This article has been written by Wageesha Agarwal pursuing the Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from LawSikho. 

Introduction

Corporate restructuring is the process of rearranging the business of a company to add to its effectiveness and profitability. A demerger is a type of corporate restructuring; an organizational restructuring wherein a part of the demerging entity is either incorporated into a new entity or dissolved fully. To go about and around any type of corporate restructuring, valuation, arriving at the economic worth of the entities involved in the process is a critical aspect. Valuation is based on the business model and external environment, supported with reasons and verified evidence. This article deals with the role Valuation and Valuation Report has to play in the case of demergers. 

What is demerger?

Companies Act, 2013 does not define demerger. However, in order to understand the concept of demerger, we can refer to the definition under the Income Tax Act, 1961. As per Section 2(19AA) of the Income Tax Act, 1961 (IT Act) “demerger”, in relation to companies, refers to the transfer, pursuant to a scheme of arrangement under Sections 230 to 233 of the Companies Act, 2013, by a demerged company of its one or more undertakings to any resulting company in such a manner that all properties and liabilities being transferred by the demerging company, become properties and liabilities of the resulting company by virtue of the demerger and such transfer is at book value. 

In the case of demerger, the resulting company issues its equity shares to the shareholders of the demerging entity on a proportionate basis, except where the demerged company is the shareholder of the resulting entity. For a transaction to be considered as a demerger under the IT Act, the transfer should be on a going concern basis.  

Process of NCLT approved demerger

The process of demerger under Companies Act, 2013 through a Scheme of Arrangement can be explained through the following points- 

1. Check whether the Board is authorized to effect a Scheme of Arrangement and if not, then pass a special resolution at a General Meeting of members to authorize such arrangement.
2. The Scheme of Demerger is prepared after consultation with the demerging entity and its various stakeholders; also specifying the Appointed date to be the effective date of the scheme.
3. A Board meeting of the Company is called to get the approval of the Scheme of demerger, authorizing the filing of an application to the National Company Law Tribunal (“NCLT”) for directions to convene a General Meeting, filing a petition for confirmation of Scheme by the NCLT and appointing a Registered Valuer to determine the share entitlement ratio for the transaction.
4. After receiving various regulatory approvals an application is made to the NCLT in Form NCLT-1, accompanied by appropriate disclosures by way of Affidavits in Form NCLT-6.
5. After the First motion petition is heard, NCLT may order a meeting of the Shareholders/creditors or class of them, to be conducted in a manner as directed by the Tribunal. (NCLT may dispense with calling of a meeting if creditors/members holding at least 90% in value agree to  not conducting a meeting on an affidavit to the scheme.)
6. The notice of the meeting ordered by the NCLT shall be accompanied by a statement disclosing details of the scheme including its effect on material interests of the creditors, key managerial personnel, directors or employees of the company and should be in Form CAA-2. A copy of the Valuation Report should also be sent along with the notice (if any).
7. The meeting is held as per NCLT directions and a report on the same is submitted by the Chairperson of the meeting to the NCLT.
8. A copy of the notice is also to be given to various sectoral regulators like the Income-tax department, Reserve Bank of India (“RBI”), Securities and Exchange Board of India (“SEBI”), Registrar of Companies (“ROC”), Stock Exchanges (“SEs”), Competition Commission of India (“CCI”) which are likely to be affected by such Scheme of Demerger, seeking representations, if any, within 30 days of receipt of the notice.
9. Recipients of the Notice may vote on the Scheme of Demerger, either through themselves or proxy or through postal ballot within a period of one month from the date of receipt of the notice. Any objections to the Scheme can be made by a person having at least 10% shareholding or owning 5% of the outstanding debt of the company as per the latest audited financial statement. 
10. The second motion petition for sanctioning the Scheme of Demerger is filed before the Tribunal within 7 days of the filing of the report by the Chairperson.
11. After hearing of the petition, an order sanctioning the scheme may be passed by the NCLT. A copy of the order is to be filed in Form INC-28 with the ROC within 30 days of receipt of such order. 

Still, as per the proviso to sub-section (7) of Section 230 no scheme of demerger can be approved by the NCLT if a certificate by the company’s auditor has not been filed with the Tribunal stating that the accounting treatment as proposed in the scheme of the demerger is in conformity with the applicable accounting standards.

Valuation : Companies Act, 2013 perspective

Valuation has become a prominent part of the business arena with the increasing evolution of various forms of business organizations, especially in the company form of businesses. Valuation holds vital importance in every phase of a company, penetrating into every stage, be it during the commencement of business, or expansion, compromise and arrangements, winding-up, etc. Estimating the theoretical worth of the equity of any company based on its underlying assets, income-generating ability and comparable transactions is the Fair Market Valuation of that company.

Section 247 of the Companies Act, 2013

Provisions of Section 247 of the Companies Act, 2013 lays down exclusive powers of Valuation of any stocks, shares, securities, goodwill or any other kind of assets or net worth of the company, on the Registered Valuers (“RV”), registered with the Registered Valuers Organization (“RVO”) recognized by the Insolvency and Bankruptcy Board of India (“IBBI”). Among other requirements, the RV has to be appointed by the Audit Committee/Board of Directors. 

Mandatory requirement of valuation in certain cases

Under the provisions of the Companies Act, 2013, a report issued by the Registered Valuer on the valuation of Equity of a Company is mandatory in the following situations:-

1. Further Issue of share capital other than a rights issue, Section 62(1)(c), where consideration is other than cash. 
2. Merger, amalgamation or restructuring under Section 230-232, requiring a valuation of assets or shares, or requiring a swap ratio to be calculated for a share swap on the merger of two companies
3. Acquisition of minority shareholding under Section 236 by existing shareholders who hold over 90% of the company’s shares
4. Allotment of shares for consideration other than cash and issue of sweat equity
5. Buyback of shares from some or all shareholders under Section 68
6. Liquidation of a company under the Insolvency and Bankruptcy Code, 2016

Thus, it can be said that Section 230 to 232 mandates the Valuation Report to be accompanied with the Scheme of Demerger (Compromise and Arrangements) filed with the Tribunal.

Valuation report in case of demerger

In a merger/demerger valuation, an attempt is not to arrive at absolute values of the shares of the Companies, but their relative values, on a standalone and as is where is basis, to arrive at the exchange/entitlement ratio.  

As discussed above, a copy of the valuation report (if any) is sent along with the notice of the meeting ordered by the NCLT to conduct and hold the meeting to approve the Scheme of Demerger. Valuation is based on various methodologies and various qualitative factors relevant to the Demerging and Resulting Companies.

The Value of the shares of each entity to determine the Share Entitlement Ratio, post the Demerger can be found by following any of the following approaches:

1. Asset-based approach – Net asset value is to be determined under this approach.
2. Income-based approach – This approach includes- (a) Discounted cash flow method (b) Earnings capitalization (c) Excess earnings method (d) Incremental cash flow method 
3. Market-based approach – This approach considers- (a) Market price (b) Comparable transaction multiple

As discussed, it can be said that a Valuation Report is mandatory in cases where valuation is required to be conducted. In the case of a demerger scheme, valuation is necessary in order to arrive at the share entitlement ratio, to calculate the number of shares to be issued post demerger, to the shareholders of the transferor company, in lieu of consideration for the demerged undertaking(s). If the demerger is going to result in a “Shell Company”, then valuation is primarily exercised to determine the capital structure of the Resultant Company.

Conclusion

Taking into consideration the above discussions, it can be concluded that the Valuation of business assets is an integral part of the process of corporate restructuring. The demerger is a business strategy where a single business is broken into two or more separate business entities, or an undertaking is separated in order to be dissolved. In the case where there is a resulting entity formed after the demerger, the business valuation is required to decide the share entitlement ratio of the shares to be allotted in the resulting entity to the shareholders of the demerging entity. Where the demerged undertaking is to be dissolved, the valuation is done to arrive at the value of the entity being dissolved to distribute the resulting wealth among the shareholders of the demerging entity. Thus, valuation is required in case of the demerger and a valuation report is sent along with other documents while filing a scheme of demerger or sending notice for holding meetings under the process of a demerger.

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