Is it time for shares with differential voting rights?

By Shinoj Koshy, L&L Partners
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Walmart’s acquisition of Flipkart and the consequent exit of its founders, and the ongoing Mindtree-L&T Infotech takeover saga have once again turned the spotlight on the case for shares with differential voting rights (DVR), especially in the context of India’s new technology, asset-light startups.

Indian technology startups, like elsewhere, are bootstrapped. As they expand their operations, their ambitious growth cannot be funded by friends and family. Their asset-light business models rule out debt financing. This leads to successive rounds of equity financing. However, this is where the similarity between Indian startups and their global peers ends.

Shinoj Koshy id
Shinoj Koshy
Partner
L&L Partners

Each successive round of capital raise leads to Indian founders ceding significant equity and control. For instance, at the time of its sale, Flipkart’s founders held about a 10% stake and did not have any meaningful say in the sale. This pattern can be seen in several Indian unicorns, where the founders’ shareholding ranges from an inconsequential single-digit to a low double-digit, while investors hold decisive 26-50% voting rights.

The startup ecosystems in more mature economies like the US, Canada, Singapore and Hong Kong follow a different trajectory. The founders of Google, Facebook and Alibaba have been able to raise growth capital and list their companies on NASDAQ and NYSE without losing control over their companies. This is primarily because these jurisdictions recognize and encourage DVR for new technology startups and provide for effective checks and balances in the form of robust corporate governance and mechanisms for enforcement of contracts. This creates more confidence among investors and allows the founders to raise capital using DVR. Typically, DVR carry fewer voting rights but may carry higher dividends and tend to be issued at a discount to the ordinary shares held by the founders.

In India, a private company cannot issue DVR unless it has a track record of distributable profits for three preceding financial years. Further, DVR cannot constitute more than 26% of the company’s share capital. Such a provision provides no assistance to technology startups. None of them, including the much-feted unicorns, have a track record of distributable profits. Nonetheless, their valuations are more than a billion dollars on the basis of their ability to create new markets and their ever-growing share of such new markets. Thus, it is time for regulators to recognize that these companies are valued for their future potential and not historical or immediate profitability. Accordingly, it should remove the track record of profitability as the eligibility criteria. In addition to providing two-way fungibility between ordinary shares and DVR, it should also remove the 26% limit and allow DVR up to 51% of the paid up share capital.

While such amendments will allow Indian entrepreneurs to raise equity capital without ceding control, the question that must also be addressed is whether foreign funds would be receptive to investing in DVR. Research in the more developed jurisdictions has shown that investors are willing to give up control to founders who have a compelling business model and execution capabilities, in return for superior financial returns. Therefore, amendments enabling DVR must be accompanied by attendant reforms like time-bound and effective dispute resolution mechanisms.

At present, a company listed in India cannot issue shares with superior or higher voting rights, but can issue shares with lower voting rights if it meets certain conditions. It would be a welcome reform if the Securities and Exchange Board of India (SEBI) clarifies that existing DVR of a private company – irrespective of whether they carry superior or inferior voting and dividend rights relative to the ordinary equity shares – could continue when it lists on an Indian exchange. This will also enable Indian startups with DVR to consider an Indian listing, rather than externalizing their holding structures to list abroad. These changes could lead to an era of Indian unicorns that are, in addition to being controlled by Indian founders, also listed in India. It will certainly have a positive impact on the Indian capital markets.

As an observer of India’s technology startup sector, one hopes these changes are introduced sooner rather than later. Recent developments such as the proposal by Indiatech (an industry body representing India’s tech-entrepreneurs) to the Ministry of Corporate Affairs and SEBI seeking enabling amendments to allow DVR and SEBI’s consultation paper on DVR issued last month are indeed steps in the right direction and it seems, perhaps the regulators also believe that the notion that DVR is an idea whose time has truly come.

Shinoj Koshy is a partner at L&L Partners. The views expressed are personal and intended for general information purposes. They are not a substitute for legal advice.

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