The Hindu Business Line : Shareholder of an unlisted company

FOR DESERVING entrepreneurs, India has remained a capital-starved nation despite enough capital floating around in the system. It is a classic case of `water everywhere but not a single drop to drink'.

The financing fraternity and systems in India have paradoxically been favouring lending to the risk-free borrowers — the so-called "AAA" — who possess a sort of cash machine generating robust and quality cash flows quarter after quarter and use external financing more as a bridge for timing the mismatch between accruals and payment obligations.

While this is true on the lending side of financing, the truth cannot be less harsh on the equity capital side. As against the plethora of large-size venture capital funds in the US which actively chase (and finance) deserving start-ups and mezzanines, the number of serious venture capital funds in India can be counted on the fingertips.

Even these funds have for long predominantly been engaged in putting serious amounts of money only on late-stage ventures, which source funds mainly for scaling-up operations, having established the brand and track record. And in financing, the prime driver for such venture funds has been the visibility for the IPO of the venture.

This situation forces entrepreneurs to look beyond such means of equity financing, and the vacuum, to a large extent, is filled by some type of financial investors. The cases could be of a technocrat entrepreneur looking for money or of a resource-constrained entrepreneur or even of an entrepreneur with domestic capabilities looking for a joint venture partner to access the relevant technology.

While such financial investors usually seek equity-related returns, even for them the visibility of exit to attain the returns they are investing for remains an important consideration. Usually, such financing is also backed by intra-shareholder understandings on the mechanism of future financing and operations, including board and management rights.

Let us examine how conducive is the environment for such financial investors in an unlisted company. The eventual exit being an important component for all the sets of financiers, the rules and regulations relating to the unlisted companies going to the capital market for listing and raising moneys from the public become extremely critical.

The relevant rules for the purpose are the SEBI (Disclosure and Investor Protection) Guidelines, 2000. It is important to understand these rules to identify some of the key challenges faced by the financial investors seeking to monetise their initial investments in an unlisted company, as they play such an important role in expanding the scope of financing options to encourage entrepreneurship.

The Guidelines provide for various eligibility norms as to which type of companies could get listed on stock exchanges, some of these being based on track record of profitability, net worth, etc. They also provide for compliance of various obligations by the promoters, which inter alia include the provisions for locking-in of their shareholding to the extent of 20 per cent of post-issue equity capital pursuant to an offer of securities to the general public.

The Guidelines also prescribe locking-in of entire pre-issue equity capital over and above the mandatory 20 per cent lock-in by promoters, whether held by promoters or others. During the lock-in period, while inter se transfer amongst promoters is allowed, subject to certain conditions, transfers such as sale in secondary market (post-listing) or sale to other financial investors are not permitted.

The only exemptions from the lock-in provision are shareholding of venture capital funds, shares issued under employee stock option scheme to non-promoters and shares being offered for sale held for one year or more.

The above-mentioned provisions open interesting scenarios.

Let us take the hypothetical case of an unlisted company, engaged in infrastructure activities. Imagine the promoters (P) hold 51 per cent of equity; a SEBI-registered venture capital fund (V) holds 26 per cent, two financial investors (F1 & F2) hold 10 per cent each; and employees collectively hold 3 per cent under the stock option scheme.

Now, let us assume that one of the two financial investors, F1, wants to monetise its investment for a variety of reasons. As the promoters may be disinterested in hiking their stake, sale to them is not an option for F1. This leaves either seeking any other investor interested in taking an exposure in an unlisted company or to make an offer for sale to the general public through the capital market.

Assuming F1 chooses to go for an offer for sale as exit through capital market to general public and establishes a better pricing benchmark for the equity. Let us evaluate how the Guidelines measure up for such a decision by F1.

As per the Guidelines, besides other eligibility norms, the following specific provisions would need compliance, by persons other than F1:

The promoters (P) would need to lock in 20 per cent shareholding for three years, and the balance 31 per cent shareholding for one year;

The other financial investor (F2) would be forced to lock in its entire shareholding of 10 per cent for one year;

Assuming Venture Capital Fund (V) and employees comply with rules to be eligible for exemption, they would not have to lock in their shares.

As the company in the illustration does not raise funds, the promoters are being locked in on their shareholding without any direct benefit to them or to the company, due to the compulsions of one of the shareholders to divest.

Similarly, the other financial investor (F2) is also locked in, apparently without any direct benefit to it. Such a provision severally constrains the ability of F2 to freely deal with its shareholding on post-listing of shares as the Guidelines prohibit its from selling or transferring shares for a period of one year.

In such a situation, both these shareholders may disagree with F1, justifiably, due to the onerous lock-in conditions without reciprocal benefits to them. This could frustrate the attempts of F1 to monetise its investment, due to the applicable provisions of the Guidelines.

One would notice that the intent of F1 to monetise its investment through offer for sale creates some form of a deadlock among all the shareholders concerned due to the provisions of existing guidelines on the subject from the regulator.

While the objective of F1 would be to seek an exit through market and investing public, the objectives of other shareholders may not be able to block the objective of exiting shareholder but the current provisions force them to act in a manner which prevents F1 from achieving his exit objective.

Such a scenario can be traced to the possible rationale at the time of introducing such lock-in provisions. As in any capital market, the concern of the regulator would have been that immediately after the listing of equity shares, there could be adverse pressure on market float if the regulations allowed the promoters/other shareholders to freely sell their shares upon listing. This could be adverse for the participants who purchased the shares in the public issue.

Hence, such lock-in provisions could protect the interests of the public issue participants. While such intention would have no doubt been noble, in practice the repercussions are severe for the investors.

Furthermore, for the purpose of lock-in provisions, the regulations do not differentiate between an issue of shares by the company (to raise money) and an offer for sale by an existing investor/ shareholder.

This creates a peculiar scenario where shareholders of any unlisted company have the offer for sale as an exit route only in theory but in practice, it becomes almost impossible to make such an offer because of the string of difficulties attached with it.

This probably is also the reason behind the fact that of the numerous public issues in the last decade, the examples of standalone offer for sale without a public issue by the company are hard to find.

This practically means that unless a company required funds from the market, the shareholders in the nature of financial investors would be forced to resort to sub-optimal ways to monetise their investments, and at sub-optimal prices, in the absence of real price discovery through the capital market.

It is time that the regulations re-examined to anticipate such situations and were provisions made so as to provide a free and conducive environment to the shareholders of unlisted companies seeking monetisation. These measures could also assist in providing the much-needed depth to the primary market with more quality paper being made available to the public at large.

The regulations can consider an insertion that in cases of standalone offer for sale where the company is not raising any funds, lock-in provisions would not be made applicable to shareholders other than the seller.

So far as the issue of increased market float by the potential promoter stock finding way to the stock exchanges is concerned, the regulations could provide that in cases of standalone offer for sale, the stock exchanges would only permit listing and trading in the shares offered for sale (some kind of a "limited listing").

Even in such cases, the limited listing could be granted only if the company meets other eligibility criterion in the current guidelines and complies with major clauses of the listing agreement, such as disclosures, etc. As and when such concept gains popularity, the stock exchanges could even consider making a separate category for such listings.

Post-limited listing, the balance shares of the company held by the promoters and other shareholders could be made freely transferable, but outside the purview/terminals of the stock exchanges, without the latter taking any responsibility for such trades. However, if such transfers result in change in control, the SEBI Takeover Guidelines could be selectively made applicable.

These measures would ensure that liquidity for such shares will not dry up but would keep such shares away from the stock exchanges. Subsequently, if the company with limited listing wants to raise funds from the capital market by way of public issue, the current stipulations of lock-in for promoters and others could be applied and the company's listing status could be enhanced to "full-scale listing" once all the requirements as per current guidelines are fully complied with.

(The author is Senior Vice-President, Corporate Finance, Aditya Birla Management Corporation Limited.)