Understanding the Exit Rights Provided by Private Companies

[The
following guest post is contributed by 
Ananya Banerjee, a 5th Year Student of University of
Calcutta, Department of Law]

Investing in companies (especially in startups)
involves a huge risk. For this reason, financial investors look for exit rights
which allow them to exit the company with a high return on the investment
amount. While the aim of the strategic investors is not to achieve a favourable
exit, the private equity (“PE”) and
venture capital (“VC”) investors
give most importance to the exit rights available to them. This post deals with
the exit rights usually provided by private companies to their PE and VC investors
and the legality of such rights.

A.        IPO
– An initial public offering (“IPO”)
has continued to be the most favourable exit option for the investors as a
private company can go through with an IPO only if certain conditions are
fulfilled (as laid down under the SEBI (Issue of Capital and Disclosure
Requirements) Regulations, 2009 and the rules and regulations of the concerned
stock exchange) which ensure that the company is doing well. An investor often
enjoys a preference over other shareholders in case of an IPO as well, by
stipulating in the investment agreement that the investor’s securities shall be
offered for sale in priority before other securities, to the extent permitted
under applicable laws. In addition to this right, the investors also ask for a
registration right which allows them to register their securities for sale in case
the company lists its securities in a foreign stock exchange.  

B.        Third Party Sale Arranged by the
Promoters
– The exit clause also provides an
option whereby the company and/or the promoters arrange a sale of the securities
held by such investors. The strategic investors often buy out such investors’
securities through mergers and acquisitions (“M&A Transactions”). The process may be initiated through common
agreements between the two parties but the sanction of the High Court is
required for bringing it into effect. The provisions of the Companies Act, 2013
(“Act”) have to be followed in case
of an M&A Transaction. It is very unusual that the subsequent round of
investors would facilitate the exit of the existing investors, although, it is
not entirely rare. Hence, the promoters (or the company) may, alternatively,
arrange a buyer for the investor securities, which could be a strategic
investor as well.

C.        Buy-back Right
– Buyback right implies that at the end of the exit period, if the company
fails to provide an exit by the options discussed hereinabove, the company
shall buy back the securities owned by the investor, subject to the provisions
of the Act and the rules made thereunder, and all other applicable laws. However,
a company can buy back its own shares only using the proceeds from its

i.    free reserves;
ii.   securities premium account; and
iii.  proceeds of any shares or other specified
securities;

It
is provided that no buyback is allowed out of the proceeds of an earlier issue
of the same kind of shares or same kind of other specified securities.

In
addition to the foregoing, there are a number of other conditions of buyback. Companies
can only buy back up to 25% of their issued and paid-up capital in one
financial year. Moreover, buyback is also prohibited through subsidiaries or
investment companies and in case of default or non-compliance, as provided
under the Act.

Due
to the statutory compliances, it is often impractical for an investor to expect
that the company would be able to provide an exit through buyback. For this
reason, the investment agreement usually requires the promoters to carry out
the buyback obligations. However, it is not always feasible for the promoters
to have the huge amount required to buy back the investor’s securities.

D.        Third Party Sale Arranged by the
Investor
– When the company and the promoters
fail to provide an exit under any of the abovementioned routes within a
specified time limit (say after six months from the date when the exit right
kicks in), the investors get to arrange a sale of the securities owned by them
to any person of their choice. Moreover, although the investors are usually
barred from selling their securities to any competitors during the currency of
any investment agreement, while exercising the exit right under this option,
they enjoy the freedom to choose any potential buyer, including such
competitors. That would, however, depend upon the precise terms of the
contractual arrangements between the parties.

Drag
Right
– The right to sell investors’
securities to a buyer of the investors’ choice also comes with a drag right. When
this right kicks in, it gives the investor the authority to drag the promoters’
(and often, other shareholders’, to the exclusion of other investors)
securities in a sale arranged by such investor. For example, if a potential
buyer wishes to buy 70% share capital of the company and the investor owns only
40%, this right entails the investor to require that the promoters and the
other shareholders (in exclusion of the other investors, if any) sell 30% of
their shareholding on a pro rata
basis, inter se their shareholding.

Put
& Call Option

In the case of the Commissioner of Income-Tax vs. Shri Bharat R. Ruia[1], the Bombay High Court
pointed out that “An option gives the
holder right to buy or sell an underlying asset at a future date at a
predetermined price.
” 

The
put option gives the investors the right to sell their securities to the
promoters within a pre-determined time period, and often, at a pre-determined
price, calculated on the basis of internal rate of return (“IRR”). The call option is similar to a
put option, but through this option the promoters enjoy the right to procure
the sale of the securities held by the investors, after completion of a
specified time period, at a pre-determined price. If the company does well in
the long run, the promoters enjoy the right to exercise this option to buy the
investors’ securities to regain more control in the company and to facilitate
an exit for the investors.

Legality
of Put & Call Options
: Put and call options
are inserted to ensure that the investors’ securities would be bought at a
pre-determined price. Often, these options specify assured returns or IRR, or
at least a floor price for return. As assured returns allow a PE or VC investor
to secure a minimum return from its investment, it actually eliminates, to a
great extent, the risk of business exposure to which other equity investors are
exposed. And hence, the legality of put option has been questioned on several
occasions.

SEBI
Notification
: Ultimately, SEBI had, pursuant to
its
notification
dated October 3, 2013 (“SEBI Notification”),
permitted contracts with put & call options for the purpose of the Securities
Contracts (Regulation) Act, 1956 (“SCRA”).
The Supreme Court, on many occasions, has taken the liberal view pertaining to
the scope of definition of ‘securities’ under the SCRA and has brought the
marketable securities of the unlisted companies under the scope of the
definition as well.

In
Sudhir Shantilal Mehta vs. Central
Bureau of Investigation
,[2] the Supreme Court held
that the definition of securities under the SCRA is an inclusive definition and
not exhaustive. It takes within its purview not only the matters specified
therein, but also other type of securities.

In
Naresh K. Aggarwala & Co. vs.
Canbank Financial Services Limited
,[3] the Supreme Court, while
referring to the definition of the term ‘securities’ defined under SCRA and the
applicability of a circular issued by the Delhi Stock Exchange, held that the
definition showed that they did not make any distinction between listed
securities and unlisted securities and therefore it was clear that the circular
would apply to the securities which were not listed on the stock exchange.

In
Sahara India Real Estate Corporation
Limited and Others vs. SEBI and another
,[4] the Supreme Court held
that the definition of the term ‘securities’ in Section 2(h) of SCRA is a wide
definition and an inclusive one. It also reinstated SEBI’s jurisdiction over all
marketable securities in accordance with the provisions of the SCRA.

Hence,
it could be said that through the SEBI Notification, optionality clauses were
made legal and valid in investment agreements of private companies as well.

RBI
Guidelines for Foreign Investors
: Even after the
SEBI Notification the validity of option contracts issued to foreign investors was
still not clear and several notices were issued by the Reserve Bank of India (“RBI”) questioning such contracts
whereby, a fixed amount of return was mentioned. Such clauses are held to
impose a liability on the company in the nature of debt and hence, require
compliance with external commercial borrowing guidelines and not foreign
investment regulations. Finally, through a notification dated January 9, 2014,
the RBI, through the “Pricing Guidelines for FDI Instruments with Optionality
Clauses” (“RBI Guidelines”), laid
down clear guidelines to be followed for optionality clauses providing exit
rights to foreign investors.

The
RBI Guidelines allowed optionality clauses, under the Foreign Direct Investment
(“FDI”) Scheme, in equity shares and
compulsorily and mandatorily convertible preference shares or debentures.[5] However, such clauses
shall be subject to the conditions laid down in the RBI Guidelines which
require that:

i.    the securities issued with such optionality
clause, would be subject to a minimum lock-in period of 1 year or such higher
period as may be prescribed under the FDI regulations; and

ii.   upon completion of the lock-in period, the
concerned non-resident investor shall be eligible to exit, provided that there
is no assured return.

Hence, as per the RBI
Guidelines, a foreign investor can have put option, or the promoters of the
investee company may have a call option, provided the return would be
performance based at the time of exit and the securities thus issued shall
comply with the other requirements laid down thereunder. The amount of return,
provided by unlisted companies, shall be calculated at a price worked out,
as per any internationally accepted pricing methodology for equity shares,
compulsorily convertible debentures and compulsorily convertible preference
shares, as per the RBI Notification RBI/2014-15/129, dated July 15, 2014,
so that the investor does not have any assured return.

The previous RBI Guidelines laid down that the pricing methodology should be
based on Return on Equity, in case of equity shares and any internationally
accepted pricing methodology, for compulsorily convertible preference shares
and compulsorily convertible debentures.


A
combined study of the SEBI Notification and the RBI Guidelines implies that
optionality clauses resulting in the exit of an investor would be valid and
legal, subject to the compliance with the RBI Guidelines, as and when
applicable.

Transfer
Involving Foreign Investors
: Any transfer to or by
the foreign investors of any securities of an Indian company, under any of the
options provided hereinabove, would require compliance with the Foreign
Exchange Management (Transfer or issue of security by a person resident outside
India) Regulations, 2000, as amended from time to time, and the pricing
guidelines laid down by RBI. In case of transfer of securities of an Indian
company held by residents to non-residents, the floor price is fixed under the
relevant statutes and the valuation of such securities must be done in
accordance with the provisions laid down in this behalf. On the contrary, in
case of transfer of securities from a non-resident to a resident Indian, the
cap price is fixed, i.e. the non-resident transferor shall be entitled to get,
at most, such cap price. The cap price in this case is equal to the floor price
a resident is entitled to get from a non-resident transferee. In each such
case, Form FC-TRS has to be filed by the resident within the prescribed time
period.

Conclusion

Although the options mentioned hereinabove are
usually provided in the investment agreements to facilitate the PE and VC
investors to get a suitable exit with high return, it must always be kept in
mind that these provisions could end up being disregarded by the company and
the promoters. If the investor follows the agreements in letter and in spirit
and the promoters (and the company) do not cooperate efficiently, a dead-lock
situation might arise and the investment amount might get embroiled in the
process of dispute resolution. Moreover, the feasibility of exit options also
depends on the performance of the company at the time of exit. Due these reasons,
in practice, the investors end up renegotiating their exit rights at the time
of exit and, at times, accept an exit option which is a little less profitable
than the ones provided under the investment agreements.

– Ananya Banerjee




[1]2011 (4) TMI 37
[2] 2009 (8) TMI 693 – Supreme Court
[3] 2010 (5) TMI 383 – Supreme Court
[4] 2012 (9) TMI 559 – Supreme Court
[5] The optionally convertible securities are treated as debt instruments
for this purpose.

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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