Summary: This blog examines compulsorily convertible preference shares (CCPS), a vital capital raising instrument for startups and M&A transactions in India. It explores the legal framework and key benefits, including balancing investor-founder interests, attracting foreign investment, avoiding tax implications, and providing strategic flexibility, despite limited legislative guidance.
Introduction
Section 43 of the Companies Act, 2013 (“the Act”), empowers Indian companies limited by shares to issue two classes of shares — equity shares and preference shares. Equity share capital may consist of ordinary equity shares with standard voting rights, or equity shares that confer differential rights in relation to dividends, voting entitlements, or other matters. On the other hand, preference share capital is characterised by the preferential rights granted to holders regarding dividend distribution and return of capital upon a company’s winding up. Whilst the Act restricts companies to issuing these two fundamental categories of shares, it permits considerable flexibility in structuring multiple classes within each category. Such classes may be differentiated by variations in dividend rates, redemption timelines, and other contractual terms, enabling companies to tailor their capital structure to meet specific commercial and financial objectives.
One such method of capital raising that has gained significant traction among startups and is being widely used during the early stages of business is the issuance of compulsorily convertible preference shares (“CCPS”). In this blog, the authors will provide an overview of the legal architecture governing CCPS and highlight its benefits, which contribute to its appeal as a capital raising instrument among startups and various private equity and M&A transactions.
Legal Architecture
Various provisions in the Act deal with procedures and conditions for issuing equity and preference shares, however the Act remains silent on the issuance of CCPS — a particular category of preference shares. The Act does not explicitly outline the requirements or procedural compliances necessary for issuing CCPS. The Act does not contain any enabling or restricting provisions in relation to CCPS even when CCPS as an instrument has been around for many years and is widely used by companies to raise capital.
For listed companies, it is also necessary to meet the compliance requirements under SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (“ICDR”). According to Regulation 2(1)(k) of the ICDR, CCPS are categorized as “convertible security”. As per Regulation 14 of the ICDR, promoters of a company may also subscribe to CCPS, in lieu of equity shares, to fulfill the minimum promoter contribution requirement of 20% for an IPO on the main board. The ICDR further lays down the tenure for converting such CCPS into equity shares, with a distinction between a preferential issue and a qualified institutional placement. For the former, Regulation 162 provides that the tenure for converting CCPS into equity shares shall not exceed 18 months from the date of allotment, while for qualified institutional placement, the tenure shall not exceed 60 months from the date of allotment.
For unlisted companies, the Act does not prescribe any fixed tenure for converting CCPS into equity shares. Section 55 of the Act, which deals with the issuance of redeemable preference shares, prescribes a maximum tenure of 20 years for redemption of preference shares. In the absence of any other explicit provision dealing with the conversion of CCPS, it is advisable to assume a maximum tenure of 20 years for the conversion of CCPS into equity shares in unlisted companies.
CCPS: A beneficial instrument
CCPS have emerged as a favoured capital raising mechanism for startups due to their ability to balance the interests of both founders and investors through a uniquely flexible structure. For investors, CCPS is low risk, as it provides fixed returns in the form of dividends, subject to the company having distributable profits as per Section 123 of the Act, which is particularly comforting in early-phase startups when profitability is always a challenge. Startup founders benefit from the ability to raise necessary capital through CCPS, without diluting their ownership stake or diluting control during the early years, as CCPS do not immediately convert to equity shares. This contrasts with traditional equity issuance, which would result in immediate dilution and potential loss of decision-making authority. However, if CCPS holders do not receive dividends for two or more years, they gain voting rights on all resolutions.
CCPS also enable startups to avoid the burden of debt financing, where regular interest payments increase cash outflow and strain already limited resources. Dividends, on the other hand, are paid only when profits are available, thereby preserving cash for operations and growth. Investors also benefit by establishing their position at the startup’s current, typically low valuation, while retaining the potential to realise substantial upside returns if the company succeeds as upon conversion, their CCPS will become equity shares at the predetermined price established at the time of issuance.
The inherent flexibility of CCPS allows both founders and investors to achieve their respective commercial interests through negotiable terms, such as conversion ratios, conversion prices, dividend rates, and protective provisions, including anti-dilution rights, ensuring that financing arrangements can be tailored to the unique circumstances and risk profiles of each venture. CCPS may also be helpful when parties fail to agree on the valuation of the company, as they can link the conversion ratio to the future performance of the company or contingent events.
Another significant advantage of CCPS for startups is their ability to attract foreign investment, since CCPS are classified as equity instruments and not debt. This classification enables startups to circumvent the regulatory complexities and restrictions associated with external commercial borrowings. The Ministry of Finance, Government of India, through a press release dated April 30, 2007 (“Press Release”), clarified that CCPS issued or transferred to any foreign investor would be treated as equity and would be aggregated with their equity shareholding for determination of sectoral caps, with effect from May 1, 2007, as provided in the FDI Policy. The Press Release also clarified that all other preference shares, namely non-convertible, partially convertible or optionally convertible preference shares, issued on or after May 1, 2007, would be regarded as debt and not share capital for the purposes of investment into India. Therefore, issuance or transfer of such shares would be subject to the terms and conditions of the External Commercial Borrowings guidelines, unlike CCPS. Therefore, CCPS would be favoured for cross-border transactions as FEMA is less stringent for equity investments (which includes CCPS) as opposed to debt instruments.
The RBI has significantly relaxed the regulatory regime for issuing CCPS by removing the SBI Prime Lending Rate plus 300 bps cap as the maximum dividend that can be paid on CCPS issued to non-resident investors.
Apart from the relaxed regulations for transactions involving foreign investors, there are several other benefits that make CCPS more favourable than ordinary equity securities in M&A transactions. CCPS provide higher flexibility through features including liquidation preference, anti-dilution rights, and performance linked milestones.
Lastly, conversion of CCPS into equity shares would also not entail tax implications as conversion is not treated as a taxable event. Section 47(xb) of the Income-tax Act, 1961 explicitly excludes any transfer by way of conversion of preference shares of a company into equity shares of that company from applicability of capital gains tax.
Accounting Treatment of CCPS
Under the Indian Accounting Standard 32, since CCPS are classified as equity, subject to fulfilment of certain conditions, it does not affect the debt-to-equity ratio of the company, which further helps startups in raising additional funding by way of borrowings.
Conclusion
CCPS has established itself as an indispensable financing instrument in India’s corporate landscape, particularly within the startup ecosystem and M&A transactions. As India’s startup ecosystem continues to mature and attract increasing domestic and foreign investment, CCPS are expected to remain a fundamental component of capital raising strategies. However, the absence of comprehensive legislative guidance necessitates careful drafting of shareholders’ agreements and constitutional documents to ensure certainty and enforceability of terms. Practitioners would also benefit from clearer statutory recognition and regulation of CCPS, which would enhance investor confidence and reduce interpretative challenges. Until such time, companies and their advisors must navigate the existing framework with prudence, leveraging the considerable commercial benefits of CCPS whilst remaining cognisant of the regulatory gaps that persist.