Background
Any typical investment agreement invariably has a “put option” which provide an exit route to the investor under circumstances where the promoter fails to achieve other exit routes such as public listing of the investee company through an initial public offering, or if the investee company is unable to either redeem or buy back the securities of an investor for legal / commercial reasons.
A put option means that the option holder has the right to require the other party, namely the option grantor, to buy shares held by the option holder on the occurrence of certain events and on the basis of pre-agreed pricing formulas which is structured in a manner which provides adequate returns (IRR) to an investor on the negotiated terms. The option grantor has obligation to buy the shares put to him by the option holder.
In most of the times, the price for the shares is not agreed upon, but the pricing formulas or the basis of calculation of the exercise price of the option (based on fair market value, IRR, discounted future cash flows or other standard industry benchmarks) is agreed upon.
In the event the investor is a non resident, the legality of granting of put options in favour of the non resident investor was uncertain because the Reserve Bank of India took a view that put option was akin to a debt / redeemable / optionally redeemable instrument, which was prohibited under FEMA, 1999 (“FEMA”) and the regulations made there under read with the FDI policy of India, unless the same was availed as an external commercial borrowing (ECB) in compliance with the relevant regulations and guidelines in that regard.
Amendment
Pursuant to a circular dated January 9, 2014, RBI has allowed optionality clauses in equity shares and compulsorily and mandatorily convertible preference shares/debentures to be issued to a person resident outside India under the FDI Scheme. The circular states that the optionality clause will oblige the buy-back of securities from the investor at the price prevailing/value determined at the time of exercise of the optionality so as to enable the investor to exit without any assured return.
Conditions for optionality clauses
Although RBI has allowed optionality clauses, the same is subjected to the below mentioned conditions:
Lock in
There is a minimum lock-in period of 1 year or a minimum lock-in period as prescribed under FDI Regulations, whichever is higher (e.g. defence and construction development sector where the lock-in period of three years has been prescribed). The lock-in period shall be effective from the date of allotment of such shares or convertible debentures or as prescribed for defence and construction development sectors, etc. in Foreign Exchange Management (Transfer or issue of security by a person resident outside India) Regulations, 2000.
Price at the time of exit
After the lock-in period, as mentioned above, the non-resident investor exercising option/right shall be eligible to exit without any assured return, as under:
i. In case of a listed company, – At the market price prevailing at the recognised stock exchanges;
ii. In case of unlisted company, – At a price not exceeding that arrived at on the basis of Return on Equity (“RoE”) as per the latest audited balance sheet. RoE shall mean Profit After Tax / Net Worth; and Net Worth would include all free reserves and paid up capital.
iii. Investments in Compulsorily Convertible Debentures (CCDs) and Compulsorily Convertible Preference Shares (CCPS) – At a price worked out as per any internationally accepted pricing methodology at the time of exit duly certified by a Chartered Accountant or a SEBI registered Merchant Banker. The guiding principle would be that the non-resident investor is not guaranteed any assured exit price at the time of making such investment/agreement and shall exit at the price prevailing at the time of exit, subject to lock-in period requirement, as applicable.
c. All existing contracts will have to comply with the above conditions to qualify as FDI compliant.
Analysis
Before the circular, though RBI used to take a conservative approach in so far as foreign investor’s exit by exercise of put option is concerned, the foreign investors were at least assured of certain minimum returns (pegged to fair market value, IRR etc) on sale of their shares based on the mechanism recorded under the investment agreement, regardless of the profitability / earnings made by the investee company.
However, by way of the circular, RBI while on one hand has expressly allowed optionality clauses in favour of non resident investors, on the other hand, it has taken away the foreign investors’ right to claim an assured returns.
As the circular states that all the existing contracts have to comply with the above conditions, the existing investment agreements like SHA, SPA etc and even joint venture agreements wherein assured returns have been granted in favour of the non resident investors pursuant to the exercise of put options may have to be amended to bring them in compliance with the amendment in so far as the put options are concerned.
Under the legislative framework of FEMA, non resident investors are not entitled to sell FDI instruments to an Indian resident at price exceeding price determined as per free discounted cash flow method (“DCF”). However, it may happen that the price of the securities of the investee company as worked out at as per the methodologies prescribed in this circular may exceed the price worked out as per DCF. Hence, in so far as exit by way of put option is concerned, the DCF value may not be taken into account.
As per the circular, in so far as equity shares of an unlisted company is concerned, the non resident investors may exercise the put option and exit at a price not exceeding that arrived at on the basis of Return on Equity (“RoE”) as per the latest audited balance sheet. RoE has been defined to mean Profit After Tax / Net Worth; and Net Worth would include all free reserves and paid up capital. Firstly, the condition that the RoE has to determined as per the latest audited balance sheet only is too short a period to provide the actual price / worth of the investee’s company’s shares as the price would reflect the financial position of the company in the last 12 months only.
Typically, return on equity is generally used for comparing the profitability of a company to that of other firms in the same industry measuring a firm’s efficiency at generating profits from every unit of shareholders’ equity and is calculated as net income (after tax) / shareholder’s equity. However, as per the circular, RoE is calculated as profit after tax / networth. The term “net worth” has been defined to mean to include all free reserves and paid up capital. Due to lack of express guidance as to whether certain reserves would qualify as “free reserves” or not under FEMA (for example securities premium account or pending share application money), the same may create uncertainty in calculation of RoE. Considering that free reserves is a denominator, the higher the amount kept in free reserves, the lesser would be the RoE. Also, usually, exit pricing for a put option is generally valued on EBIDTA (earnings before interest, depreciation, tax and amortisation). However, the circular mandates profit after tax. This reduces the exit price per share for foreign investor because the profits (numerator) gets reduced after deducting tax.
The circular sets out that exit price for convertible securities on exercise of put option shall be a price worked out as per any internationally accepted pricing methodology at the time of exit duly certified by a Chartered Accountant or a SEBI registered Merchant Banker. Firstly, there is uncertainty as to which price methodology would be considered as “internationally accepted pricing methodology”. Secondly, even when the price is worked out as per the internationally accepted pricing methods, the circular states that there must be not be any assured exit price under the agreement and the same would be at the price prevailing at the time of exit. Considering that a typical investment horizon spreads over an average period of 4 to 5 years during which the price of investee’s company’s shares / securities may vary and fluctuate on account of various financial and commercial factors, it may happen that at the time of exit, the price of the securities as worked out at the time of the exit may not be the correct indicator of the investee company’s value.
About Bulwark Solicitors
Bulwark Solicitors is a law firm pioneered by Solicitor Chirag Sancheti and Advocate Deep Shridharani. The firm has expertise in the areas of both Litigation and non-Litigation. Under the non-litigation Law practice, the firm practices in the areas of Corporate Law, Intellectual Property Law, Bankruptcy & Insolvency Law, Competition Law, Real Estate and Conveyancing and DTAA Advisory. Further, under Corporate Law area, we practice Company Law, Securities Law, Mergers and Amalgamations, Private Equity and Venture Capital Investment Transactions, Legal Due Diligence and Foreign Exchange Management Law.