Organizational Restructuring for IPO: Before Appointing a Merchant Banker

Organizational Restructuring for Initial Public Offer (IPO)- before you appoint a Merchant Banker

The single biggest reason for queries and delay in approval for DRHP/ IPO (Initial Public Offering) is not the financial issue. More often you will find that the company has good profitability, net worth, solid business but the shareholding is chaotic, board meetings are on papers only and most decisions are taken by founders on WhatsApp and independent directors are relatives only.  In this article, let us explore the organizational and other issues which must be initiated and addressed, at least 2 years before appointing a merchant banker for IPO.

The discussion will flow as below:

• Founders’ dilemma
• Shareholding and Promoter group
• Complex Corporate Structure
• Board Composition
• Audit Committee
• Related Party Transactions
• Legal and
• Governance Documents
• Timeline for restructuring
• Mistakes to avoid

1. Founders’ dilemma: A founder has grown his business from the ideation to the present level. There is emotional attachment to everything in the organization. He/she is infatuated with whatever is there. He may not be ready to delegate his powers. He has seen the company from zero to say Rs. 100 crores. All these are fine from humane angle. However, from the regulatory and SEBI perspective, the whole approach has to be institutionalized and decisions have to flow from that structure. There are contradictory attractions pulling a promoter. He wants to grow but not willing to forego his power. For a successful IPO, the promoter has to be logical and he has to listen the professional advice.

2. Shareholding and Promoter Group: The starting point for any merchant banker will be shareholding of the promoter and his group. The SEBI’s rule book has clearly defined concept of promoter and promoter group. The following steps must be taken to clean shareholding:

• Shares held in the name of HUF is not recognized as valid shareholder by SEBI. Any such shareholding must be transferred to individual names after paying proper stamp duty and valid documentation.
• Shares in minors name will create complications, as SEBI’s promoter lock-in rules will not apply to minors.
• Shares given as gifts must be properly documented through deeds, payment of stamp duty and intimation to the company.
• Promoter Group must formally identified and documented and filed with ROC.

Way out: Start a full shareholding audit. Map every shareholder, every transfer and every beneficial interest and regularize with proper documentation, board resolutions and stamp duty payment and               receipts.

3. Complex Corporate Structure: Your corporate structure should be simple and easy to understand for your business. Delay in IPO filings happen due to related entities, overlapping business, shared employees, common customers and others. Specific issues and complexity can be understood as below:

• Land and building held in promoter’s name and is rented to the operating entity, thus creating related party transaction.
• Manufacturing in one entity and trading in another entity, which create problem of revenue recognition and transfer pricing issues.
• Inter-company loans and advances without documentation, with no interest rate, no repayment schedule.
• Non-core assets like farms, vacation property must be transferred before launching IPO.

Way Out: You should have a principal operating entity with a clean P & L, clearly defined group structure, which is easy to understand.

4. Board Composition and Independent Directors:

Most SMEs do not have a compliant board. SEBI’s requirements for a board of directors are very strict.  Appointment of family members or friend/relatives are not as per the SEBI’s independence criteria.                   Requirements for Board of Directors:

• Minimum three directors with at least one-woman director.
• At least 1/3 directors must be independent.
• Managing Director cannot be Chairperson of a listed entity.

Independent Directors should bring value and expertise to your organization. They should have domain expertise, regulatory knowledge, finance background. They should not be afraid to ask genuine but                      uncomfortable questions. They will bring governance discipline to your organization.

5. Audit Committee and Financial Controls:

Any due diligence before initiating IPO process will examine last three years audited financial statements, internal audit reports and the minutes of the audit committee of the company.

As per SEBI LODR, the Audit Committee must have a minimum three members, 2/3^rd independent directors and the independent chairperson.  The committee must meet at least four times in a year.

Audit Committee overseas the financial reporting process, approves related party transactions, review the performance of internal and external auditors. CFO reports to Audit Committee.

6. Related Party Transactions: All related party transactions with promoters, directors, relatives, related entities must be disclosed in DRHP. The following grey areas are found in due diligence:

• The promoter salary is very inflated and appears to be income extraction mechanism.
• Promoters and family’s personal expense like car, petrol, driver, family vacations, home furnishings are billed as business expenses.
• Unrealistic rent being paid to relative.
• Interest free loans given to group entities without agreement, interest, repayment schedule.

Way Out: Have a full 3-year RPT audit,  correct the queries raised and properly document them.

7. Legal Compliance Audit: Institute a legal compliance audit which will cover the following areas:

• Companies Act: Minutes, registers and share transfer and ROC filings will be examined.
• Income Tax: Three years’ ITRs, TDS deduction and deposits, payment of advance tax, transfer pricing documentation will be checked and flagged.
• GST & Indirect Tax: Returns and reconciliation are done properly.
• Labour Laws: PF, ESI, Gratuity, employment agreements, disputes if any.
• Environmental licenses are all current.
• Sector licenses are current and running.
• Litigation: Every pending cases must be disclosed and contingent liabilities must be quantified and disclosed.

8. Governance Documents: As per SEBI LODR,  a listed company must maintain a specific set of board approved policies, codes and frameworks. The specific actions for documents must be as below:

• Amend MOA and AOA as compliant with SEBI framework.
• Board level policies must be in place. Like Board diversity policy, Code of conduct for directors and senior management, whistle-blower policy, RTP policy etc.
• Financial policies like dividend distribution policy, preservation of documents policies, risk management policy.
• Other operational documents like delegation of authority matrix, KMP contracts, ESOP Scheme and policy of review of contracts with key customers and vendors.

9. Time lines before DRHP:

• Foundation Work- 24 to 18 months before filing DRHP: Restructuring of Shareholding, group company, RPT, governance documents.
• Governance structure: 12 to 9 months: Board and Audit Committee restructuring
• Compliance works: 9 to 6 months: Legal and compliance due diligence.
• Merchant banker: 6 to 3 months

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In case you are planning to have IPO in next 2-3 years, it is right time to start. Remember: Structure of your company will impact IPO valuation. If you have any concern and queries or need any support regarding IPO, due diligence and valuation, you may like to contact us.

Author: Abhinarayan Mishra, FCA, FCS, LLB, IP, RV, ID; Partner, KPAM & Associates, Chartered Accountants, Dwarka, New Delhi;  +9910744992; ca.abhimishra@gmail.com;