India: Should Investors Still Prefer The Preferred? – A Perspective On Investing In Preference Shares In The Light Of The New Companies Act, 2013*

With the passing of the Companies Act, 2013 (New Act) replacing the Companies Act, 1956 (Old Act), investors have to deal with several new concepts and principles now governing their investments into Indian companies. The government is implementing the New Act in a phased manner but most of the provisions of the New Act have already been notified.

Hitherto the restriction on kinds of capital being only of two types i.e. equity (with voting rights and with differential voting rights) and preference (with limited voting rights) was applicable only to public companies (and subsidiaries of public companies). However, under the New Act, many of these provisions also apply to private companies.2

In this article, we explore the impact of a couple of key changes relating to share capital and rights available to holders of equity shares and preference shares; viz., (a) applicability of provisions relating to restrictions of rights available on preference shares to private companies; and (b) issuance of equity shares with differential voting rights by private companies.

The chapter on kinds of share capital has undergone some change under the New Act.3 The key change though, is that the provisions under the New Act apply to private companies as well. The minor modifications include a requirement that issuance of preference shares would need to be authorized by a special resolution and also that for issuance of preference shares a company would be required to have not defaulted in repayment of dividend on or redemption of any preference shares.4 The decision of investors in choosing the preferred instrument for investments has been most affected by the applicability of restrictions on voting rights on preference shares. Section 87 of the Old Act specifically identifies the voting rights available to the holders of preference shares in public companies. Therefore, the more conservative view taken under the Old Act is that in public companies, preference shares will have voting rights only in the manner provided for in Section 87 and additional voting rights cannot be offered contractually.5

However private companies did not face any such problem under the Old Act and they were allowed to freely issue hybrid instruments including preference shares with voting rights and equity shares with differential voting rights. Under the New Act, the restrictions/requirements in relation to issuance of equity shares with differential voting rights ("DVRs") including the requirement to have a track record of distributable profits for the last 3 years also apply to private companies.6 Further, under the New Act, preference shares (whether in a public or a private company) are permitted to vote only on resolutions that (i) affect their rights or (ii) are in relation to winding up or reduction of capital of the Company7 Therefore, as things stand, under the New Act, if Investors are issued preference shares, they will not have voting rights except for limited matters as provided for under New Act.8 Also, structuring investments by ensuring voting to the extent of shareholding through DVRs will be challenging now. The criteria with respect to having a track record of distributable profits for preceding 3 years is generally difficult to meet, specifically for companies that are either start-ups or in the growth phase. However, often such companies are the ones that probably need and indeed attract the most amount of investment through private equity and venture capital funding.

These new provisions create a quandary for investors as to whether they should opt for voting rights by subscribing to equity or seek protection with respect to economic rights like liquidation preference and anti-dilution which are better enforced through preference shares.9

Voices were raised from several corners in this regard and to address the same the Ministry of Corporate Affairs also issued a draft notification dated June 24, 2014 proposing amendments to several provisions of the New Act inter alia exempting private companies from applicability of section 43 (restrictions with respect to kinds of share capital that a company can issue), section 47 (restrictions with respect to voting rights exercisable on the kinds of capital) and several other provisions. The proposal was placed before the Lok Sabha on July 14, 2014 with a modification that the exemptions shall not apply where memorandum or articles of association of the private company so provides. However, the said draft remains pending till date and there is enormous uncertainty of its fate as of date.

In the meanwhile, investors intending to invest into companies, which do not satisfy the requirements permitting them to issue equity shares with differential voting rights, need to explore the options listed below.

1. Investors abandoning voting rights.

Given that investors have affirmative voting rights incorporated in the articles and the New Act recognizing entrenchment provisions, voting rights may not be substantially important to investors, especially if the holding of the investors is less than the threshold required to block special resolutions. Also, under the New Act, if any variation of rights of one class of shareholders will affect the rights of other class, consent of 3/4th of other class to be obtained. In such situations investment into convertible preference shares may still be a comfortable option. Also, since there is an expectation of revision in the law, it could always be provided that the preference shares held by the investors would be allowed to vote on an "as if converted basis" if and when permitted under applicable law.10 Furthermore, in the event the situation demands and voting rights become more important at any given point in time, the investors may choose to convert the preference shares.

2. Investors acquiring equity shares and not preference shares.

In this model, investors will have the necessary voting rights but weak anti-dilution and liquidation preference rights. This may be useful in situations where investors (between them) own a substantial portion of a company's paid up share capital. In some venture financed companies, investors own as much as 90% of a company's paid up capital. Without going into a complex analysis, there could be scenarios where the anti-dilution and liquidation preference rights are not really material but voting rights are. One must also remember that investors will always have the option of moving to this model from model 1 above, if a situation warrants the same. The option of moving to this model may be relevant particularly in situations where investors hold more than 50% of the paid up capital and the founders / promoters of the company are not being very co-operative with investors.11

3. Investors taking a combination of equity and preference shares

The combination may be determined in such manner that investors hold about 70-90% of their holding in equity shares and the balance in preference shares. The investors will have voting rights on a substantial portion of the shares they own and will have liquidation preference rights and anti-dilution through the preference shares.

This concept is best explained through an example. Let us say a company's pre-money valuation is INR 275 crores. An investor proposes to invest INR 125 crores to acquire a 31.25% stake in the company. The investor can invest say INR 100 crores to acquire equity shares. This will give the investor about 26.67% voting rights. In terms of voting rights there is not much difference between having 26.67% voting and 31.25% voting rights. Both would be above the threshold of 25% enabling the investor to block special resolutions. The investor can invest 25 crores to subscribe to preference shares. The preference shares can be given disproportionate liquidation preference of say 4x to cover any short-fall arising on the equity holding. This is unlikely to work where investors have liquidation preference on a participating basis. This kind of structure is likely to work only in private equity transactions where investors take a substantial exposure reasonably above the thresholds of 25+%, 50+%, 75+% and have the flexibility to play with the capital structure and the liquidation preference is on a non-participating basis.12 This structure will clearly not work for venture-funded companies with multiple rounds of financing. The capital structure will be very complicated if a company has even three rounds of financing. While the complexity is not something that cannot be dealt with, it will make transactions and documents more complicated.

4. The investor subscribing to preference shares and the shareholders' agreement and the articles of association of the company has a simple covenant that every resolution of the board of directors of the company requires the affirmative approval of the investor.

While this option seems to provide good protection to the investors, one must remember that the investor may put itself in the position of a being a promoter of the company in view of Section 2(69) of the New Act.13

Conclusion.

It is clear that the above situations do not provide an ideal solution for all kinds of investments that might be envisaged by different investors. A careful analysis will need to be made of each situation and investors will need to look at what is more important to them from a commercial and legal perspective and adopt the appropriate structure. One may only hope that the draft notification granting exemptions to private companies receives the much awaited approval soon to avoid these complexities. Till then, Investors will have to wade their way through such options.

Footnotes

* Article written by Suneeth Katarki, Partner and Winnie Shekhar, Senior Associate. The views expressed in this article are the personal views of the authors and do not reflect the views of the Firm.

2 The applicable provisions of the New Act have not been notified yet.

3 Section 43 to 48 under the New Act have made some modifications to the principles set forth in Sections 85 to 87 and 106 and 107 of the Old Act.

4 Also Under section 85 of the Old Act preference shares could contractually be provided with a preferential right for repayment of arrears of dividend remaining unpaid up to winding up or repayment of capital. Since this provision has been deleted in the New Act, this might not be possible now, even for private companies.

5 While this is the general principle, if company's don't pay dividends in respect of preference shares for two years, preference shares shall have voting rights based on their percentage ownership of paid up share capital (excluding for clarity premium).

6 For issuance of equity shares with differential voting rights the Company will also be additionally required to meet certain criterions including not being in default of filing of returns for last 3 years or of payment of any declared dividend, matured deposits, interest on debentures or preference shares, amounts towards redemption of preference shares, any term loan or interest thereon, etc.

7 Preference shares would have voting rights on all resolutions in the event dividend on such shares remain unpaid for 2 years. Please see section 47 of Companies Act, 2013.

8 Preference shares will be entitled to vote on resolutions effecting their rights, resolutions for winding-up and reduction of share capital and on all resolutions if dividend remains unpaid for 2 years (no distinction for cumulative/non-cumulative).

9 Preference shares are issued with an intrinsic right of preference with respect to payments (of the capital invested with or without a premium) during winding up or repayment of capital. Also, convertible preference shares can ensure that on happening of an anti-dilution event, higher number of equity can be issued to ensure valuation protection for the investment.

10 Section 5 of the New Act provides for entrenchment provisions. Entrenchment provisions means provisions that prohibit amendments to articles of association of the Company unless some prescribed consent is obtained. Entrenchment provisions need approval of all members of a company. This must be noted in situations where a company has a large number of shareholders including angel investors and employees.

11 One must remember that the option of blocking declaration of dividends when management recommends payment of fixed dividend to the holders of preference shares is questionable.

12 Of course liquidation preference can be structured through equity shares as well. There are issues and questions around this. They are not for this article.

13 Per this section, a person per whose instructions, the board of directors of a company routinely acts will be considered a promoter of the Company.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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