Authored by Mr. Gurcaran S. Arora and supported by Ms. Paridhi Gupta.
Published on May 12, 2023
Introduction
With India securing its position as the world’s third-largest ‘startup’ ecosystem with over 90,000 ‘startups’ and 107 unicorn companies worth more than 30 billion dollars,[1] it is high time that people, particularly novel founders and investors, familiarise themselves with how to benefit best from these developments. While the traditional practice of purchasing and selling equity shares is typical for drawing investments and generating cash from the market, the notion of Compulsory Convertible Preference Shares ( “CCPS”) has taken the modern corporate world by storm.
With globalisation and international markets, CCPS has also become the pro-choice of investors and founders in China and Indonesia.[2] However, their popularity in India can be attributed to the regulatory framework that permits their issuance and the convenience they afford companies to raise funds. Despite CCPS being plagued by their issues, after reading this article you will understand why and how CCPS is a better choice over equity shares by the end of this article.
An Overview Of Equity Shares and CCPS
The term ‘equity’ pertains to the ordinary shares or proportionate ownership stake held by the shareholders in a given corporate entity. Equity shareholders are legally entitled to participate in the company’s decision-making process through voting rights and receive a portion of the company’s profits which fluctuate depending upon the company’s profit and loss, i.e., equity shares do not have a fixed dividend. Equity financing is a commonly utilised means of procuring funds for corporations, given that it obviates the need for the corporation to remunerate interest or reimburse the principal sum.
On the other hand, CCPS combines the features of preference and equity shares while offering a mandatory conversion feature. The conversion ratio of CCPS is fixed at the time of issuance, and it determines the number of equity shares the holder will receive upon conversion. This ratio is calculated based on the market price of the equity shares at the time of issuance and the face value of the CCPS. They typically offer a fixed dividend rate and a specific maturity date or a triger event, after which they must be converted into equity shares, regardless of the current market price.
Benefits Of CCPS Over Equity Shares
Although equity shares and CCPS are both financial instruments used to raise capital, CCPS could be a better fit for the current market for the following reasons:
1. Anti-Dilution: CCPS can serve as a viable option for companies to secure funding without reducing the ownership percentage immediately of current shareholders, known as non-dilutive funding. Conversely, equity financing can potentially diminish the company’s ownership and control.
2. Balanced Interests: The flexibility of CCPS allows for customisation to accommodate the requirements of both the issuing company and the investors. Adjusting the conversion ratio and conversion price can serve as a means to balance the interests of both parties involved.
3. Risk Mitigation: CCPS appeal to strategic and institutional investors seeking a greater return than conventional debt instruments, who are unwilling to assume the full equity risk. The company can potentially increase its capital by seeking investment from individuals or entities with valuable expertise or connections.
4. Certainty: By giving investors the option to convert their shares into equity at a predetermined rate, CCPS ensures that they receive a premium when they convert their shares into equity. Since the conversion rate and the conversion date/ event are pre-decided at the time of issuance, it is usually higher than the prevailing market price of the shares.
5. Cost-Effective: CCPS can be a viable alternative for companies seeking to raise capital at a lower cost and in a shorter time frame than conventional equity financing. CCPS is a more cost-effective option for companies because they offer investors a lower required rate of return compared to common shares, unlike Equity shares.
6. Liquidation Preference: CCPS offers investor protection by providing priority in liquidation since preference shareholders have primacy over the company’s assets after the debt has been paid off.
7. Fixed Returns and Profitable Exit: CCPS provides investors with a fixed dividend yield, which appeals to individuals seeking a consistent income source and potential for capital appreciation. Also, the mandatory conversion feature facilitates a clear pathway to attain equity ownership, increasing the likelihood of a profitable exit for investors. Investors may tie the conversion to the company’s performance to maximise profits.
8. Avoids Valuation Disputes: CCPS issuance can mitigate founder-investor valuation discrepancies. While the effectiveness of the valuation method of equity shares is impeded by the multiple assumptions necessary to determine the reasonable capital cost and terminal value, investing in convertible preference shares with a predetermined price for the investor is a viable strategy to avoid valuation disputes with the promoter.
Illustration:
The funding round led by the UAE-based Abraaj Group of the Indian online grocery startup ‘BigBasket’ is one of the best illustrations of how companies and their investors can mutually benefit from the effective use of Compulsory Convertible Preference Shares (CCPS). In 2016, BigBasket secured $150 million, with a sizable contribution from the International Finance Corporation (IFC), by distributing CCPS to its investors as part of the investment round, with the shares scheduled to convert to equity after a predetermined time. [3]
Through CCPS, BigBasket allowed new investors to join in without affecting current shareholders and guaranteed investors equity in the business regardless of its valuation. By offering a premium to the company’s share price, BigBasket encouraged investors to support its expansion because they would receive shares regardless of its valuation. As a result, investors were willing to pay more for the ability to convert their shares. Overall, BigBasket acquired a sizable amount of investment through CCPS by encouraging the investors to support the company’s growth while allowing the founders to raise substantial sums of money without instantly diluting their ownership position.
Potential Risks and Limitations
Like any financial instrument, Compulsory Convertible Preference Shares (CCPS) have downsides that investors should be aware of before investing. Some of the principal risks and limitations associated with CCPS include:
1. Lack of liquidity: CCPS is not as liquid as equity shares and may be difficult to sell before the mandatory conversion date.
2. Ultimate Dilution: CCPS ultimately dilutes equity ownership, as they are mandatorily converted into equity shares at a future date.
3. Interest rate risk: CCPS carry a fixed dividend rate, which means that investors are exposed to interest rate risk if interest rates rise, as the value of the CCPS may decline.
4. Market risk: The value of CCPS may be influenced by market factors, such as changes in economic conditions and investor sentiment.
5. Regulatory risk: Changes in regulatory policies or guidelines may impact the value and marketability of CCPS.
6. High Cost of Capital: CCPS may carry a higher cost of capital than other forms of financing, as investors may require a higher return to compensate for the risk and illiquidity associated with CCPS.
7. Limited voting rights: CCPS typically carry limited or no voting rights, which may limit the ability of investors to influence the company’s decision-making process.
Therefore, investors must consult a financial or legal advisor and conduct due diligence before making investment decisions.
Compliance and Procedural Requirements
Despite their innumerable advantages, issuing CCPS securities can be a multifaceted and thorny decision for investors, especially without capable and legitimate legal counsel.
In India, CCPS is regulated by the Securities and Exchange Board of India (SEBI) under the Companies Act, 2013[4], and the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018[5]. Companies can issue CCPS only if authorised in their Articles of Association under the Companies Act, along with the approval of the board of directors and shareholders of the company. SEBI regulations also prescribe the minimum subscription amount, pricing guidelines, and disclosure requirements for CCPS issuances and regulate the conversion of CCPS into equity shares, requiring companies to obtain the necessary approvals and comply with disclosure requirements.
Broadly, the process for companies to issue CCPS involves appointing a registered valuer to determine the issue price, holding board meetings to approve the draft offer letter and determining the terms of the CCPS subject to shareholder approval in an extraordinary general meeting. A notice must be issued before the general meeting, and a special resolution must be passed to approve the issue of CCPS. The company must file e-Form MGT-14 to report the special resolution, circulate the offer letter to intended parties, receive subscription money, and hold another board meeting to allot CCPS to subscribers and issue share certificates. Finally, the company must file e-Form PAS-3 with the allotment details within 30 days of allotment.
Conclusion/Way Forward
Through the comparison and observation of the attributes of equity and CCPS, as well as the aforementioned case study of BigBasket, it is evident that CCPS is a good choice. CCPS, akin to a superhero endowed with the ability to fly, allows investors to ascend to unprecedented altitudes, leveraging the advantages of debt and equity financing. In the interim, equity resembles a rollercoaster experience – exhilarating, capricious, and conceivably hazardous. By electing to utilise CCPS, investors can benefit from the advantages of debt financing, which provides stability and predictability, and equity ownership, which offers the potential for future growth and profitability.
If you seek to invest your hard-earned funds, do not settle for any ordinary investment opportunity like equity shares. Instead, opt to soar to new heights with CCPS and witness your investments flourish!
[1] https://economictimes.indiatimes.com/tech/startups/india-ranks-third-in-world-startup-ecosystem-union-minister-anurag-thakur/articleshow/97616474.cms
[2] Innovative Financing Instruments for Infrastructure: Volume 2 – Country Case Studies (International Finance Corporation, 2011)
[3] https://www.livemint.com/companies/start-ups/bigbasket-receives-150-million-in-funding-becomes-the-newest-unicorn-1557134984121.html
[4] The Companies Act, 2013, No. 18, Acts of Parliament (India).
[5] SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018, Securities and Exchange Board of India Notification No. SEBI/LAD-NRO/GN/2018/24.