Will Superior Voting Rights Help Founders Of Tech Firms Prevent Hostile Takeovers?

The market regulator has paved the way for founders of technology companies in India to retain control when they raise capital by going public.

To ease their way into the equity markets, Securities and Exchange Board of India has approved Differential Voting Rights framework. The key aspect of this framework is the introduction of Superior Rights Shares, which gives superior voting rights to those holding them as compared with ordinary shareholders.

DVRs have been a popular instrument for founders of companies like Google Inc. and Facebook Inc. to retain control over decision-making in the company. In India, while DVRs of superior and inferior rights have been permitted under corporate law, SEBI disallowed incorporation of SR shares in the share capital of a listed entity in 2009.

Prompted by the need to allow fundraising by technology companies without dilution of control and ensuring strict governance standards at the same time, SEBI has released the terms of issuance of SR shares for companies that plan to subsequently list their ordinary shares.

With the introduction of DVRs, the investors will now look at a company’s business model and founder’s capabilities—if they are compelling, investors may consider investing even without control simply because of the promising financial returns, Manan Lahoty, partner at L&L Partners, had told BloombergQuint when SEBI had put out the draft framework for public consultation.

Key Terms

A technology company with SR Shares can undertake an initial public offering. But only ordinary shares of such a company can be listed on stock exchanges. Some of the other requirements are:

1. SR shares may only be issued to a shareholder forming part of the promoter group whose collective net worth mustn’t exceed Rs 500 crore. While determining the collective net worth, investment of SR shareholders in the shares of the issuer company can’t be considered.
2. SR shares may only be issued to those promoters or founders who hold an executive position in the company. Any such issuance will need to be authorised by a special resolution.
3. SR shares must have been held for at least six months before the filing of red herring prospectus.
4. Voting rights: SR shares can have voting rights in the ratio of minimum 2:1 to maximum 10:1 compared with ordinary shares.
5. Conversion to ordinary shares: SR shares will automatically convert to ordinary shares on the fifth anniversary of listing. But this can be extended by an additional five years through a resolution in which SR shareholders cannot vote. SR shares will get converted to ordinary shares in case of death or resignation of SR shareholder, or in the event of a merger or acquisition, when the control is no longer with the SR shareholder.

These provisions may not apply to existing listed companies but only to those tech companies that intend to undertake an IPO going forward, Mukherjee said. But further clarity will come in when amendments to the regulations are released, she said.

To protect the interest of public shareholders, SEBI has also mandated a perpetual lock-in for SR shareholders unless they convert their holding to ordinary shares. No inter-se transfer of SR shares will be allowed between promoters and no security interest can be created on such shares. Apart from voting, SR shares will have no other special rights and will be treated on a par with equity shares in every other aspect, including distribution of dividend.

Additional Corporate Governance Requirements

Corporate governance is a heavily contested issue around DVRs in developed jurisdictions like U.S. A robust corporate governance framework ensures that promoters don’t abuse their powers, which in case of SR shares is a significant risk.

To avoid these challenges, SEBI has mandated strict governance requirements for companies that have issued SR shares:

1. At least half of the board, and 2/3rd of the committees prescribed under the Listing Regulations must comprise of independent directors.
2. Audit committee must comprise only independent directors.

Additionally post IPO, for some matters—called coattail provisions by SEBI—SR shares will have same voting rights as ordinary shares i.e. one vote per share.

These matters include:

• Appointment or removable of independent directors or auditor
• Consensual transfer of control from promoter to another entity
• Related party transaction involving SR shareholder
• Voluntary winding up of the company or initiating voluntary resolution under IBC
• Changes in articles or memorandum of association - unless the changes are to terms of SR shares
• Substantial value transactions as per Listing Regulations
• Delisting or buyback

SEBI’s proposal to include coattail provisions—matters in which SR Shares will have same voting rights as ordinary shares—will largely take care of the governance concerns. This is key since governance standards are still evolving, Shruti Rajan, partner at law firm Cyril Amarchand Mangaldas, said.

Lahoty agreed that these coattail matters will certainly balance the power equation, which is more unique to India. Checks on related party transactions and appointment of directors and auditors are crucial, he said.

SEBI’s consultation paper in March proposed that in case of a change in control, SR shares would be treated as ordinary shares. This would’ve meant that higher voting rights of founders with SR shares would be diluted completely in case of a hostile takeover. At that time, some experts raised concerns that the utility of SR shares will get diluted with this condition since it’s in hostile situations that DVRs would be most useful.

SEBI has addressed this concern by now specifying that only if the promoter willingly cedes control can the SR shares be treated as ordinary shares. This would protect promoters in retaining their superior voting position during a hostile takeover—like in the case of Larsen and Toubro’s acquisition of Mindtree Ltd.

SR shares will be a useful weapon in case of a hostile takeover situation, Abhimanyu Bhattacharya, partner at Khaitan & Co., told BloombergQuint. But it will be interesting to see how SR shares will be tested in the backdrop of the Takeover Code, which at present, does not accommodate SR shares.

SR shares, Mukherjee said, will now offer protection against hostile takeovers since SR shares will not lose their voting rights in case of a non-consensual or hostile change in control. The regulatory intent has been well reflected in this change and it will be an adequate control, she added.