This article has been written by Palak Gupta pursuing the Diploma in Global Corporate Practices from LawSikho. This article has been edited by Amitabh Ranjan (Associate, Lawsikho) and Dipshi Swara (Senior Associate, Lawsikho).
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The rush of filing of new shares by some start-ups such as Paytm, Zomato, etc. has put the limelight on the legal provisions of Superior Voting Rights Shares (“SR Shares”). The concept of SR shares was introduced two years ago. It assured the founders of start-ups that they’d be allowed to hold maximum ownership even after the Initial Public Offer (“IPO”). But the promoters have been saying that these rules are very cumbersome. Here’s a detailed look into the issue:
What are SR shares?
Superior voting rights shares do not follow the principle of one share equals one vote. The dividend given on these shares is usually higher than the ordinary shares. These shares give founders the right to control their companies even after the new investors join.
Why did SEBI introduce this framework?
SEBI released a consultation paper on 1st July 2021. In this article, while explaining the concept of SR shares, SEBI said, “Founders or promoters of the companies may have the required skills and vision to carry out their day-to-day activities; they may not be able to invest as much capital as needed. Therefore, they go through significant shareholding dilution to raise capital for the company in the beginning.”
One of the reasons for introducing SR shares was to encourage the founders or promoters to retain a specific amount of control with them for five years, extendable by five more years (Sunset Clause) with balances and checks.
Although SR shares were introduced recently in India, countries like the US, Singapore, Hong Kong are pretty familiar with this concept. But the corporate governance norms in these countries are stricter than in India. For instance, while taking the company public, Mark Zuckerberg, Founder, and CEO of Facebook issued shares carrying ten votes each to himself and his associates to control social media networks compared to one vote to public shareholders.
Previously, SEBI was concerned that promoters or founders could misuse the power given to them by this concept, and it may go against the shareholders’ interest. In 2019, the regulator allowed the founders of tech-oriented start-ups (for instance, nanotech, data analytics, infotech, biotech) to issue shares to themselves in the ratio of 10:1 (i.e.,1 share equals 10 votes). At the same time, they were asked to issue shares in the ratio of 2:1 (i.e., 1 share equals 2 votes) to public shareholders. According to those rules, SR shares should be converted to ordinary shares after five years of listing or if the shareholder with superior rights dies or exits the company.
What are the new proposals to revise the framework?
The new proposals to revise the framework were stated in the consultation paper. They are:
Net worth requirements of SR shareholders
According to the current regulatory framework, regulation 6 (3) (ii) of the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (“ICDR Regulations”) states as follows:
- Clause 3 of regulation 6 states that “If an issuer has issued SR equity shares to its promoters/ founders, the said issuer shall be allowed to do an initial public offer of only ordinary shares for listing on the main board subject to compliance with the provisions of this Chapter and these clauses.
- Sub-clause (ii) of Clause 3 states that “The SR shareholder shall not be part of the promoter group whose collective net worth is more than rupees 500 crores:
Explanation: While determining the collective net worth, the investment of SR shareholders in the shares of the issuer company shall not be considered.”
SEBI has received feedback from the market participants that the SR shareholder’s provision should not be part of the promoter group whose collective net worth is more than ₹500 crore, is too cumbersome to comply. Also, it is probably keeping the prospective and deserving SR shareholders away from using the SR shares framework.
Under the ICDR Regulations, the definition of promoter group and promoter is very broad and can include a large set of entities/relatives. Hence, the net worth of such entities or relatives will also be taken into consideration to determine the collective net worth. Furthermore, a company may have multiple founders, and the promoter group has many members, which complicates the whole matter.
Matter for public consultation
Although the explanation of the regulation makes it clear that the SR shareholders’ investment in the company of the issuer shall not be taken into consideration while calculating the collective net worth, a situation can arise wherein the SR shareholders’ family members would also be the owners of some shares of the issuer company. According to the current regulatory framework, such an investment will be included while calculating the collective net worth. Additionally, not including the proceeds from the sale of shares by an SR shareholder in the issuer company is not precisely stated in the explanation.
Issuance of SR shares to trusts/entities on behalf of founders/promoters in executive position
According to the current regulatory framework, regulation 6 (3) (iii) of ICDR Regulations states as follows:
- Clause 3 of regulation 6 states that “If an issuer has issued SR equity shares to its promoters/founders, the said issuer shall be allowed to do an initial public offer of only ordinary shares for listing on the main board subject to compliance with the provisions of this Chapter and these clauses.
- Sub-Clause (iii) of Clause 3 states that “The SR shares were issued only to the promoters/founders who hold an executive position in the issuer company.”
The purpose of giving SR shares only to founders or promoters was to acknowledge their significant and unique efforts towards the present and future matters of the business.
In the potential issuer companies, the shareholding of promoters or founders may be represented through either limited liability partnerships (“LLPs”) or family trusts or holding companies. It is contended that this is done for tax planning, long-term succession planning, and operational efficiencies. In the issuer company, the decisions are taken by the promoters/founders, but various entities own the company.
Further, it is also contended that wherever applicable, mostly founders will hold the holding companies. Otherwise, the family members who own minority shares in the company will hold the same. These LLPs, /family trusts/holding companies are the ownership vehicles where the partners/shareholders/trustees are the promoters/founders. Additionally, the beneficiaries are mainly promoters or founders and their descendants, if they aren’t there.
The prevailing regulations would need to unwind these structures to allow promoters/founders’ direct holding of the SR shares. This may result in several implications, such as impacting the taxation front and the issuer company’s ability to conduct an Offer for Sale in the IPO.
Nonetheless, allowing the LLPs, family trusts, and holding companies to hold SR shares leads to various concerns as some of these structures, such as family trusts, are very opaque and make it problematic to identify where the voting power arises.
Matter for public consultation
Whether LLPs/family trusts/ holding companies where founders/promoters are the sole trustees or are in control can also be allowed to hold SR shares as long as these trustee/founders/promoters have the executive positions in the issuer company?
Timing of issuance of SR shares
According to the current regulatory framework, regulation 6 (3) (v) of ICDR Regulations states as follows:
- Clause 3 of regulation 6 states that “If an issuer has issued SR equity shares to its promoters/ founders, the said issuer shall be allowed to do an initial public offer of only ordinary shares for listing on the Main Board subject to compliance with the provisions of this Chapter and these clauses.
- Sub-clause (v) of Clause 3 states that “The SR equity shares have been held for a period of at least 6 months prior to the filing of the red herring prospectus.”
Earlier, the promoters held the SR shares for at least one year before the filing of Red Herring Prospectus (“RHP”). Based on the comments received, this provision was modified, and the period was brought down to 6 months instead of 1 year.
The concept of SR shares is relatively new for India. The examples of many tech start-ups and companies preparing for IPOs and gearing to enter public markets in India are also increasing day by day.
Market participants have given their feedback to SEBI and said that this provision is too cumbersome to comply with as it makes it difficult for the issuer companies to raise funds from the capital market.
It is contended that preparation of an IPO requires a considerable amount of time, and structuring, evaluating and issuing SR shares also takes much time.
Issuing the SR shares includes:
- Sensitizing the shareholders.
- Understanding the SR construct.
- Enabling authorized capital for SR shares with required corporate actions.
- Seeking board and shareholders’ approval.
- Meeting other conditions relevant for SR shares and higher compliance in terms of the constitution of the board and committees.
All of these tasks are also time-consuming.
Matter for public consultation
Whether the requirement of holding SR shares for six months before the filing of RHP should be deleted?
How have tech companies reacted to these proposals?
As expected, tech start-ups and companies have accepted these proposals with enthusiasm. For instance, IndiaTech, an industry association representing investors and start-up founders, has suggested that the net-worth requirement for start-up founders should not be calculated as a group; instead, it should be calculated individually.
IndiaTech also suggested that the Sunset Clause of five years, extendable to ten, should be prolonged. Last but not the least, it is also recommended that SEBI consider the capital requirement of IPO for promoters to 5 percent. It can also mandate the founders with less than a 20 percent holding if they want to lock in their shares for a year.
The need for SEBI to correct stand on superior voting rights
It is difficult to comprehend the reason why SEBI is promoting SR shares. The purpose of these shares is to help the promoters/founders of new-age tech companies, yet other companies can issue these shares. The contention that it isn’t easy for these promoters/founders to retain control over their new business for a specific period is not appealing as it was earlier.
There are numerous instances where it has been proved that if the investors feel that the company has excellent potential, they invest without asking for something unreasonable. Therefore, these promoters/founders get the capital required in the initial stages of the business.
Then why is it a problem for them to dilute control of the same? Undoubtedly, in today’s time, raising capital is more accessible than ever because many ideas in China and the West can be adapted to India’s conditions, and the capital is sloshing around. As mentioned earlier, if your business idea is commendable, plenty of private equity firms are waiting to write you a cheque.
Because of the poor corporate governance standards prevailing in India and their more than ever poor implementation, promoters/founders don’t need more powers. It is not wise to believe that these start-ups will follow these rules better than any other well-established business. They are more likely to adapt to shortcuts if they think these shortcuts will help them grow faster.
The question that comes to almost everyone’s mind is why these companies are so adamant that the shareholders might not accept their proposals. SEBI should also take care of the small shareholders in this chaos as they can be easily marginalised if the promoters/founders have superior voting rights. It has to make sure that the small shareholders don’t get a raw deal.
Although SEBI had good intentions and wanted to make the journey easier for start-ups, it is rightly said that good intentions do not always yield good results. Therefore, it’s high time that SEBI corrects its stand on superior voting rights.
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