By Cyril Shroff and Ravi Kumar
The volume of venture capital investments in India has been increasing steadily. According to the Economic Times (July 2, 2014), the 121 investment deals in early-stage companies and start-ups in the first half of 2014constituted a 40% increase in the number of such deals compared with the same period in 2013.The transaction value of these 121 deals was $605 million (₹36.3 billion)—a 66%increase from the same period in the previous year.Thissurge in early-stage investments has been led by an increased appetite for investments by venture capitalists (“VCs”) in consumer technology (with e-commerce being by far the favorite), healthcare, technology and education.Thestrong appetite for investing in VCs has been hard to satisfy—and competition among VCs for investment opportunities remains high-in part because of a paucity of good-quality deals. This has caused VCs to takemore time to become comfortable with value creation potential and conduct more comprehensive due diligence than before.
The goal of this article is to provide a brief overview of some of the legal and regulatory challenges that currently face VCs in India as they invest in Indian portfolio companies. The article will describethe various stages of the investment process and the key challenges VCs encounter when investing in India.
II.Entry and the Investment Phase
A.Regulatory Valuation Requirements
India does not have full capital account convertibility. Instead, the Indian government imposes extensive foreign exchange control regulations. These include restrictions on pricing for the issue ofshares (including compulsorily convertible preference shares or debentures) by Indian companies to non-residents and transfers of shares between Indian residents and non-residents. Both the issue of shares and the transfer of shares between residents and non-residents, or vice versa, are subject to a floor price, or cap (depending on the counterparties) at the fair value of the shares, determined in accordance with internationally accepted valuation methods certified by a chartered or certified public accountant or a registered merchant banker. These valuation requirements are prescriptive and the valuation certified by such a valuer is typically not examined in detail by the regulators. While these measures are intended to ensure that transactions with non-residents and Indian parties take place at a fair value, the requirements can become contentious, especially at the time of exits.
The Companies Act, 2013 (the “Act”) includes a similar provision, which subjects any preferential allotment by an Indian company to a floor valuation certified by a registered valuer. While these provisions of the Act are not yet in force, the valuation should be certified by a chartered accountant with at least ten years of experience or by a registered merchant banker.
B.Running the Preferential Allotment Process
Currently, company law in India is undergoing a complete change following the enactment of the Companies Act, 2013, which replaces the earlier Companies Act, 1956. The 2013 Act imposes additional requirements for allocating a preferential allotment to a non-resident. This requirement is a clear departure from the earlier regime. Under the Act, Indian companies can make a preferential allotment only after obtaining the approval of 75% of the shareholders present and voting at a shareholder meeting. The Act requires that an offer document that needs to conform to a prescribed format has to be issued to the allottees. This document forms the basis for the allotmentand can be issued to the allottee only after the passage of the shareholders’ resolution mentioned above. This requirement is a complete departure from the earlier regime because: (1) the basis for the allotment was the contractual agreements between the company and the investor; and (2) private companies did not require approval of the shareholders for preferential allotment; approval of the board of directors was sufficient. As a result,co-ordinating executions becomesmore challenging with these additional requirements becausethe corporate approvals from the investee company must be obtained prior to the execution of the definitive documents and there is additionalpaperwork(i.e., the offer document). In a private company, planned coordination can ensure that all of these actions take place sequentially on the date of execution itself, thereby placing increased emphasis on planning out the closing date actions. The coordination required by these new procedures makes the execution process cumbersome.
Given certain ambiguity in the purpose or intent of relevant provisions of the Act, considerable debate exists regarding whether these provisions apply to negotiated investment transactions (such as bilateral investments or co-investments) or whether they areapply to preferential allotments made to multiple unrelated parties (i.e. non co-investments.
C.Finalizing the Capital Structure
For obvious reasons, finalizing the capital structure is another critical aspect of pre-investment. Capital structure changes are attributable to two factors:(i) investment in compulsorily convertible preference shares by the VCs and(ii) employee stock options (“ESOPs”) issued by the target company. While both these situations are well documented, the consequent impact needs to be factored in and handled carefully while finalizing fully diluted ownership of the VCs. While VCs recognize the importance of ESOPs for attracting competitive talent at lower salaries, VCs are reluctant to dilute their equity stake. Consequently, pre-investment discussions on the size of the ESOP pool tend to be long-drawn. The situation gets exacerbated from the portfolio company’s perspective as the vintage of the portfolio company increases because the pool typically reduces on a yearly basis as new ESOPsvest.
The outlook on the ESOPs and the VCs’ requirement to maintain shareholding may be at cross-purposes requiring careful handling, particularly when a VC exits. Consequently, VCs prefer ESOPs which do not result in accelerated vesting at the time of an exit or sale of the portfolio companies. As a result, ESOPs achieve the objective of compensation and with these clauses, the VCs’ stake does not get diluted upon an exit. However, these discussions tend to be difficult, nuanced, and emotive because the promoters (and the employees) of the portfolio company would like to cash out in a sale transaction at the least. With increasing awareness among employees of this issue, such an approach may be difficult to follow because the employees are likely to demand ESOPs with accelerated vesting at the time of a VC’s exit or a sale transaction (at the very least).
D. Voting Rights
Another fairly common problem regarding the capital structure is linked to voting rights on shares. The Act prohibits holders of compulsorily convertible preference shares from exercising voting rights on these preference shares unless such matters directly affect the rights of the preference shareholders. This prohibition marks a departure from the earlier version of the Act that permitted these arrangements in the context of private companies. Of course, if the company does not pay a preferred dividend on the preference shares for a period of two years or more, then the preference shares will be entitled to voting rights on all matters being decided at a shareholder meeting.
E. Non-compete restrictionson Promoters
Typically, investment transactions imposestrict non-compete and non-solicit obligations on the promoters (i.e. controlling shareholders). Given that VCs will be making investments based on the commitment of the promoter(s) to the target company, the VCs would naturally want the exclusive, ongoing focus of the promoters to be the business of the company. India’s cultural and traditional background of extended families and relations encourages these obligations to be broad and wide (i.e. direct and indirect obligations of the promoters). However, enforcement of these obligations in “indirect” situations, such as, businesses promoted by relatives, remains a massive challenge given the difficulty of proving “indirect” competition by Indian promoters. Consequently, the legal challenge consists of articulatingthese obligations in broad terms to cover indirect competition and taking adequate steps, which impose strong disincentives for breaches, to ensure that the promoters comply with their obligations.
Indian law has always recognized the fiduciary duty owed by the directors to a company. However, the Act has changed the role and responsibility of directors by encouraging their active participation in the company’s affairs and increasing director liability aimed at curbing instances of corporate malpractice in India, such as falsification ormanipulation of accounts by promoters and diversion of funds.The Act has extended the fiduciary duty concept and codified the directors’ duty to act in the best interests of not only the company and its shareholders, but also those of the community at large. Even though this list may appear innocuous, it is sweeping and encompasses a diverse set of interests, which the directors may find difficult to balance. Further, there is insufficient guidance on how a director is expected to discharge these duties.This increase in the duties and liabilities of the directors is, however, not accompanied by a concomitant enhancement of incentives to act as a director, thereby igniting a lively debate. Moreover, while the enhanced penalties provided by the act could motivate directors to participate more actively in a company’s affairs, the specter of personal liability can effectively discourage VCs from nominating directors on the board of directors of portfolio companies.
The Act limits the liability of independent and non-executive directors to (i) those acts and omissions that have occurred with the knowledge of these directors, where such knowledge can be established through evaluation of the processes followed by the board of directors;and (ii) a director’s consent or connivance with respect to the proposed corporate action,or failure to act diligently. The Act continues to recognize the right of the directors to record their dissent, which should be diligently recorded to establish a legal defense for mitigating any potential liability. The Act seems to permit a company from indemnifying its directors from any liability incurred on account of negligence, default, misfeasance, or breach of duty or trust, which is a departure from Act’s predecessor. This position seems to be a tacit acknowledgement for permitting directors and officers insurance policies to protect against liability. However, these may not obviate the concerns of VCs when they appoint directors on the board of portfolio companies given reputational and other aspects involved in such sticky situations.
In addition to the increased obligations of directors under the Act, various Indian statutes (such as labor, welfare, and environmental legislation) impose personal liability on directors for infractions by the company. While some of these statutes provide similar exclusions for the liability of directors who can demonstrate that they werenot involved in the breaches by the company, the looming threat of director liability creates significant obstacles for institutional VCs, especially given that these investments typically occur in the early stages of investment.
As a fall-out of these positions in Indian law and with a view to managing the risk of liability of nominee directors, there is an increasing trend for foreign investors to seek the right of appointing directors to the board of directors of portfolio companies as well as non-voting observer rights for attending board meetings. In practice, the VCs seem increasingly content to allow their representatives to attend board meetings as observers and not exercise their rights to appoint nominees on the board of directors.
G. Veto Rights and Control
One of the most critical ways VCs protect their rights is through their ability to veto decisions undertaken by their portfolio companies. The justification for these veto rights is investor protection, i.e., the ability of VCs to determine whether portfolio companies may undertake certain actions that would have an impact on the value of the company. Unlike growth capital or late stage investors, VCs typically obtain veto rights on a few significant items, such as changes in capital structure, approval of the business plan or budget, and appointment or replacement of key managerial personnel.
Section 2(27) of the Act defines “control” inclusively as the right to, directly or indirectly, “control the management or policy decisions” exercisable by a person, either individually or in concert with the other persons, by virtue of shareholding, management rights or shareholders’ agreements, voting arrangements, or in any other manner.The Act imports this definition verbatim from the Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (the “Takeover Code”), although the context is arguably different. Under the Takeover Code thatis applicable to Indian listed companies (i.e., whose equity shares are listed), a change in control triggers an open offer to the shareholders to acquire at least 26% of the target company. Under the Act, acquiring “control” could make such a person a “promoter” (another new concept under the Act), the identities of whom must be disclosed annually in filings submitted toIndia’s Ministry of Corporate Affairs.
The Takeover Code constructs veto rights and control to mean that any investor with these rights acquires control. If the same interpretation is adopted, VCs whoacquire such veto rights would be adjudged to be in control of the target company, necessitatingtheir disclosures as “promoters” in India on anannual basis. This could potentially trigger consolidation requirements overseas for VCs. Indian lawyers are still considering this issue, and a final answer remains elusive.
III. Exit Related Issues
A.Enforceability of Put and Call Options
The status of put and call options involving residents and non-residents (including VCs) under Indian regulations has been ambiguous for some time. While, under Indian securities law, doubts existed regarding the enforceability of such options on the securities of public companies (including unlisted public companies), the exchange control implications of such arrangements were likewise uncertain. To draw an important distinction, although Indian securities law permitted put and call options for securities of private Indian companies, issues in relation the pricing of these put and call options remained because of foreign exchange control regulations.
Indian regulators have clarified these positions over the past year. Put and call options on securities of public companies in India are now enforceable subject to a holding period of at least one year, and Indian exchange control regulations currently regulate pricing. Interestingly, these changes are prospective and do not apply to earlier investments.
Indian exchange control regulations prohibit fixed price put and call options on securities of Indian companies. However, the regulations permit put and call options based on fair market value at the time of exitat a price not exceeding the price computed under any internationally accepted pricing methodology. In essence, the regulations prohibit guaranteed or assured exit pricingbecause the Reserve Bank of India views such options as guarantees back-stopping debt instruments. While this approach may not be a significant departure from the previous one (being that investors must comply with pricing norms at the time of exit following an option exercise), the most significant question elicited by this change is whether the transaction documents can even set out an internal rate of return based option price.
While some embrace the changes forcreating certainty regarding legal enforcement, others bemoan the lack of contractual flexibility to provide exits to investors in a market where exits are growing increasingly tougher.
B. Buy-back Related Issues
Another typical exit mode for VC investments consists of buying back shares of the portfolio company. Share buybacks in India are heavily regulated and subject to a whole range of restrictions from a cap of number of equity shares that can be brought back (25% of the equity shares) to the quantum of funds that can be utilized for a buy-back (25% of the paid-up share capital and free reserves of the portfolio company) and other considerations that render buying back in India cumbersome and ineffective. An added complication is that Indian regulators view buy-backs as transfers of shares from non-resident to resident Indians and therefore apply the relevant pricing regulations.
C. Capital Markets Related Issues
Preparing for an initial public offering (“IPO”) in India is atime-consuming and painstaking exerciseinvolving investors, the company, promoters, employees, merchant bankers, and lawyers. In most cases, an IPO takes upwards of seven to eight months from start to finish, assuming steady market conditions (a very big ask indeed). However, other complications have emerged recently.For instance, in the Just Dial IPO the Securities and Exchange Board of India, India’s capital markets regulator insisted on a “safety net” for retail investors, which was price protection for a period of sixty days. Under this requirement, Just Dial had to refund retail investors in case of a price fluctuation after this period. One of the reasons set out for this requirement was that the fact that the company was in a “new sector.” Given these sorts of additional requirements, capital market backed exits pose their own set of challenges for VCs and the company.
D. Currency Related Issues
Although not a legal or regulatory issue, the plunging value of the rupee has sucked out the potential profitability that most VCs expected. This inflation has caused has caused many exit deals to fall through because VCs are betting on a rally by the rupee or better performance by the portfolio company.
Despite the many challenges for VCs, the ecosystem for early stage investments is definitely developing and improving in India. The Act sets out a corporate governance framework applicable to all companies. It is intended to improve governance levels across companies. Such improvements will benefit VCs. The recent election results giving a clear majority to the present government has also provided reassurance in the form of enhanced stability to investors across the spectrum. Analysts generally agree that India’s new government will pass and enforce regulations in a way that is more beneficial to business and investment, with the clear majority also providing enhanced stability that the investment community requires to thrive.
VCs are also sharpening their focus on the best-quality deals based on their investment philosophy and are investing in relationships with promoters and management teams with a view to determining reasonable valuations, growth plans, and exits. In addition, the emphasis on value creation after the acquisition has gained more importance. Moving forward, VCs should focus on the “softer” aspects of the deal, such as corporate governance and the integrity of the leaders of the target company, as much as on issues relating to the valuation itself.
In sum, even though VCs are wisely approaching investing in India with increased caution and clarity, the India story is alive and here to stay because VCs continue to believe in the long-term potential of India and the value of staying invested.
Cyril Shroff is the Managing Partner of Amarchand & Mangaldas & Suresh A. Shroff & Law, one of India’s leading corporate law firm and is based in Mumbai. He is regarded and has been consistently rated as India’s top corporate, banking and project finance lawyer.
Ravi Kumar is a Senior Consultant with Amarchand & Mangaldas & Suresh A. Shroff & Law, one of India’s leading corporate law firm and is based in Mumbai. He specializes in M&A and Private Equity transactions.