By Shraddha Ray Menon and Mehajabeen Haider
Dictionary meaning of Differential includes- varying according to circumstances or relevant factors.
The stock of founders or experts are becoming more refined that what we have seen and they shoulder the responsibility of controlling the future of a company while offering the financial benefits to the investors by diluting their own rights.
Dual-class shares or shares with differential voting rights (DVRs) allow promoters and founders to steer management control while bringing in investors on board.
The differential rights on give the holder/ founders a maximum of 10:1 voting powers per share, as opposed to stock held by the public/ investors, whose ratio would be 1:1. These could be issued as inferior or superior voting rights.
DVR-Globally
With recent regulatory support, around 2019 from the SEBI, India is still warming up to dual class shares. Globally, they aren’t as novel a concept.
It was conceptualized in the U.S. as early as1800s. It took almost two decades for it to be recognised as a preferred tool for retaining management control and generate the capital fast growing companies desire. Technology companies like Facebook, when faced with the challenge of balancing growth and control, issued DVRs. Founder, Mark Zuckerberg, has close to 54% voting rights in the company where he holds roughly 28% of class B shares, the class B shares have 10 votes per share.
DVR listings in the US as % of total US IPOs have increased from around 2% in the early 80s to +25% by 2018.
Around 2018, both, Singapore and Hong Kong amended their listing rules to allow DVR listing to offer a conducive environment for start-ups to reach full value and not miss on listing of multi-billion-dollar IPOs. Alibaba reached out to NYSE only upon being refused by Hong Kong stock exchange of dual share listing.
The first DCS listing at the Hong Kong stock exchange was from Xiaomi Corporation.
In comparison, India has flip-flopped a little on these with Tata Motors pioneering these in 2008 and immediately, thereafter in 2009 being banned by Securities and Exchange Board of India (SEBI).
A decade later, SEBI, on June 27, 2019, approved for adoption a new framework on DVR Shares, which is when it issued a Consultation Paper on issuance of DVRs. Tata Motors, Pantaloons Retail India (Future Retail group), Gujarat NRE, Coke and Jain Irrigation are companies which have issued DVRs. The trading volume in these is 75-90% less than that in company with ordinary shares. We can hope that in the coming years, this change is what will benefit fast growing and emerging tech companies, and as defined under Innovators Growth Platform.
Deconstructing Indian Legislation on DVRs
India’s DVR legislation is relatively noew, long and complex. We are attempting to deconstruct and familiarise you with.
Starting with Company law, Section 43(1) of the Companies Act, 2013 allows issuing equity shares with differential voting rights. Typically, section 43 gets couched in Companies (Share Capital and Debenture) Reules, 2014 where Rule 4 set out pre-requisites for issuing shares with differential rights. Although, these are applicable for public companies they form an indicative lamp post for private companies moving towards IPO. Interestingly, if public companies do not meet the pre-requsites under section 43, they receive a small protection under Section 47 (2) (b) of the Act, which states –
“every member of a company limited by shares and holding equity share capital therein, shall have a right to vote on every resolution placed before the company.”
This essentially means, despite the ‘one-share-one-vote’ requirement under section 47, companies which fulfil the conditions of section 43, can issue shares with DVR. Private companies are exempt from sections 43 and 47, they can also through the Articles excuse themselves from the ambit of these.
SEBI’s consultation paper of March 2019, on the issuance of DVRs addressed the debate around the need and issuance and listing of shares with DVRs in India (“Consultation paper“). Amongst other things, it highlit the benefits of DVRs in India’s “high growth phase, which requires companies to raise capital to sustain this growth.” Subsequently, the Approved framework by SEBI was delivered in June 2019.
The Consultation paper, gives a broad idea on the expanse on which SEBI was building it, though the approved framework had some deviations.
A. Deviations:
| Consultation Paper | Approved Framework |
| possibility of issuance of DVRs by even listed companies | does not provide the guidelines for this. restricted the scope of issuance of DVRs to new listings made by tech companies; |
| Consultation Paper did not permit issuance of SRs to any persons, including the promoters, by rights issue or bonus issue, once its ordinary equity shares have been listed. | approved framework has allowed for issuance of SRs under bonus issue, split of shares or rights issues. The clarification says that the SR shareholder will not be able to renounce these shares |
| Consultation Paper had placed the ceiling @75% | Approved Framework allows voting rights of the SR shareholders up to 74% of the total voting power |
| Consultation Paper proposed for the SR shares to remain in perpetual lock-in after the IPO | Approved Framework requires the SRs to be under lock-in till after the IPO till their conversion to ordinary shares. In the event of early conversions, the SRs share continue to be in lock in for 3 years after listing for SR shares considered for minimum promoter contribution and 1 year SR shares in excess of minimum promoter contribution as per ICDR regulations. Approved Framework clarifies that the SR shares would be allowed towards computation of minimum promoter contribution requirement of ICDR Regulation. |
| Consultation Paper had not restriction on the time bound sunset clause and had imposed no restriction on the number of times the validity of SR shares could be extended | Approved Framework has divided the sunset clauses into two categories on the basis of the time and/or event |
| Less detail on the scope of the sunset clause and the operation of the same. | Approved Framework detailed the scope of the Sunset clause and provides that the validity of SR shares can be extended once by 5 years. The Approved Framework also mandates the conversion of SRs into ordinary shares in the event of a SR shareholder resigning from the executive position in the company and when the merger/acquisition of a company having SR shares would lead to a loss of control in the hands of the SR shareholder |
Sieving from the Consultation paper to the Approved Framework, indicates the following broad road map for DVRs.
- criterias of Eligibility, with issuer company being a tech company, which means it is intensive in the use of technology, information technology, intellectual property, data analytics, bio-technology or nano-technology to provide products, services or business platforms with substantial value addition;
SR shareholder being a part of the promoter group whose collective net worth does not exceed rupees 500 crores. The collective net worth of the investment of SR shareholders will not include the shares of the issuer company;
SR shares have been issued only to the promoters/ founders who hold an executive position in the company;
issue of SR shares have been authorized under a special resolution passed at a general meeting of the shareholders with notice of (a) Size of SR issuance, (b) Ratio of voting rights of SR shares vis-à-vis ordinary shares, (c) Rights as to differential dividends, (d) Sunset clause, and (e) Coat tail provisions (scenarios where SR shares would have same voting rights as ordinary shares);
SR shares have been held for a period of at least 6 months prior to the filing of Red Herring Prospectus;
SR shares have voting rights in a ratio, not less than 2:1 and not greater than 10:1, compared to ordinary shares. The ratio shall be in whole numbers only; - criteria of Disclosures include as under SEBI’s Issue of Capital and Disclosure Requirement Regulations, 2018 (ICDR Regulations);
Pre-Issue Disclosure, for company to disclose names of SR shareholders, with details of special rights and Coattail provisions required under ICDR Regulations. - Pre-Issue, include Articles of a company should authorize the issue of shares with differential rights;
Approved by the shareholders in the general meeting through an ordinary resolution;
No default in filing of annual returns and financial statements for 3 financial years immediately preceding the financial year in which shares are being issued;
The company has not endured any default in payment of dividend to shareholders or repayment of debenture holders or preference shareholders on their maturity & redemption or repayment of any term loan from a public financial institution or State level financial institution or scheduled bank that has become repayable or interest payable.
Not penalized in last 3 years of any offence under Reserve Bank of India Act, 1934, the Security and Exchange Board of India Act, 1992, the Securities and Contract Regulation Act, 1956, the Foreign Exchange Management Act, 1999 or any other Special Act - Criteria for Minimum Promoter Contribution, include SR shares being allowed towards computation under the ICDR Regulations.
- Listing and Lock-In requirements include that the SR shares be listed on stock exchanges after the issuer company makes a public issue;
SR shares would be under lock-in of 5 years after the IPO until converted to ordinary shares;
In event of early conversion (before the stipulated first 5 years) of SR shares to ordinary shares, for SR Shares towards Minimum Promoter Contribution the lock-in would have to continue as per ICDR Regulations for 3 (three) years after listing and for SR shares in excess of Minimum Promoter Contribution it would be for 1year;
Transfer of SR shares among promoters is not permitted. No pledge/ lien is allowed on SR shares - For Sun-set clause, for time based, SR shares have an outer“sun-set” provision for conversion to ordinary shares. It is the 5th anniversary of listing. This can be extended by another 5 years, once through a resolution.
SR shareholders are not permitted to vote on these resolutions. Conversion to ordinary shares prior to the time based sun-set, is permitted.
For Event based sun-set clause, on the occurrence of some events, SR shares get compulsorily converted into ordinary shares.
Like: demise, resignation from executive position of the promoter(s) holding such shares, mergers or acquisition of the company having SR shareholder with the control passing from such SR shareholder. - enhanced corporate governance is imposed because of disproportionate voting rights as against economic interest. 2/3rd of the Board have to comprise of Independent Directors, excluding the Audit Commiittee as per the SEBI (LODR) Regualtions 2015;
Audit Committee to have only Independent Directors. - Coat-Tail Provisions, include, Post-IPO, the SR Shares get treated as ordinary shares in terms of voting rights (i.e. one SR share shall have only one vote) in event of: Appointment or removal of independent directors and/or auditor; Related Party Transaction involving SR shareholders as per SEBI (LODR) Regulations; Willing transfer by promoter control to another entity; Voluntary winding up; Changes in the company’s article of association or memorandum-except any changes affecting the SR instrument; Initiation of a voluntary resolution plan under IBC; Substantial value transaction based on materiality threshold as prescribed under LODR Regulations;
- For subsequent issues, SR shareholders are entitled to bonus or split shares and rights issue in subsequent issues. The SR shareholder can not renounce the rights of SR shares, the ratio of the voting rights shall remain the same as adopted initially.
- post-issue disclosures include disclosing SR shareholding in periodic disclosure.
The voting power with differential rights can not exceed 74% (earlier 26%, including ordinary shares.
Amendments to Share Capital and Debenture Rules, 2014 (SCDR): Removal of the need for a consistent track record of distributable profits for the previous 3 years in order to be eligible to issue DVR shares;
Increase in percentage of shares with differential rights out of the total post-issue paid up equity share capital from 26% to 74%.
“One share One vote” is fair and square and has been the bedrock in India for voting rights. This is set to change with the willing step SEBI has taken in the direction. DVRs have generally been quoted at a discount of 30-40% in the Indian context for inferior rights, which would make the dividend yield a lot more attractive for the investors. On the founder side, DVRs can act as the safety valves against hostile bids and acquisitions.
New framework of DVR will help entities in raising capital for their business and will also allow promoters retain control over the company. They can cultivate good governance and expedecious IPOs.