Is equity capital deemed as preference capital ?

Companies which are raising funds from angel investors or through venture capital funds are in dilemma which instrument is required to be issued against the investment. The decision is taken by the investors in general to which instrument they should get against their investment. However, the promoters of the company should be aware on the rights and obligations that goes to the investors against the instruments issued. Majority of the investors prefer to have the convertible instruments such as convertible preference shares, convertible debentures, convertible notes, bonds as these instruments carry the preferential rights and also the liquidation preference.

As per the provisions of the Companies Act, 2013 the share capital of a company limited by shares will be of two kinds namely (Section 43)

1. Equity share capita with voting rights;
2. Equity share capital with differential voting rights as to dividend, voting, or otherwise in accordance with such rules as may be prescribed and
3. Preference share capital.

Explanation for the purpose of this Section–

“Equity share capital” with reference to any company limited by shares means all share capital which is not preference share capital”

“Preference Share capital” with reference to any company limited by shares, means that part of the issued share capital of the company which carries or would carry a preferential right with respect to

1. Payment of dividend, either as a fixed amount or any amount calculated at a fixed rate, which may either be free or subject to income tax; and
2. Repayment, in case of a winding up or repayment of capital, of the amount of share capital paid-up or deemed to have been paid up, whether or not, there is a preferential right to the payment of any fixed premium or premium on any fixed scale, specified in the memorandum or articles of the company.

“Deemed Preference capital”

Explanation three to this section is quite confusing as this explanation leads certain capital as deemed preference capital. Explanation reads as (iii) capital shall be deemed to be preference capital, notwithstanding that it is entitled to either both of the following rights, namely;-

1. That in respect of dividends, in addition to the preferential rights to the amounts specified in sub-clause (a) of clause (ii) it has a right to participate, whether fully or to a limited extent, with capital entitled to the preferential right aforesaid;
2. That in respect of capital, in addition to the preferential right to the repayment, on a winding up, of the amount, specified in sub-clause (b) of clause (ii) it has a right to participate, whether fully or to a limited extent, with capital not entitled to that preferential right in any surplus which may remain after the entire capital has been repaid.

By the explanation above it means that any instrument including equity shares having the special rights to dividend or liquidation preference such instrument shall be deemed to be preference capital.