Fund raising by companies has picked up pace in the last few years on account of rise in start-up culture and entrepreneurship in India. While starting – up one’s enterprise faces numerous challenges, the primary hurdle faced by every start-up company is capital raising.
Companies incorporated under the Companies Act, 2013 (“Act”) have the option of issuing various instruments to its investors and meet their capital requirements from time to time. The technical term for instruments issued by companies to investors is ‘securities’. While the issue of securities represent an investor’s interest in the company, they are primarily a bundle of rights and obligations accruing to the investor either at the time of its issue or on the occurrence of specific events or winding up of the company. Once the securities are issued to investors they may or may not alter the capital table of the company. The capital table is a structure depicting the total capital infused in a company sub-divided into the percentage of shareholding held by each shareholder.
Instruments issued by companies under the Act
The instruments commonly issued by companies at the time of fund – raising are equity based instruments, debt based instruments or hybrid instruments (containing a combination of features of both equity and debt based instruments). The nature of instrument to be issued by a company depends to a large extent on the valuation of the company obtained through different mechanisms. A common problem faced by early stage start – ups is valuation of the company. That being said, for every promoter group of a start – up, the issue of a security having least risk factors is generally the rule of thumb.
The primary difference between the issue of equity and debt based instruments is the dilution of shareholding of the existing shareholders of the company. While the issue of purely equity based instruments result in the immediate dilution of existing shareholding the issue of debt instruments (if convertible in nature) will result in dilution of shareholding at a later stage in the shelf life of the company. Simply put, dilution of shareholding is the reduction in total amount of shareholding percentage of existing shareholders caused by the issue/allotment of new equity shares to a new investor. The types of securities typically issued in a fund raise (under the Act) are elaborated below
Equity Instruments / Equity Shares
|Nature||Types of Equity Shares|
|Shares of a company which represent ownership to the investor upto the fraction of shares held by such person and permit a right to vote in decisions pertaining to the company.||· Equity Shares with voting rights – shares which allow each holder to participate and vote in all meetings of the company and thus, run the operations of the company.
· Equity Shares with Differential Voting Rights (“DVRs”) – shares carrying superior voting rights (i.e., multiple votes on an equity share), inferior voting rights (i.e., a fraction of the voting right on an equity share or shares with differential rights as to dividend).
· Employee Stock Options (“ESOPs”) – ESOPs are benefits given to employees of a company to purchase, or to subscribe for, the shares of the company at a future date at a pre-determined price.
· Sweat Equity Shares – equity shares which are issued by a company as a reward to its employees for providing their know-how or making available rights in the nature of intellectual property rights or value additions, by whatever name called for consideration other than cash.
|Nature||Types of Preference Shares|
|· Shares which entitle the holder to a preferential right to receive fixed dividend during the life of the company as well as a preferential right to receive the amount paid on such shares during the winding up of the company.
· Does not confer voting rights in ordinary circumstances.
|· Participating and non – participating preference shares – right to a fixed preferential dividend and a right to participate in surplus profits.
· Cumulative and non – cumulative preference shares – right to claim dividend fixed at a sum or percentage for the past and current year out of future profits; and
· Redeemable preference shares – obligation on the company to redeem the shares after a specified limit.
|Nature||Types of Debentures|
|· Security evidencing debt due to the holder of debenture by the company repayable in principal amount with interest.
· The debenture may or may not be secured by the assets of the company.
|· Redeemable debentures – debentures which upon issue will be repaid to the holder upon a specific time limit;
· Convertible debentures – debentures which may be converted into equity shares upon a specific time limit or upon the occurrence of specific events. Compulsorily convertible debentures or CCDs must be converted to equity shares within a period of 10 years from the date of its issue otherwise the same will be treated as “deposit” under the Act.
|Nature||Types of Hybrid Securities|
|· Securities which have elements of both debt securities and equity securities.||· Hybrid securities typically issued by companies include optionally convertible debentures (fully or partly), compulsorily convertible debentures, compulsorily convertible preference shares and optionally convertible preference shares (fully or partly) all of which are convertible into equity shares of the company at specified events.|
Capital raising is one of the primary requirements of commencing and sustaining a successful start-up business. While the idea and/or the innovation proposed is a seed that may be planted initially by bootstrapping, continued operation of the idea requires constant watering in order to grow and develop from a plant to a fully rooted tree. The continuous watering process is carried out by way of a steady in-flow of funding which in turn is implemented through the issue of capital instruments explained above.
The issue of instruments in turn, entitles the investor to certain rights and obligations by virtue of fulfilling the capital requirements of the company. Each instrument has different nuances surrounding their issue and its resultant impact on the operations of the company. Culling out and finalisation of instruments during fund raising is also largely dependent on factors such sector, company’s business plan and the nature of investor to name a few. For instance, the real estate sector is based on long term development and hence, the primary choice would be the issue of optionally convertible debentures or optionally convertible preference shares. Whereas, service / knowledge based companies prefer to issue compulsorily convertible debentures, compulsorily convertible preference shares or equity shares in light of short term milestones chalked out by such companies. Lastly, structuring of a fund raise differs according to the nature of the investor approached by the company. While ‘friends and family’ rounds comprise of compulsorily convertible preference shares route owing to the flexibility of investors to a dilution under future rounds, several other investors such as foreign portfolio investors, venture capital funds, angel funds etc. have their own pre – determined strategies to achieve high growth on their investment.
– Sanjana Buch
 For further information on different aspects of valuation, please refer to our article on Start-Up Investment: Essentials Of A Term Sheet And Methods Of Valuation – An Indian Perspective (Part 2) available at https://archanabala.com/2017/01/23/start-up-investment-essentials-of-a-term-sheet-and-methods-of-valuation-an-indian-perspectivepart-ii/, last visited on 8th April 2020
 Shruti Rajan, SEBI’s differential voting right plan a critical change, Livemint, 28th June 2019 available at https://www.livemint.com/opinion/online-views/opinion-sebi-s-differential-voting-right-plan-a-critical-change-1561660899490.html, last visited on 8th April 2020
 Explanation to Section 43 of the Companies Act, 2013
 Rule 2(c)(ix) of the Companies (Acceptance of Deposits) Rules, 2014