Mindtree’s hostile takeover.

The proposed SEBI framework does advert some of these challenges due to mechanisms such as the coat-tail provisions, which allow for flattening of the voting rights in some situations.

By Vatsal Gaur 

What do Facebook, Google and Snapchat have in common, apart from being some of the most powerful companies in the world? Unequal voting rights! Yes, at a time when the blue-eyed boy of the Indian startup ecosystem, Ritesh Agarwal of Oyo Rooms, had to devise a leverage-backed buyback in his unicorn to maintain shareholding befitting his founder status, world over, the likes of Mark Zuckerberg and Larry Page have had their voting rights safely secured, regardless of dilutions to their equity stakes through series and series of equity fundraising.

Disproportionate voting rights, known in the Indian legal regime as shares carrying differential voting rights (DVRs), have been a subject of constant policy changes, but with SEBI waking up to smell the coffee recently, when it released the framework for listing of superior rights shares for tech-based startups, it was only time that the Ministry of Corporate Affairs (MCA) followed suit. Some of the laudable changes introduced by the MCA, via amendments to the share capital and debenture rules, include ability to issue up to 74% DVRs (from the erstwhile 26% sanction) and doing away with the notorious regulation mandating a track record of three years distributable profits, which was completely impractical to begin with (for the record, We Work, the $47 billion co-working company, which has been in the news recently over its IPO filing, is still not profit making!).

Let’s for a moment assume that Mindtree, prior to its listing, had created a Class B share, with voting rights 10x the voting rights of an ordinary share or a Class A share. The L&T hostile takeover would surely have been a tougher battle to fight, and perhaps the Mindtree founders would still be on the board. In much the same way, the recent public spat in Indigo, between its co-founders, too, could have been preempted if either one of the founders would have secured with himself a special kind of security that gave him larger voting rights. In a larger context, logjams in decision making of a company are mostly the nemesis of ‘business as usual’, and with prime minister Modi recently branding Indian entrepreneurs as ‘Growth Ambassadors’, I suppose the brief with the cabinet is clear—make company law easier! Proposals to decriminalise numerous company law violations are already underway and, with the oppressive angel tax regime being nebulised for startups raising funds—and tax officers being told to ease the whip during investigations—the stand of the government (although reactive in nature) deserves complete credit and gratitude.

I anticipate creativity in structuring of investment deals, to follow this change, in the universe of unlisted companies. For example, a Nike kind of corporate structure can be adopted suitably, wherein Class A shareholders have the power to elect 75% of the board. Alternatively, there could also be some interesting issues arising, where equity could be diluted below 50%, with the investors holding equal or greater strength at the Board level, but with the startup founders holding more than substantial voting rights at a shareholder level. A simple case of approving an amendment to a company’s articles of association, therefore, could be met with a challenge, where, say, Class A shareholders of a company with DVRs could block a special resolution, through their voting rights being disproportionately higher, despite equity dilutions following multiple rounds of capital raising. The proposed SEBI framework does advert some of these challenges due to mechanisms such as the coat-tail provisions, which allow for flattening of the voting rights in some situations.

A protectionist regime in favour of domestic founders is only fair at a time when countries and continents face de-globalisation and trade wars at a macro level. It is also a great way to ensure effective control of a company is retained with entrepreneurs regardless of enormous rounds of funding, by allowing for a separation between stock ownership, economic rights attached to such stock, and voting control.
There are various other aspects which, I believe, will come into play going forward. For instance, how would superior voting rights shares be valued? Would they be taxed higher at the time of their sell down? Could VC investors look to set off superior voting arrangements against a higher contractual liquidation preference during deal negotiations, assuming disproportionately higher liquidation preference could be read within the ambit of how DVR shares are defined under the law?

Needless to say, a new era of capital raising has begun, thereby allowing for more Silicon Valley inspired investment structuring and negotiations. Sell-side deal lawyers and founders rejoice!

Associate Partner, HSA Advocates. Views are personal

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