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Sashank Saravanan & Gauravi Talwar are 3rd Year Students at Gujarat National Law University
Introduction
In light of the Securities and Exchange Board of India’s (“SEBI”) continuing attempts to improve the ease of doing business, on 12 January 2024, a consultation paper was released by an expert committee on the harmonization of the Issue of Capital and Disclosure Requirements (“ICDR”) and the Listing Obligations and Disclosure Requirements (“LODR”) regulations.
The proposal aims to address the growing issues associated with promoter ownership in numerous startups as they approach the IPO stage. The rising prevalence of Private Equity ownership and investments has resulted in promoters experiencing share dilution across multiple funding rounds, creating challenges in meeting the required minimum contribution.
This article analysis specific recommendations by the committee regarding Minimum Promoter Contributions, the inclusion of non-individual shareholders and equity shares received on conversion or exchange of fully paid-up Compulsory Convertible Securities (“ESFCCS”) and depository receipts along with the possible impact this change could have on the ease of doing business.
ICDR: Current framework and the proposed changes
Under the current Regulation 14 of the ICDR, promoters are obligated to contribute 20% of the post-offer paid-up share capital on a fully diluted basis as part of the minimum promoter contribution. Through the most recent consultation paper SEBI proposes to increase the scope of contributions eligible for the minimum promoters’ contribution. This expansion includes the incorporation of two types of contributions, namely from non-individual shareholders and equity shares arising from the conversion of fully paid-up compulsorily convertible securities (“ESFCCS”).
Key points on non-individual shareholders
According to Regulation 14 of the ICDR, If the promoter’s post-offer paid-up equity share capital falls below 20%, specific categories of QIB shareholders, including alternative investment funds, foreign venture capital investors, scheduled commercial banks, public financial institutions, or insurance companies registered with the IRDAI, are allowed to contribute their equity shares to fill the gap, up to a maximum of 10%, without being recognized as promoters. In response to stakeholder suggestions, the consultation paper aims to modify this. The suggestion by the expert committee proposes that any public non-individual shareholder holding at least 5% of the post-offer equity share capital should be allowed to contribute to the minimum promoters’ contribution shortfall.
While the existing regulations allow certain categories of investors to contribute equity shares towards the shortfall, more flexibility is suggested. The proposal recommends that any non-individual shareholder holding 5% or more of the post-offer equity share capital should be permitted to contribute to the shortfall in the minimum promoters’ contribution, up to the existing maximum of 10%, without being identified as a promoter. Additionally, these contributed equity shares towards the shortfall should be eligible under Regulation 15.
Key points on ESFCCS
In regard to ESFCCS, presently, the existing regulatory framework, such as Regulation 15, excludes equity shares acquired through the conversion of convertible securities within one year prior to filing the DRHP from the minimum promoters’ contribution. Moreover, Regulation 8 allows for an offer for sale of equity shares resulting from the conversion of fully paid-up compulsorily convertible securities, provided they have been held for at least one year before the DRHP filing. Acknowledging stakeholder input, there is a recommendation to further enhance the regulations by including equity shares obtained through the conversion of fully paid-up, compulsorily convertible securities held for a minimum of one year before the DRHP filing in the calculation of the minimum promoters’ contribution. This proposal is underpinned by the rationale that the capital represented by these convertible securities has been in existence and held for at least one year before the filing of the DRHP, with the conversion occurring prior to the submission of the red herring prospectus.
Underlying intent towards the protection of promoter ownership
The primary motive behind this regulatory shift is to address challenges faced by startup promoters in acquiring or safeguarding their 20% required equity by the time of filing of the draft red herring prospectus (“DRHP”). Often, companies undergo multiple funding rounds before reaching the final IPO phase, leading to a potential shortfall in promoter holding at the time of the IPO, particularly for start-ups undergoing frequent equity dilution to private equity players. In turn, these companies fail to have an identifiable promoter on time of filing the DRHP.
In essence, the modification acknowledges and accommodates the dynamic funding patterns prevalent in companies led by entrepreneurs. Practically, this change allows entrepreneurs to retain a promoter position with a lower ownership threshold, supporting their company’s identity and facilitating self-funding through equity with enhanced stability and potential control.
An analysis of the possible side effects of these changes
The proposed amendment envisages a scenario wherein entrepreneurs, acting in the capacity of promoters, may fall below the prescribed minimum promoter contribution threshold, potentially giving rise to operational challenges if mismanaged. While this presents an avenue for potential divestment, it concurrently introduces complexities in decision-making dynamics, fostering conflicts that could detrimentally impact the enterprise. Startups thrive on their agility and first-mover advantage, setting them apart from traditional companies mired in protracted decision-making processes. Permitting individuals to retain their promoter status despite falling below the 20% minimum contribution threshold may precipitate disputes and further dilution, jeopardizing the promoter’s control over the company. This, in turn, poses bureaucratic impediments and jeopardizes the foundational advantages of the startup.
A pertinent illustration lies in the surge of private equity ownership, conferring special rights, such as the right to nominate a director. Additionally, contemporary businesses, including those in the technology sector, often lack a discernible promoter group, challenging the conventional paradigm. According to the SEBI’s prior consultation paper, the aggregate promoter shareholdings in the top 500 listed entities witnessed a peak at 58% in 2009, subsequently experiencing a decline. Simultaneously, institutional investors in the top 500 listed firms increased their shareholdings from 25% (non-family-owned) in 2009 to 34% in 2018.
Changes in ownership structures could lead to situations where individuals lacking controlling rights and possessing minority shareholdings are categorized as promoters. For instance, In the case of OYO post-IPO, the approximate 8.21% dilution of Rakesh Agarwal’s promoter shareholding exposes him to potential board removal by major stakeholders, notably Softbank, at any stage. This dilution also significantly diminishes his decision-making authority, subject to institutional investor discretion. Contrastingly, OYO’s current dynamics rely on mutual understanding and trust between parties. In a hypothetical scenario with a new market entrant having a promoter share below 20%, and lacking control and trust, the promoter faces heightened vulnerability to immediate board removal by institutional investors, hindering startup evolution and adversely impacting the industry.
Additionally, bestowing the title of promoters upon such individuals may grant them influence disproportionate to their economic stake, potentially conflicting with the interests of stakeholders. A discernible promoter, conventionally associated with higher shareholding, also signifies a more significant commitment to the business. Allowing individuals with lower holdings to assume a promoter position raises apprehensions regarding their substantive contribution to the company, thereby undermining the creation of investor confidence over time.
Conclusion
SEBI’s proposed amendments aim to adapt Minimum Promoters’ Contribution rules to the dynamic funding landscape of startups. While the expansion to include non-individual shareholders and ESFCCS is a positive move, caution is needed. The intent to protect entrepreneurs is clear, but potential conflicts arise if promoters retain control despite falling below the 20% threshold. Balancing flexibility with control is crucial for sustainable growth. As SEBI seeks to harmonize regulations, a vigilant and adaptable approach will be key to ensuring these changes effectively support startups on their IPO journey without compromising essential attributes like agility and decision-making efficiency.
