Startup fundraising through issue of shares on preferential and private placement basis and legal aspects thereof for unlisted company
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:
|Debt Funding||Equity Funding|
|Does not dilute the Ownership.||Dilute the Ownership.|
|Schedule repayment of principal along with interest.||No schedule repayment is required.|
|Does not have claim over profit of the Company.||Have claim over profit of the Company.|
|Lender does not bear the loss of the Company.||Shareholder bears loss of the Company.|
|Does not receive dividend.||Receive dividend.|
|Repayment of principal along with interest is mandatory.||Repayment of capital is not mandatory, however, company has to pay dividend but payment of dividend every year is not mandatory.|
|High debt increases the financial risk.||No such risk.|
|Compliance requirement is very low.||Compliance requirement is high.|
|Repayment is mandatory even the Company is suffering from loss.||Payment of dividend in case of loss is not mandatory.|
|Interest paid on Debt is tax deductable expense.||Dividend paid to Shareholder is not tax deductable expense.|
|High financial Debt leads to financial distress||No such risks.|
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
|Preferential Allotment||Private Placement|
|The issue is authorized by Articles of Association of the Company.||Not required.|
|The issue has been authorized by a special resolution of the Members of the Company.||Same|
|Allotment of Shares must be completed within 12 months from the date of passing of special resolution.
However, where allotment is not completed within said 12 months, then, Company has to pass another special resolution to complete the allotment.
|Allotment of Shares must be made within 60 days from the date of receipt of application money.|
|Valuation of Shares from Registered Valuer is mandatory.||Same.|
|Selected group of persons must be identified by the Board of Directors of the Company.|
|Company cannot issue Shares unless allotment of previous offer has been made.|
|Offer shall not be made to more than 50 persons at a time and not to more than 200 persons in a Financial Year, however for counting these limits, Qualified Institutional Buyer and Employees of the Company to whom shares has been issue under ESOP, shall be excluded.|
|The Private Placement offer cum application letter must be in the name of identified person.|
|The Private Placement offer and application shall not carry any right of renunciation.|
|The Company cannot dispatch Private Placement offer cum application letter unless copy of special resolution has been filed with the Registrar of Companies.|
|The identified person can only make application for Shares.|
|Payment shall be made from the Bank Account of the identified person only through cheque, demand draft or other banking channel but not by cash.|
|To receive the application money, the Company has to open a Separate Bank Account.|
|The Company shall not release any public advertisements or utilise any media, marketing or distribution channels or agents to inform the public at large about such an issue.|
|Return of Allotment must be filed with ROC within 15 days from the date of Allotment.|
|The Company shall maintain the complete record of Private Placement offers in Form PAS-5.|
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.
|Who is “Qualified Institutional Buyer”?
As per Regulation 2(1)(ss) of SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 “Qualified Institutional buyer” means:
(i) A Mutual Fund, Venture Capital Fund, Alternative Investment Fund and Foreign Venture Capital Investor registered with the Board;
(ii) Foreign Portfolio Investor other than Individuals, Corporate Bodies and family offices;
(iii) A Public Financial Institution;
(iv) A Scheduled Commercial Bank;
(v) A Multilateral and Bilateral Development Financial Institution;
(vi) A State Industrial Development Corporation;
(vii) An Insurance Company registered with the Insurance Regulatory and Development Authority of India;
(viii) A Provident Fund with minimum corpus of Twenty Five Crore Rupees;
(ix) A Pension Fund with minimum corpus of Twenty Five Crore Rupees;
(x) National Investment Fund set up by resolution no. F. No. 2/3/2005-DDII dated November 23, 2005 of the Government of India published in the Gazette of India;
(xi) Insurance Funds set up and managed by Army, Navy or Air Force of the Union of India; and
(xii) Insurance Funds set up and managed by the Department of Posts, India; and
(xiii) Systemically Important Non-Banking Financial Companies.
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 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
|Dispatch Notice of Board Meeting.|
|Hold Board Meeting and Pass Resolutions:
> Approve the list of Identified Group of Person in case of Private Placement or Person(s) in case of Preferential Allotment;
> Determine quantum of fund to be raised;
> Approve issue of Shares;
> Appoint registered valuer to make valuation of Shares;
> Authorise Directors to open Escrow Account;
> Call and hold the Extra-Ordinary General Meeting;
> Authorise Director to sign and dispatch the Notice calling Extra-Ordinary general Meeting; and
> Authorise Director to draft Form PAS-4 (Private Placement cum Application Letter) and Form PAS-5 (Record of Private Placement Offers).
|Obtain valuation report of Shares form Registered Valuer.|
|Open Escrow Account with any Scheduled Bank.|
|Dispatch Notice of Extra-Ordinary General Meeting.|
|Hold Extra-Ordinary General Meeting and pass Resolutions:
> Approve issue of Shares;
> Approve Form PAS-4; and
> Authorise Director to sign and dispatch the same.
It should be noted that the gap between the date on the basis of which valuation of Shares have been done and the date of Extra-Ordinary General Meeting, should not be less than 30 days.
|In case of Unlisted Public Company immediately inform the Depositary, Depositary Participant and Registrar & Share Transfer Agent.|
|File Form MGT-14 with Registrar of Companies for registration of Resolution passed at Extra-Ordinary General Meeting.|
|Dispatch the Form PAS-4 to Identified Persons.
It should be noted that the Company cannot dispatch Form PAS-4 unless Form MGT-14 has been filed.
|Receive application from Identified Persons along with application money.|
|Dispatch Notice of Board Meeting.|
|Hold Board Meeting and pass Resolutions:
> Approve allotment of Shares;
> Approve the List of Allottees
> Authorise Director to file Form PAS-3 (Return of Allotment) with Registrar of Companies;
> Authorise Director to make entries in Statutory Registers;
> Authorise Director to sign and issue the Share Certificates;
> Authorise Director to pay Stamp Duty on Share Certificates; and
> Approve the Form PAS-5 and authorise Director to sign the same.
|In case of Unlisted Public Company immediately inform the Depositary, Depositary Participant and Registrar & Share Transfer Agent.|
|File Form PAS-3 with the Registrar of Companies within 15 days from the date of allotment.|
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.
|S. No.||Particulars||Yes/ No/ NA||Remark|
|Whether the Company is authorised to make Preferential Allotment Shares by Articles of Association (AOA)?|
|(ii)||If No, alteration of AOA is to be initiated or not?
(AOA has to be amended by passing a Special resolution) File MGT-14 within 30 days.
|2.||What is the quantum of amount to be raised?|
|3.||Whether list of Identified Persons (not exceeding 50 in single tranche and 200 in a financial year) to whom offer may be made, is prepared?
While counting 50 and 200, QIB & ESOP are excluded.
|4.||Whether fully paid securities are issued?|
|Whether allotment of any previous offer/ invitation of any kind of security, is pending?|
|(ii)||If yes, first complete the previous pending allotment.|
|6.||Whether valuation report from Registered Valuer, is obtained?|
|7.||Whether Escrow Account in Scheduled Bank has been opened?|
|8.(i)||Whether special resolution is passed?|
|(ii)||Whether the notice of the same is given at least 21 clear days prior to the date of passing the Special Resolution?|
|(iii)||Check that the gap between the date on the basis of valuation is made and the date on which special resolution has been, is not less than 30 days|
|(iv)||Whether Explanatory Statement contains disclosures as per Rule 13 of Companies SCD Rule and Rule 14 of Companies PAS Rules?|
|(v)||Whether Form MGT-14 is filed with the registrar along with the fees within 30 days from passing special resolution?|
|9.||In case of unlisted Public Company, whether Company has immediately informed the Depositary, Depository Participant and RTA?|
|10.||Check that issue price is not less than price determined by the Registered Valuer.|
|Have you verified the information and disclosure provided in Form PAS-4?|
|(ii)||Whether Form PAS-4 dispatched to identified persons only after filing of Form MGT-14?|
|Check that application received by the Company only from the identified persons?
Except in case of offer made only to the existing Members of the Company.
|(ii)||Check that application money received only by way of Cheque, Demand Draft or from other banking channel from the Bank Account of the subscriber, but not by Cash|
|(iii)||In case of joint applicant, check that application money has been received from the Bank Account of first applicant?|
|(iv)||Check that money received with application kept in Escrow Account by the Company?|
|(v)||Check that application received is not utilised for any purpose other than:
(a) For adjustment against allotment; or
(b) For the repayment of monies where the Company is unable to make allotment.
|Whether allotment has been made within 60 days from the date of receipt of Application money?|
|(ii)||If not, whether application money has been refunded within 15 days from the expiry of 60 days from the date of receipt of application money?|
|Whether allotment has been made within 12 months from the dated of passing Special Resolution as mentioned in point No. 8(i) above?|
|(ii)||If not, whether another Special Resolution has been passed to complete the allotment?|
|15.||Check that the Company has not utilised the application money unless the allotment has been made and the Form PAS-3 is filed|
|Whether Form PAS-3 has been filed within 15 days from the date of allotment?|
|(ii)||Whether List of Allottees contains the required information in terms of Rule 14(6) of Companies PAS Rules?|
|17.||In case of unlisted Public Company, whether Company has immediately informed the Depositary, Depository Participant and RTA?|
|18.||Whether Letter of Allotment is issued to Allottees?|
|In case of Private Limited Company, whether Share Certificates issued within 2 months from the date of allotment?|
|(ii)||Whether Share Certificates has been as per the requirement of Section 46?|
|(iii)||Whether adequate Stamp Duty has been paid on Share Certificates?|
|Whether requisite entries in the Statutory Registers of the Company have been made?|
|(ii)||Whether entry made in Statutory Registers have been verified and authenticated by the Director or Company Secretary of the Company?|
|21.||Whether record of Private Placement Offer is maintained in Form PAS-5?|
AUTHOR; NARENDRA PRATAP, SENIOR ASSOCIATE, DUCTUS LEGAL
CO-AUTHORY; DIXIT MEHTA, FOUNDING PARTNER, DUCTUS LEGAL