MCA amends provisions with respect to DVRs and ESOPs

August 2019

On August 16, 2019, the Ministry of Corporate Affairs (“MCA”) amended the Companies (Share Capital and Debentures) Rules, 2014 (“SCD Rules”) and issued the Companies (Share Capital and Debentures) Amendment Rules, 2019 (“Revised SCD Rules”). This edition of the alert apprises you with the amendments pertaining to issue of shares with differential voting rights (“DVRs”) and Employee Stock Options (“ESOPs”).

Issue of shares with DVRs

Rule 4 of the SCD Rules listed various conditions to be met before a company could issue DVRs. These are (a) the Articles of Association should authorize the issue; (b) shareholders’ approval is sought by ordinary resolution; (c) DVRs should not exceed 26% of the total post-issue paid-up equity capital; (d) there is a consistent track record of distributable profits for last 3 years; (e) no default in filing annual financials and annual returns for last 3 financial years; (f) no default in making payment of declared dividend and matured deposits, redemption of preference shares or debentures, or payment of interest thereon; (g) no default in payment of dividend on preference shares, repayment of any term loan from a public financial institution or State level financial institution or scheduled Bank, any interest payable thereon, payment of statutory dues relating to its employees, crediting the amount in Investor Education and Protection Fund to the Central Government; and (h) no penalty imposed by any Court or Tribunal during last 3 years for any offence under the Reserve Bank of India Act, 1934, the Securities and Exchange Board of India Act, 1992, the Securities Contracts Regulation Act, 1956, the Foreign Exchange Management Act, 1999 or any other special Act.

While most conditions are the same, the MCA has amended #(c) and (d) by issue of the Revised SCD Rules. Now, an Indian company can issue equity shares with DVRs up to 74% of its total paid-up equity capital and there is no longer a requirement of having distributable profits for 3 years. This is especially beneficial for start-up founders who often get substantially diluted when they raise capital from institutional investors. Now, such founders can continue to retain control despite being diluted. Further, since most start-ups do not necessarily focus on profits during their initial years, DVRs were inapplicable to them under the erstwhile SCD Rules. With the requirement of profits being removed, a lot more companies/founders would be able to benefit by issuing equity shares with DVRs.

Despite the intent behind the aforementioned amendment being positive, practically, founders of existing companies may not be able to effectively leverage it. Rule 4 of SCD Rules makes it clear that existing equity shares cannot be converted into those with DVRs. This means that fresh equity will have to be allotted to founders after they (in most cases) infuse additional capital. For companies that have already raised money at high valuations, it may be difficult for founders to infuse capital to restructure their shareholding to retain control. New ventures, on the other hand, will be able to benefit from these Revised SCD Rules. In our view, the MCA should at least allow founders of government registered “start-ups” to convert their equity to benefit from the liberalized DVR regime.

Issue of ESOPs

Rule 12 of the SCD Rules allowed companies to offer ESOPs to “employees” but such employees excluded (a) a promoter or a person who belongs to the promoter group; and (b) a director holding, directly or indirectly, himself or through any relative or body corporate, more than 10% of outstanding equity shares of the company. This requirement was liberalized in 2016 with the formal recognition of “start-ups”. On July 19, 2016, the MCA issued the Companies (Share Capital and Debentures) Third Amendment Rules, 2016 where the aforementioned two conditions were relaxed for Department for Industrial Policy and Promotion (“DIPP”) registered “start-ups” for 5 years from their date of incorporation. This meant that such start-ups could issue ESOPs to promoters as well as directors who held more than 10% stake in the company. Under the Revised SCD Rules, this 5 year exemption has now been extended to 10 years which will continue to allow start-ups to creatively structure salaries of their founders and directors.

As a background, the 5 and 10 year duration described above is linked to the definition of “start-ups”. On February 17, 2016, the DIPP allowed a company to be termed as a “start-up” only for 5 years from the date of its incorporation. On February 19, 2019, this definition was revised where the 5 year term was extended to 10 years. To align with these changes, the MCA also allowed ESOPs to be issued to promoters and directors for  a period of 5 years and then increased it to 10 years.

By:

Jaya Moorjani