Empowering Startups: The 2024 FEMA NDI Rules Amendment on Cross-Border Equity Share Swaps
Introduction
India is rapidly moving towards the goal of making itself the 3rd Largest Economy in the world, by building a robust startup ecosystem, as envisioned Prime Minister.[1] In pursuance of the Union Budget 2024-25 announcement by Union Minister for Finance and Corporate Affairs Smt. Nirmala Sitharaman to simplify rules and regulations for Foreign Direct Investment and Overseas Investment, as one of the initiatives, The Department of Economic Affairs (DEA), Ministry of Finance, has amended Foreign Exchange Management (Non-debt Instruments) Rules, 2019[2] (“NDI Rules”) vide notification[3] dated 16.08.2024.
The amendments aim to simplify cross-border share swaps and provide for the issue or transfer of Indian company’s equity instruments[4] in exchange for another Indian company’s equity instrument or foreign company’s equity capital[5]. This will enable Indian startups to expand globally by leveraging mergers, acquisitions, and strategic initiatives, allowing them to access new markets and grow their international footprint.[6]
Cross Border Share Swaps: Meaning and Facets
A share swap is a cash-neutral transaction where shares of one entity are exchanged for shares of another. During this type of transaction, an entity can acquire shares from another entity or from its existing shareholders by issuing (Primary swap) its own shares or by transferring (Secondary swap) existing shares of another entity held by it, instead of paying cash, or sometimes just partially paying cash.
In Indian context, a cross-border equity share swap is a transaction where equity shares of an Indian company are exchanged with equity instruments or equity capital of either another Indian company or a foreign entity, between a resident and a non-resident investor, without involving cash. The NDI Rules require that the valuation of share swap transactions be carried by a merchant banker registered with the Securities and Exchange Board of India (SEBI), or by an investment banker registered outside India.[7] Prior to amendments, cross border share swap was permitted under the automatic route (without prior approval of RBI) only through Primary FDI-FDI, wherein an Indian company issues its equity instruments to a non-resident investor against the swap of equity instruments of another Indian company held by that non-resident investor.
The amendment to the NDI Rules, introduced rule 9A[8], mentioning about methods of transferring equity instruments between Indian residents and non-residents. This rule permits two types of swaps: equity instruments of an Indian company and equity capital of a foreign company. Both types must comply with rules set by the Central Government and regulations specified by the Reserve Bank of India. For foreign company equity swaps, additional compliance with the Foreign Exchange Management (Overseas Investment) Rules, 2022[9] (“OI Rules”) is required.
Now, post the amendments, cross-border share swap can be done through (a) Secondary FDI-FDI, i.e., when an Indian Company or a resident transfer its existing equity instruments of an Indian Company held by them to a non-resident investor against the swap of equity instruments of another Indian Company which is held by that non-resident investor, (b) FDI-ODI, i.e., when an Indian company issues its equity instruments to a non-resident in exchange for the equity capital of a foreign entity held by that non-resident (Primary), or when an Indian company or resident transfers existing equity instruments of an Indian company held by them to a non-resident resident investor against the swap of the equity capital of a foreign entity held by that non-resident investor (Secondary).
When an Indian Company transfers the equity capital of a foreign entity held by it to the non-resident investor against the swap of the equity capital of another foreign entity held by that non- resident investor, it is called ODI-ODI equity share swap, which is governed by OI rules of 2022. A pertinent point to mention here is, ‘Foreign Entity’ includes any company or any other business structure (like LLC, overseas LLP, firm or fund) which is registered or incorporated outside India and having limited liability, whereas, for India, only companies can reap the benefits of relaxed share swap options, as this benefit has not been extended to LLPs and other such entities.
Irrespective of these relaxations, Amended Rules specifically mandate Government’s prior approval wherever required under the NDI Rules[10]. This is basically to cover certain restricted cases like investment from land-bordering countries or the sectors where such approval is necessary.
Effect of this amendment on Indian Startups
Easier and Quicker Access to Capital
The execution of certain share swaps was often subjected to onerous restrictions within the folds of the Indian regulatory framework, including the requirement to obtain regulatory approvals and permits.[11] It is anticipated that the ease of cross border share swaps will eliminate these regulatory impediments to a great extent, because now, post the amendments, those share swaps which required prior approval of RBI, can proceed under the automatic route. This could possibly lure more strategic investors to Indian market, who were previously hesitant due to regulatory hindrances. This would bring not just capital, but also valuable expertise and global connections to Indian startups. This relaxation will save time in the fast-paced startup sector. Swapping shares with foreign entities or with Indian companies can now proceed under the automatic route without the delays associated with prior RBI approval, making cross border share swap transactions faster as well as easier.
This relaxation will also provide easier access to capital, since share swaps are cash neutral transactions and startups, particularly those in early growth stages, often face liquidity constraints, so this allows them to expand or form strategic partnerships without depleting their cash flow. Equity swaps open the door to international investors who may be more willing to enter into share swap agreements than provide direct cash infusions.
Easier Integration into Global Markets
Early-stage Indian startups are increasingly turning to offshore jurisdictions to restructure their holding company setups, a process known as ‘flipping’ or ‘externalization.'[12] Share swaps have emerged as a key mechanism in this externalization strategy[13], enabling companies to seamlessly integrate into international markets. This relaxation brought in by the amendment enhances Indian startups’ ability to integrate into the global market by creating global networks and strategic partnerships, thus promoting synergies. This regulatory relaxation makes it easier for startups to form strategic alliances, joint ventures, or subsidiaries, allowing them to expand into the global market while retaining operational flexibility. Indian startups can improve their products and services, enhance innovation, and accelerate growth by combining their own expertise with international talent and expertise. This integration helps startups to create a global network of operations, where they can operate in different regions of the world but work synergistically, sharing technology, market insights, and strategies.
Wider opportunities for Restructuring
One way through which Indian startups can integrate themselves into international markets is through Mergers and Acquisitions. While mergers can be defined to mean unification of two players into a single entity, acquisitions are situations where one player buys out the other to combine the bought entity with itself.[14] Startups now have the option to leverage share swaps to acquire or merge with companies in their target markets, securing a foothold in the international market, without the requirement of prior RBI approval. Startups can effectively scale their operations this way. An Indian logistics tech startup could, for example, quickly establish a pan-Asian presence by acquiring local logistics firms in different countries through share swaps, instantly gaining local expertise and infrastructure.
The eased rules also open up possibilities for reverse acquisitions/mergers where an Indian startup could merge with a larger foreign public company and secure entry into international capital markets. This approach provides an alternative route to global listings for Indian startups bypassing the typically long and complicated IPO process. For example, a SPAC (Special Purpose Acquisition Company) is a publicly traded corporation with a two-year life span formed with the sole purpose of effecting a merger, or “combination” with a privately held business to enable it to go public.[15] Take for instance, An Indian unicorn could merge with a SPAC listed on NASDAQ through a share swap, instantly becoming a publicly traded company with access to global investors.
This relaxation could also offer greater opportunities for more diversified funding routes. For instance, an Indian startup could raise funds through a multi-party share swap involving domestic investors, foreign VCs, and even other startups. This could lead to the creation of syndicates that were previously difficult to form, due to the mandate of prior RBI approval.
Effect on Valuation of Startups
The valuation of Indian startups could possibly raise as a result of this amendment. This ease will facilitate the start-up’s accessibility to international markets and investors, possibly leading to an increase in demand for their equity, subsequently raising their valuation. This will also lead to an expansion in their peer group against which they can be valued. For example, an Indian fintech startup initially valued at $50 million based on domestic comparisons could see its valuation soar after a share swap with a European company. This swap would grant access to the EU market and attract global investor interest, positioning the startup alongside higher-valued global peers, thereby significantly raising its valuation.
However, to the downside, there is also a possibility that these startups might have irrational valuations leading to inefficiency and unnecessary competition in market. This might also have a detrimental effect on startups that might actually be worthy of such high valuations.
Caution to be exercised
While it’s true that this particular amendment is anticipated to be fruitful for Indian startups, it might sometimes lead to premature or ill-considered international expansions, potentially stretching young startups thin before they’re truly ready for global markets. There’s also a possibility of foreign entities using these relaxed rules to acquire promising Indian startups at relatively low valuations, potentially leading to a brain drain or loss of intellectual property.
Conclusions
By simplifying cross-border share swaps and allowing for more flexible equity exchanges between Indian and foreign entities, the recent amendment to India’s FEMA Rules, 2019 creates a more favourable environment for Indian startups to expand globally and undoubtedly is an effort towards the objective of ‘Ease of doing business.’
These reforms are particularly advantageous for startups. They enable faster scaling, easier and quicker mergers and acquisitions, and integration into global markets. Moreover, the new developments open up diversified funding routes and provide alternative routes to global listings through mechanisms like reverse acquisitions and merger with SPACs.
However, these changes also come with potential risks, such as premature international expansions or the possibility of irrational valuations or the possibility of foreign entities acquiring these startups at relatively low valuations. Despite these concerns, the overall impact of these amendments is expected to be positive, positioning India’s entrepreneurs to compete more effectively on the global stage and contributing to the country’s goal of becoming the world’s third-largest economy.
Notes:
[1] Press Trust of India, India Has World’s Third Largest Startup Ecosystem: PM at Startup Mahakumbh, Business Standard (Mar. 20, 2024, 4:39 PM), https://www.business-standard.com/industry/news/india-has-world-s-third-largest-startup-ecosystem-pm-at-startup-mahakumbh-124032000287_1.html.
[2] Foreign Exchange Management (Non-debt Instruments) Rules, 2019.
[3] Ministry of Finance, S.O. 3492(E) (Notified on August 16, 2024).
[4] Foreign Exchange Management (Non-debt Instruments) Rules, 2019, Rule 2(k).
[5] Foreign Exchange Management (Overseas Investment) Directions, 2022, Rule 2(e).
[6] Press Information Bureau, Department of Economic Affairs amends Foreign Exchange Management (Non-debt Instruments) Rules, 2019 in pursuance of Union Budget 2024-25 announcement, Press Information Bureau (August 16, 2024), Press Release:Press Information Bureau (pib.gov.in).
[7] Foreign Exchange Management (Non-debt Instruments) Rules, 2019, Rule 21(2)(c)(iv); Foreign Exchange Management (Non-debt Instruments) Rules, 2019, Schedule I, Clause 1(d)(i).
[8] Supra note 3.
[9] Foreign Exchange Management (Overseas Investment) Rules, 2022.
[10] Foreign Exchange Management (Non-debt Instruments) Rules, 2019, Rule, Rule 9 (1)(i).
[11] Ayesha Bhattacharya, Externalizing Indian Startups: Exploring the Flip Side, 42 Bus. L. Rev. 33 (2021), https://kluwerlawonline.com/journalarticle/Business+Law+Review/42.5/BULA2021033.
[12] Nivedita Nivargi & V. Vandana, Externalization: Key Issues Companies Need to Consider (7 June 2018), https://law.asia/externalization-keyissues-companies-need-consider/.
[13] Supra note 11.
[14] Ministry of Corporate Affairs, Report on Mergers and Acquisitions, https://www.mca.gov.in/content/mca/global/en/data-and-reports/reports/other-reports/report-company-law/mergers-and-acquisitions.html.
[15] Max H. Bazerman and Paresh Patel, SPACs: What you need to know (August, 2021),SPACs: What You Need to Know (hbr.org).
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This article is co-authored by Ashish Rawat and Kinjal Ahuja. Both of them are undergraduate (2nd Year) students at Chanakya National Law University, Patna.
