Startup fundraising through issue of shares on preferential and private placement basis and legal aspects thereof for unlisted company

Startup fundraising through issue of shares on preferential and private placement basis and legal aspects thereof for unlisted company

INTRODUCTION

Startup ecosystem is at growth stage since from year 2015 and it has encouraged individuals or group of person to make a shift from the status of employee to employer by founding their own startup, wherein, investment or say series of funding by venture capital investor or private equity investors in Indian Startups has encouraged youth to start their own success journey, Besides, it is well known and acknowledged that startups contributed with their all resource, innovation and technology in fight against the brutal second covid waive. As per a US-based research firm Pitch-Book report Startups raised total investments of $7.8 billion in the first four months of this calendar year, which is almost 70% of the overall corpus of $12.1 billion raised in entire 2020 and more than 50% of $14.2 billion raised in 2019. Nevertheless, as reported by Economic Times average funding size has increased to $25.21 million so far in 2021, up from $14.94 million in 2020 and $18.41 million in 2019.

ABOUT PREFERENTIAL BASIS

“Preferential Basis” is also known as the Preferential Allotment, wherein, it’s one of the modules to obtain capital investment in the Private Limited or Unlisted Company. Preferential Allotment and Private Placement is issued to raise funds from the investors, though, in general parlance of startups corridor one may not be familiar with these two technical terms, however, majority of people are aware about the terms “Seed Funding” or “Series A Funding” or Series B Funding” etc.

A bare reading gives a representation that Preferential Allotment and Private Placement are similar though there is difference between two, wherein, both of these modes are widely used to raise funds from outsider, outsider herein means investors; other than the existing Shareholders, Directors or Employees of the Company, however, a Company can also issue Shares to existing Shareholders, Directors or Employees of the Company under the Preferential Allotment and Private Placement. The law and procedure for raising funder through this methodology is govern by the Companies Act, 2013 (the Act).

“Preferential Allotment” as term itself suggests that it is an offer or preferential treatment towardsthe particular person or group of persons, therefore, under this mode a Company can issue its Shares to any particular person or any group of persons, whereas, said person or the group of persons can be a particular Shareholder or group of Shareholders, particular Director or Directors, particular Employee or group of Employees, Promoter, Promoter-Director of the Company or of any other Company, or may be any institutional Investor. It is to be noted that through Preferential Allotment a Company can only issue Equity Shares, fully convertible debentures, partly convertible debentures or any other securities, which would be convertible into or exchanged with equity shares at a later date or stage. Nevertheless, Company can also issue Shares for consideration other than cash.

Whereas in case of Private Placement; Shares are offered only to a selected group of persons as identified by the Board of Directors of the Company instead of offer to any particular person. As explicated above, under Preferential Allotment a Company can offer its Shares to particular person or a group of persons, whereas, under Private Placement a Company can offer its Shares only to a group of persons.

PREFERENTIAL ALLOTMENT AND PRIVATE PLACEMENT AS FUNDING DEVICE FOR STARTUPS

A startup needs fund not only to execute the idea but to develop the product, to increase the traction, to tap new market areas, to expand its operations as well as to improve its operations either through technology advancement or human or other resources. Many times an idea is executed through bootstrapping which simply means self-financing and thereafter a startup raises the fund through seed funding and series of funding thereafter, for instance Ayurshakha.com is the startup which has utilized boot strapped funds not only for development of idea but also for the growth of product, whereas, no series fund has been raised by promoter until now. In India between last two decades many technology based Startups have been evolved and series of investment has played the crucial role in turning these startups into Indian Unicorns be it Paytm or Unacademy or Byjus, wherein, few of the startups have recently launched their IPO such as Zomato, Delhivery, etc. These Startups were founded with the unique and different idea in amalgamation of technology aside; however, for the expansion of business fund is required, accordingly, for Private Company there are two ways to raise funds; among them one is Debt Funding and other is Equity Funding, however, Debt Funding is comparatively an easy source of fund but it emanates with the burden of interest along with timely repayment of principal amount, recently in last few years, government has announced many such lucrative debt offers for MSME startups to encourage manufacturing as well as to support the economic health of country, though, this Funding may leads to additional burden on the initial growth or survival of Company. Whereas Equity funding involves dilution of ownership stake in Company, however, raising such nature of investment demands a convincing product or service, passionate core human resource team and reliable growth plan. It is to be noted that equity dilution doesn’t brings the burden of interest or principal amount unlike debt funding, however, Company may distribute profit through dividend on shares though it’s not mandatory. Nevertheless, investment in startups is motivated with the return at the time of exit at any later round of funding or funding by giant venture capital investor in later series round or buy back by Company or at the time of Initial Public Offer, for all such equity funding through Preferential Allotment and Private Placement are widely known methodologies as shares can’t be offered to the public at large due to restriction in nature of Company.

DEBT FINANCING VS EQUITY FINANCING

Debt involves repayment of debt along with interest whereas Equity does not involve such repayment, however, Equity Funding involves distribution of interest in the Company i.e. distribution of ownership right and claim in profit of the Company. A lender does not have ownership right over the Company and also he cannot make claim on the profit of the Company. Let’s discuss some key difference between Debt Funding and Equity Funding:

LEGAL ASPECT OF PREFERENTIAL ALLOTMENT AND PRIVATE PLACEMENT

The Companies Act, 2013 is the governing Act for the Companies, accordingly, legal aspects of the Preferential Allotment and Private Placement is governed by the Companies Act, 2013 (the Act). The Section 42 of the Act read with Rule 14 of the Companies (Prospectus and Allotment of Securities) Rules, 2014 governs the Private Placement and Section 62(1)(c) of the Act read with Rule 13 of the Companies (Share Capital and Debentures) Rules, 2014, governs the Preferential Allotment, however, for making Preferential Allotment compliance of Section 42 is also required. Let’s discuss about legal requirement of Preferential Allotment and Private Placement.

CONDITIONS FOR PREFERENTIAL ALLOTMENT AND PRIVATE PLACEMENT

The conditions for making Private Placement is high as compared to Preferential Allotment but as discussed earlier in this article provisions relating the Private Placement is also applicable on Preferential Allotment, accordingly, all condition mentioned above relating the Private Placement are also applicable on Preferential Allotment.

EXEMPTIONS IN CERTAIN CASES

1. In case of Preferential Allotment made only to the existing Shareholders of the Company, than compliance of Sub-Rule (1) and proviso to Sub-Rule (3) of Rule 14 of Companies (Prospectus and Allotment of Securities) Rules, 2014 is not required, i.e.:

a. Disclosures specified under that Sub-Rule (1) is not required to be given; and

b. Person other than identified person can make application to subscribe the Shares.

2. In case issue of Shares for consideration other than cash then opening of separate Bank Account is not required.

3. The limit of 200 persons in a Financial Year is not applicable to:

a. Non-Banking Financial Companies (NBFCs) which are registered with the Reserve Bank of India under the Reserve Bank of India Act,1934; and

b. Housing Finance Companies which are registered with the National Housing Bank under the National Housing Bank Act, 1987,

Provided they are complying with regulations made by the Reserve Bank of India or the National Housing Bank, in respect of offer or invitation to be issued on private placement basis, However, such Companies are required to comply the aforesaid limit of 200 persons, in case the Reserve Bank of India and the National Housing Bank, have not specified similar regulations.

VALUATION ASPECTS

Valuation of Shares under Preferential Allotment and Private Placement is mandatory, accordingly, valuation report from Registered Valuer is required to obtain. Further, in case of issue of Shares for consideration other than cash, valuation of such consideration by the Registered Valuer is also required.

Though investor needs to be vigilant with the fact that valuation is justified and exorbitant projections have not been taken by startup for the valuation purpose, Nevertheless, startup or Company needs to be diligent with the fact that Preferential Allotment and Private Placement done in a gap of small tenure should not have unreasonable difference in their equity value.

ACCOUNTING OF CONSIDERATION OTHER THAN CASH

In case of Private Placement of Shares for consideration other than cash, the method of accounting treatment of the consideration is not specified; however, in case of Preferential Allotment accounting treatment of such consideration shall be made in following manners:

(i) Where the non-cash consideration takes the form of a depreciable or amortizable asset, it shall be carried to the Balance Sheet of the Company in accordance with the accounting standards; or

(ii) Where Clause (i) is not applicable, it shall be expensed as provided in the accounting standards.

PROCEDURE OF PREFERENTIAL ALLOTMENT AND PRIVATE PLACEMENT

CONTENT OF EXPLANATORY STATEMENT

Disclosures in respect of Preferential Allotment:

(a) The objects of the issue;

(b) The total number of Shares to be issued;

(c) The price or price band at/within which the allotment is proposed;

(d) Basis on which the price has been arrived at along with report of the registered valuer;

(e) Relevant date with reference to which the price has been arrived at;

(f) The class or classes of persons to whom the allotment is proposed to be made;

(g) Intention of Promoters, Directors or Key Managerial Personnel to subscribe to the offer;

(h) The proposed time within which the allotment shall be completed;

(i) The names of the proposed allottees and the percentage of post preferential offer capital that may be held by them;

(j) The change in control, if any, in the Company that would occur consequent to the preferential offer;

(k) The number of persons to whom allotment on preferential basis have already been made during the year, in terms of number of securities as well as price;

(l) The justification for the allotment proposed to be made for consideration other than cash together with valuation report of the registered valuer; and

(m) The pre issue and post issue shareholding pattern of the company in prescribed format;

Disclosures in respect of Private Placement:

(n) Particulars of the offer including date of passing of Board resolution;

(o) Kinds of securities offered and the price at which security is being offered;

(p) Basis or justification for the price (including premium, if any) at which the offer or invitation is being made;

(q) Name and address of valuer who performed valuation;

(r) Amount which the Company intends to raise by way of such securities; and

(s) Material terms of raising such securities, proposed time schedule, purposes or objects of offer, contribution being made by the Promoters or Directors either as part of the offer or separately in furtherance of objects; principle terms of assets charged as securities.

CHECKLIST

REGARDS

AUTHOR; NARENDRA PRATAP, SENIOR ASSOCIATE, DUCTUS LEGAL

CO-AUTHORY; DIXIT MEHTA, FOUNDING PARTNER, DUCTUS LEGAL