Hybrid Instruments For Investments In Startups – Corporate/Commercial Law – India

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INTRODUCTION

The fast-paced growth of Start-ups in India has attracted
support and aid from the government and also numerous industrial
sectors. With the idea of promoting growth of the Indian economy,
entrepreneurs have received several incentives and benefits to
establish start-ups. The essence for their growth and success lies
in the ‘financing and funding’, which is most often than
not a challenge for these entrepreneurs.

At the nascent stage, the funding is usually provided by an
internal source, such as friends and family, or the founder
himself. This is called ‘Seed Capital’ which helps convert
a business idea into something viable, thereby attracting
additional financers. After this stage, the startups tend to tap in
external sources of investment, usually through private individuals
such as ‘Angel Investors’. This helps in a bringing a
certain degree of advancement and stability to the business.
However, the predominant source of start-up financing in India is
through Venture Capitalists or Private Equity, done using different
methods and instruments, some of which are discussed below.

FINANCING THROUGH CONVERTIBLE INSTRUMENTS

Financing is generally of two kinds, a) Debt Financing and b)
Equity Financing. The former source is through loans and External
Commercial Borrowings (ECB’s) which invites a high rate of
interest along with a pre-requisite for collateral. Considering the
nature and instability of these startups, debt financing is usually
disregarded as a suitable option for such entrepreneurs.

On the other hand, Equity financing encompasses a high-risk
factor as there is no guarantee of repayment in case the venture
fails to perform. A private equity investor or venture capitalist
invests in the shareholding of the company by way of subscribing to
the equity share capital. This majorly helps in the expansion or
diversification of the startup ventures.

Over the years, a recent development has emerged in equity
financing to balance the interests of startup entrepreneurs as well
as the investors. Financing is done by subscribing to
Convertible Instruments such as Compulsory Convertible
Preference Shares (CCPS) and Compulsory Convertible Debentures
(CCD). These hybrid options are favorable as equity shareholding
does not ensure fixed return on investment and does not offer any
special rights or preferences. Additionally, by issuing convertible
securities, the founders are able to retain their control over
management and decision making in the venture.

Whilst there are other unconventional forms of investing such as
‘crowdfunding’ and ‘incubation’ which are now
available, investors prefer hybrid securities due to their secure
nature. The most eminent instruments are discussed below-

a. Compulsory Convertible Debentures (CCD)

These are ‘deferred equity instruments’ as they
mandatory get converted into equity shares with a lapse in their
maturity period. They are hybrid securities as they get converted
from a debt (debenture) to an equity share and thus possess
qualities of both.

Section 71(1) of the Companies Act, 2013 authorizes a company to
issue a CCD. Considering the nature of these hybrid securities the
Hon’ble Supreme Court in the case of Narendra Kumar
Maheshwari v. Union of India1
held that “any
instrument which is compulsorily convertible into shares is
ultimately regarded as equity and not as a loan or debt”. On
the other hand, according to the RBI Guidelines, they are treated
as equity for all financial statements and records but not as Share
Capital of the Company. Thus, it can be deduced that though they
provide security to investors in the nature of debentures, and are
ultimately rendered as shares, upon their conversion. According to
Rule 2(1)(c) of the Deposit Rules, they can be issued provided they
are converted to shares within 5 years of issue.

Since the initial stages of a start-up are not stable, there is
usually a lack of assets and cash flow with the entrepreneurs. This
makes it difficult to arrive at an accurate valuation of the
company, which is an essential prerequisite for investors who pool
in their resources. This is when the investors opt for such
securities.

If the start-up venture fails to deliver, the investors are
still secured as they are bound to receive interest with a future
promise of receiving dividend on the equity shares. Additionally,
the start- up eventually has to merely issue shares without the
burden of exhausting their cash flow. Furthermore, they promote
foreign investment as opposed to certain other hybrid securities.
Thus, their subscription proves beneficial to both parties most of
the time.

However, there are certain downsides to the subscription of
CCD’s which is provoking investors to gradually shift to other
hybrid securities. Whilst the initial purpose of this instrument
was to curb the difficulty of valuation, the ventures are now
required to obtain a ‘Valuation Certificate’ from the
appropriate certifying officer at the time of investment. They also
have to align with FEMA Guidelines, SEBI rules, FDI Regulations and
Tax procedures. This severely increases the compliance requirements
to be adhered to, which makes the investment procedure
cumbersome.

b. Compulsory Convertible Preference Shares
(CCPS)

Compulsory Convertible Preference Shares are the preferred
choice and most favoured amongst investors for two main reasons

-Dividend is first paid to preference shareholders, and the
fixed amount of dividend gives them more.

– In case of liquidation, the preference shareholders have
priority as per the waterfall mechanism (Section 53 of Insolvency
and Bankruptcy Code,2016) which gives them a prior claim over the
assets of the venture.

Additionally, in case the business renders successful, the
preference shares get converted to equity shares thereby increasing
the scope of capital growth and profit retention of the
investors.

The main privilege with these shares is their conversion linked
with the performance of the company. This helps the private equity
investors to balance any disparity in the valuation expectation of
the venture, as the general valuation method renders inefficient in
case of start- ups due to the absence of a profit and loss account
to show.

In this case, the investors chip in their resources when the
company is at a lower valuation and eventually convert their shares
to equity, which yields them higher dividend, without pooling in
additional resources when the venture has higher valuation.
Additionally, it benefits the start- ups to prevent the exhaustion
of cash-flow, as contrary to CCD, this security is not a
‘debt’ or ‘loan’ which needs to be paid off with
interest. This strikes a balance in the interests of the investors
as well as the entrepreneurs.

However, like convertible debentures, this hybrid security is
also infamous for its hefty load of compliance requirements and
paperwork that is involved, mainly the pre-requisite for a
valuation certificate.

The issue of these shares is regulated by Section 42, 62 and 55
of the Companies Act, 2013. Additionally, since the instrument is
eventually converted into equity, foreign investment is permitted
which makes it mandatory to adhere to FDI policy and FEMA
Regulations. Similarly, the compliances under the Income Tax Act
1961 have to be followed. Issuance of these shares also provides
certain rights to the shareholders, thus restricting the promoters
of the venture in their decision- making process.

With the advent of CCPS, another form of modified investment was
introduced in India, namely Term Sheets with Staggered
Investments
. In this the investments
are made through preference shares and later divided into segments
to meet certain pre-determined goals. These are usually referred to
as ‘milestone’ based, as they are diverted to meet
objectives and are highly driven by market conditions.

All things considered, CCPS is the most used instrument for
start-up investments currently, due to the liquidity advantage and
repayment of share capital in an event of failure.

OTHER SECURITIES

While CCPS and CCD are the most popular investment instruments
used in India, some venture capitalists are now adopting different
methods which have been proven successful in…

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