Investing in companies (especially in startups) involves a huge risk. For this reason, financial investors look for exit rights which allow them to exit the company with a high return on the investment amount. While the aim of the strategic investors is not to achieve a favourable exit, the private equity (“PE”) and venture capital (“VC”) investors give most importance to the exit rights available to them. This post deals with the exit rights usually provided by private companies to their PE and VC investors and the legality of such rights.
A. IPO – An initial public offering (“IPO”) has continued to be the most favourable exit option for the investors as a private company can go through with an IPO only if certain conditions are fulfilled (as laid down under the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 and the rules and regulations of the concerned stock exchange) which ensure that the company is doing well. An investor often enjoys a preference over other shareholders in case of an IPO as well, by stipulating in the investment agreement that the investor’s securities shall be offered for sale in priority before other securities, to the extent permitted under applicable laws. In addition to this right, the investors also ask for a registration right which allows them to register their securities for sale in case the company lists its securities in a foreign stock exchange.
B. Third Party Sale Arranged by the Promoters – The exit clause also provides an option whereby the company and/or the promoters arrange a sale of the securities held by such investors. The strategic investors often buy out such investors’ securities through mergers and acquisitions (“M&A Transactions”). The process may be initiated through common agreements between the two parties but the sanction of the High Court is required for bringing it into effect. The provisions of the Companies Act, 2013 (“Act”) have to be followed in case of an M&A Transaction. It is very unusual that the subsequent round of investors would facilitate the exit of the existing investors, although, it is not entirely rare. Hence, the promoters (or the company) may, alternatively, arrange a buyer for the investor securities, which could be a strategic investor as well.
C. Buy-back Right – Buyback right implies that at the end of the exit period, if the company fails to provide an exit by the options discussed hereinabove, the company shall buy back the securities owned by the investor, subject to the provisions of the Act and the rules made thereunder, and all other applicable laws. However, a company can buy back its own shares only using the proceeds from its
i. free reserves;
ii. securities premium account; and
iii. proceeds of any shares or other specified securities;
It is provided that no buyback is allowed out of the proceeds of an earlier issue of the same kind of shares or same kind of other specified securities.
In addition to the foregoing, there are a number of other conditions of buyback. Companies can only buy back up to 25% of their issued and paid-up capital in one financial year. Moreover, buyback is also prohibited through subsidiaries or investment companies and in case of default or non-compliance, as provided under the Act.
Due to the statutory compliances, it is often impractical for an investor to expect that the company would be able to provide an exit through buyback. For this reason, the investment agreement usually requires the promoters to carry out the buyback obligations. However, it is not always feasible for the promoters to have the huge amount required to buy back the investor’s securities.
D. Third Party Sale Arranged by the Investor – When the company and the promoters fail to provide an exit under any of the abovementioned routes within a specified time limit (say after six months from the date when the exit right kicks in), the investors get to arrange a sale of the securities owned by them to any person of their choice. Moreover, although the investors are usually barred from selling their securities to any competitors during the currency of any investment agreement, while exercising the exit right under this option, they enjoy the freedom to choose any potential buyer, including such competitors. That would, however, depend upon the precise terms of the contractual arrangements between the parties.
Drag Right – The right to sell investors’ securities to a buyer of the investors’ choice also comes with a drag right. When this right kicks in, it gives the investor the authority to drag the promoters’ (and often, other shareholders’, to the exclusion of other investors) securities in a sale arranged by such investor. For example, if a potential buyer wishes to buy 70% share capital of the company and the investor owns only 40%, this right entails the investor to require that the promoters and the other shareholders (in exclusion of the other investors, if any) sell 30% of their shareholding on a pro rata basis, inter se their shareholding.
Put & Call Option – In the case of the Commissioner of Income-Tax vs. Shri Bharat R. Ruia[1], the Bombay High Court pointed out that “An option gives the holder right to buy or sell an underlying asset at a future date at a predetermined price.”
The put option gives the investors the right to sell their securities to the promoters within a pre-determined time period, and often, at a pre-determined price, calculated on the basis of internal rate of return (“IRR”). The call option is similar to a put option, but through this option the promoters enjoy the right to procure the sale of the securities held by the investors, after completion of a specified time period, at a pre-determined price. If the company does well in the long run, the promoters enjoy the right to exercise this option to buy the investors’ securities to regain more control in the company and to facilitate an exit for the investors.
Legality of Put & Call Options: Put and call options are inserted to ensure that the investors’ securities would be bought at a pre-determined price. Often, these options specify assured returns or IRR, or at least a floor price for return. As assured returns allow a PE or VC investor to secure a minimum return from its investment, it actually eliminates, to a great extent, the risk of business exposure to which other equity investors are exposed. And hence, the legality of put option has been questioned on several occasions.
SEBI Notification: Ultimately, SEBI had, pursuant to its notification dated October 3, 2013 (“SEBI Notification”), permitted contracts with put & call options for the purpose of the Securities Contracts (Regulation) Act, 1956 (“SCRA”). The Supreme Court, on many occasions, has taken the liberal view pertaining to the scope of definition of ‘securities’ under the SCRA and has brought the marketable securities of the unlisted companies under the scope of the definition as well.
In Sudhir Shantilal Mehta vs. Central Bureau of Investigation,[2] the Supreme Court held that the definition of securities under the SCRA is an inclusive definition and not exhaustive. It takes within its purview not only the matters specified therein, but also other type of securities.
In Naresh K. Aggarwala & Co. vs. Canbank Financial Services Limited,[3] the Supreme Court, while referring to the definition of the term ‘securities’ defined under SCRA and the applicability of a circular issued by the Delhi Stock Exchange, held that the definition showed that they did not make any distinction between listed securities and unlisted securities and therefore it was clear that the circular would apply to the securities which were not listed on the stock exchange.
In Sahara India Real Estate Corporation Limited and Others vs. SEBI and another,[4] the Supreme Court held that the definition of the term ‘securities’ in Section 2(h) of SCRA is a wide definition and an inclusive one. It also reinstated SEBI’s jurisdiction over all marketable securities in accordance with the provisions of the SCRA.
Hence, it could be said that through the SEBI Notification, optionality clauses were made legal and valid in investment agreements of private companies as well.
RBI Guidelines for Foreign Investors: Even after the SEBI Notification the validity of option contracts issued to foreign investors was still not clear and several notices were issued by the Reserve Bank of India (“RBI”) questioning such contracts whereby, a fixed amount of return was mentioned. Such clauses are held to impose a liability on the company in the nature of debt and hence, require compliance with external commercial borrowing guidelines and not foreign investment regulations. Finally, through a notification dated January 9, 2014, the RBI, through the “Pricing Guidelines for FDI Instruments with Optionality Clauses” (“RBI Guidelines”), laid down clear guidelines to be followed for optionality clauses providing exit rights to foreign investors.
The RBI Guidelines allowed optionality clauses, under the Foreign Direct Investment (“FDI”) Scheme, in equity shares and compulsorily and mandatorily convertible preference shares or debentures.[5] However, such clauses shall be subject to the conditions laid down in the RBI Guidelines which require that:
i. the securities issued with such optionality clause, would be subject to a minimum lock-in period of 1 year or such higher period as may be prescribed under the FDI regulations; and
ii. upon completion of the lock-in period, the concerned non-resident investor shall be eligible to exit, provided that there is no assured return.
Hence, as per the RBI Guidelines, a foreign investor can have put option, or the promoters of the investee company may have a call option, provided the return would be performance based at the time of exit and the securities thus issued shall comply with the other requirements laid down thereunder. The amount of return, provided by unlisted companies, shall be calculated at a price worked out, as per any internationally accepted pricing methodology for equity shares, compulsorily convertible debentures and compulsorily convertible preference shares, as per the RBI Notification RBI/2014-15/129, dated July 15, 2014, so that the investor does not have any assured return.
The previous RBI Guidelines laid down that the pricing methodology should be based on Return on Equity, in case of equity shares and any internationally accepted pricing methodology, for compulsorily convertible preference shares and compulsorily convertible debentures.
A combined study of the SEBI Notification and the RBI Guidelines implies that optionality clauses resulting in the exit of an investor would be valid and legal, subject to the compliance with the RBI Guidelines, as and when applicable.
Transfer Involving Foreign Investors: Any transfer to or by the foreign investors of any securities of an Indian company, under any of the options provided hereinabove, would require compliance with the Foreign Exchange Management (Transfer or issue of security by a person resident outside India) Regulations, 2000, as amended from time to time, and the pricing guidelines laid down by RBI. In case of transfer of securities of an Indian company held by residents to non-residents, the floor price is fixed under the relevant statutes and the valuation of such securities must be done in accordance with the provisions laid down in this behalf. On the contrary, in case of transfer of securities from a non-resident to a resident Indian, the cap price is fixed, i.e. the non-resident transferor shall be entitled to get, at most, such cap price. The cap price in this case is equal to the floor price a resident is entitled to get from a non-resident transferee. In each such case, Form FC-TRS has to be filed by the resident within the prescribed time period.