The Securities and Exchange Board of India (Sebi), in its meeting on June 27 this year, approved certain key changes which financial investors may factor in while structuring transactions with public listed companies and its promoters.
Key changes include: (i) approving IPO of tech companies which have issued shares with differential voting rights (SDVRs), in effect, paving the way for dual class share capital structures, for enhanced founder control post IPO; (ii) expanding definition of ‘encumbrance’ under Sebi Takeover Code, effectively increasing disclosures of structured obligations which impact marketability of promoter stakes; and (iii) requiring shareholder consent for royalty and brand usage related pay-outs to related parties beyond thresholds.
Framework for IPO of companies with SDVRs
Tech companies which have issued SDVRs to its founders, – such that SDVR holders are part of a promoter group whose collective net worth does not exceed Rs 5 billion, are now permitted to undertake an onshore IPO. Under this framework, initially ordinary shares can be listed and subsequently, SDVRs can be listed – however, no time period has been prescribed for SDVR listing.
Key conditionalities include that voting arrangement (SDVRs against ordinary shares) is a minimum of 2:1 and maximum 10:1 and post listing, total voting of shareholders holding SDVRs should not exceed 74 percent. SDVRs should be held for at least six months prior to filing of red herring prospectus and other than in case of voting, SDVRs should be treated at par with ordinary shares.
Post an IPO, for certain corporate governance matters such as related party transactions (RPT), substantial value transaction, delisting, buy-back, SDVRs shall have one vote per SDVR. Further, in terms of enhanced corporate governance of such companies, at least half the board and two-third of the committees (excluding audit committee) shall comprise independent directors and audit committee shall comprise only independent directors.
SDVRs are locked-in until converted, for instance, inter-se transfers of SDVRs between promoters are prohibited. Sunset on conversion of SDVR to ordinary shares falls within two buckets -- time-based and event-based. SDVRs shall be converted into ordinary shares within 5 years of listing, which can be extended for an additional 5 years, and SDVRs shall be converted into ordinary shares upon certain events, such as demise/resignation of SDVR holder or merger/acquisition where SDVR holders no longer have control.
In the absence of such framework, founders had to give up special rights in the company post an Indian IPO. Given the increasing instances of founders insisting on higher control, despite economic dilution due to multiple funding rounds, Sebi’s approval is a welcome step and will encourage founders towards IPO on the basis that listing will not result in cessation of control.
From a private equity perspective, there are checks and balances imposed on founders from ‘abusing’ their DVRs. Accordingly, new tech financing rounds in India should include issuance of SDVRs to deserving founders, or reclassification of certain existing shares held by them into SDVRs. Given that SDVRs can only be exercised on a 1:1 voting basis for RPTs and substantial value transactions, as such SDVRs should not affect the economics attached to ordinary shares – while at the same time provide founders with additional comfort to make the leap towards IPO. Expanded scope of ‘encumbrance’
Considering recent concerns, where promoters have raised funds from financial sponsors, mutual funds or NBFCs through structured obligations such as pledges at holding company level, contractual lock-in, non-disposal undertakings, some of which were not required to be disclosed, Sebi has proposed a widened definition of ‘encumbrance’, to include: (i) restriction on free and marketable title to shares, whether direct or indirect, and (ii) arrangement in the nature of an encumbrance, e.g. a right of first refusal, lock-in or non-disposal arrangement.
Further, with a view to increase promoter accountability, in certain specified instances, Sebi has required promoters (and PACs) to disclose detailed reasons for encumbrances.
The amended definition of ‘encumbrance’ and increased compliance are likely to bring more transparency in disclosures being made by promoters, as opaque structures for encumbrance which could earlier escape disclosure, may no longer work.
At the same time, assurances given by promoters to financial sponsors would now require disclosure. Although such covenants are meant to provide comfort to investors, signal to the market would be that of a promoter encumbrance/increased promoter leverage; thereby affecting market perception of the issuer. Of course, explanation (in disclosure statements) of such ‘encumbrances’, are likely to help in assuaging negative market perceptions.
Royalty and brand usage pay-outs
Sebi had previously proposed that royalty or brand usage payments to related parties exceeding 2 percent of the company’s annual consolidated turnover during a financial year, should require a simple shareholder resolution. However, based on industry representations, implementation was deferred and Sebi has now decided to make this provision effective, with an increased limit of 5 percent of the annual consolidated turnover.
Royalty or brand usage payments are quite common in sectors such as industrials, pharmaceuticals, media and IT/ITes. A 2 percent limit would have adversely impacted the ability of parent companies/majority shareholders to monetise or realise value of its intellectual property. As such, this relaxation is welcome, especially for international parent companies with listed Indian subsidiaries.
On the other hand, activist public market investors will expect more transparency and transfer pricing justification with respect to Indian public listed companies which seek to pay royalty/brand use payments to significant shareholders.
Each of these approvals are welcome and are likely to be effective upon amendment of regulations governing them.
Kartick Maheshwar and Deepak Jodhani are Partners and Tanushree Bhuwalka is Principal Associate at Khaitan & Co. The views of authors in this article are personal and do not constitute legal/professional advice of Khaitan & Co.