You just have raised a new round of financing for your company at a rich valuation. It has been a particularly hard and well-fought negotiation with your investors. Before the celebrations can begin, however, you should pause and look closely at the exit waterfall in your shareholders’ agreement.
Companies and founders are required, often on a best-effort basis, to provide an exit to investors by conducting an initial public offer, or facilitating a trade sale (that is finding a willing buyer for investors’ securities) before the expiry of a predetermined period. As fallback, the exit waterfall, among other exit rights, requires the company to buy back investors’ securities, often at the prevailing fair market value. If this sounds innocuous you should think again, this time considering the implications of accounting standards. Under generally accepted accounting principles compulsorily convertible preference shares (a type of financial instrument that a company issues to a non-resident investor) form part of the company’s share capital and are recorded as equity in the balance sheet. This well-established position could now be undone because of the provisions of Indian Accounting Standard 32 (IndAS32).
IndAS32 applies to any unlisted company with a net worth of at least ₹2.5 billion (US$34.9 million) and a maximum of ₹5 billion. If a company meets this threshold in any financial year, compliance with IndAS32 will be mandatory from the following financial year in producing its financial statements. IndAS32 classifies financial instruments into financial liabilities, financial assets or equity instruments. These terms have been comprehensively defined in IndAS32, but the following simple explanations will be sufficient. A financial liability is the existence of a contractual obligation to deliver cash or another financial asset to another entity. An equity instrument means any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. Emphasis has been placed on looking at the substance of a financial instrument rather than its form when classifying such a financial instrument as either an equity instrument or financial liability in the company’s balance sheet.
Moreover, financial instruments containing contingent settlement provisions are classified as financial liabilities under IndAS32. In this regard, a company’s obligation to buy back investors’ securities, as specified in the exit waterfall of a shareholders’ agreement, is a contingent settlement provision for two reasons. Firstly, the company has a contractual obligation to deliver cash to investors and to buy back investors’ securities based on the outcome of uncertain future events that are beyond the control of the company and the holders of the financial instruments. Examples would be the completion of an initial public offering, or trade sale, both of which would depend on market conditions among other factors. Secondly, the company does not have an unconditional right to refuse payments to the investors and to buy back their securities.
Compulsorily convertible preference shares issued to investors will therefore be classified as financial liabilities under IndAS32 and recorded as such in the company’s balance sheet. This can greatly reduce the net worth of a company that may have raised large financing rounds from investors. A negative net worth will mean that the company will not be able to raise additional financing from banks and other financial institutions. There will be other ramifications as well.
It may be arguable that a company’s obligation to buy back investors’ securities does not constitute a financial liability because (a) the company and founders’ obligation to provide an exit to investors is on a best-effort basis only (subject to the exact provisions of the shareholders’ agreement); (b) a buyback is not the sole exit default right available to investors who may have other discretionary exit default rights such as drag-along rights and put options involving the founders themselves; (c) buyback is subject to company law restrictions and is often not a viable exit right for investors, and (d) buyback is subject to board approval. Having said that, it is important to examine this issue on a case-by-case basis under companies’ law, accounting standards and exchange control regulations before arriving at a conclusion.
Simple solutions to this problem would be either to amend the shareholders’ agreement to ensure that the exercise of the right to buy back is at the sole discretion of the company not investors, or to delete the buyback clause. Before adopting either solution the company should consult its statutory auditor and investors and be completely transparent regarding the proposals.
Siddharth Seshan is a counsel and Tushar Gogoi is an associate in the Bengaluru office of Samvad Partners.
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