Differential Voting Rights: A Necessary Initiative or is SEBI Biting Off More Than It Can Chew?
[Dhanshree Sharma is a third-year student at Rajiv Gandhi National University of Law.]
Given the number of initial public offers (IPOs) in the last two years, the Indian business ecosystem is long awaiting a turnaround in fortune. However, such number by itself is not indicative of a fertile ground for startups. There is a slight reluctance from the asset-light startup entrepreneurs to undergo an IPO due to the dilemma between capital investment and dilution of control in the management. Further, dilution of equity takes the company off its long-term vision, thereby severely affecting its performance.
Internationally, many countries allow for listing and issuing of dual class structures (DCS) which can either have superior voting rights or economic benefits by way of dividends. The USA does not allow for listed companies to issue DCS. However, in Hong Kong, the issue can be made by a specific companies, and the beneficiary must play an active role and contribute materially to the company.
The concept of differential voting rights (DVRs) or dual class structures, as known in other countries, is not unknown to the Indian business environment. The Companies Act 2013 permits a company limited by shares to issue shares with differential rights. And in 2008, Tata Motors was the first company to issue DVRs. However, in 2009, the Securities and Exchange Board of India (SEBI) had banned the listed companies from issuing superior rights (SRs) in shareholding with respect to differential voting and higher dividend payment. This move was undertaken with the objective of preventing oppression of minority shareholders and entrenchment of management in the hands of family-owned businesses. Despite this, India has the highest number of family-owned companies and promoters owning close to 45% of the total shareholding.
But SEBI had to depart from its previous actions to bring the Indian economic sphere in tandem with that of American and Chinese systems to promote foreign direct investment. Besides, it should facilitate the knowledge-based tech startups which are asset-light and require DVRs to get better quantum of investment via IPO while ensuring that the founders do not lose control of the company even after several rounds of private equity financing.
Evaluating the effects of the recent changes
Recently, SEBI issued a consultation paper on issuance of DVR shares (Consultation Paper) that will significantly change the structure of transactions in the Indian market. It deviates from the principle of ‘one share one vote’ standard. Under Regulation 6 of the SEBI (Issue of Capital and Disclosure Requirements) Regulations 2018 (ICDR), only companies having a consistent track record of distributable profits for the last 3 years, net tangible assets equivalent to INR 3 crores, average profits of at least INR 15 crores and net worth of INR 1 crore can issue DVRs. But as the new technology-based companies have less tangible assets compared to tangible and they focus more on business expansion in the initial years, the profits and the other requirements laid down are not fulfilled. The Consultation Paper highlighted this issue and proposed an amendment in the ICDR.
The new framework has instilled confidence and optimism among the promoters, as the requirement for DVRs has augmented especially after the hostile takeover of Mindtree by Larsen and Turbo after the promoters of the former were unable to prevent the takeover bid by the latter.
The risks involved with financial security i.e. loss of substantial control, it is argued, can be averted by venture capital debt financing. However, the specific kinds of businesses that the regulation intends to benefit thrive on intangible assets and are quite low on assets. The new framework will certainly result in increased IPO activities by the startup and would encourage them to tap the public markets for investment.
Although the framework removes the inhibition faced by the pre-revenue startups from public markets, the issue of inferior voting rights will deter private equity investors from investing as they wish to have a say in the decision making of the company. Moreover, the institutional investors express concerns over market valuation of such shares and fear that the companies may violate the principles of corporate governance.
The issuance of DVRs creates 2 classes of shareholders; one with higher voting rights than the other. And the SR shareholders are able to control the decisions in the boardroom. Post the acceptance of the framework, there would be two identifiable issues that would affect the reputation of the business environment.
Exclusion of short-term investors, as the shares with the lower voting rights will be traded at a value less than that of the ordinary shares.
The entrepreneurs will be unable to achieve long term growth. Due to increasing agency costs as a consequence of separation of stock ownership and voting control, the framework will deter the long-term investor.
As the controlling shareholders ostensibly control the decision-making of the company without a forethought of economic costs, the non-voting rights shareholders would not have a substantial and equal voice in the company.
Addressing the debate
Conventionally, it is believed that the separation of stock ownership and voting rights affects corporate governance. But market analysis shows that, lately, the vexed question is about the separation of ownership from ownership. The institutional investors act as the intermediary between the shareholders and the company, and since they control the shares of most public companies, instances of proxy contests are bound to arise. Recently, US proxy advisory firm had nearly ousted Deepak Parekh as a non-executive chairman of HDFC Ltd. In such instances, the SR shares provide protection against control contests and are, therefore, preferred by newly arrived companies. And, therefore, technology-based start-ups are able to sidestep the financial investors that look for higher returns in the short term, and are also able to gain immunity from erratic market reactions and short-term market pressures.
The long-term focus of technology companies, that have long product development cycles and are research intensive is to maintain independence and stability within the firm. Technology companies particularly entail significant investment over a substantial amount of time to reach their potential. Google claims that their highly successful products like Google Chrome and YouTube enjoy unparalleled usage because of a higher degree of independence in the company.
Additionally, the founders of FundsIndia.com exited their firm due to excessive command and intervention by private equity investors; which makes it abundantly clear that the companies led by first-generation entrepreneurs must be protected and promoted. This is especially crucial to prevent “startup deaths”.
The recent IPOs of Pinterest and Lyft has spurred the debate around DCS in the US as well. ‘Tiny-Minority Controllers’ has been identified as one of the perils of DCS, when the two digital companies, decided to go public with the DCS in an IPO. And the concerns have been predicted to increase the discount per share value at which the low-voting shares of these companies will trade. This will gradually decrease the market price of the low-voting shares. The tiny-minority controllers indicate that although the founders of the company may only hold a minority voting power, the DCS is bound to present special governance risks as the controller will be insulated from the disciplinary actions of the control market, which also does not address the problem of under-performance.
Assessing the feasibility of the differential voting rights regime
In so far as prevention of mismanagement of control by promoters is concerned, SEBI has considered the Kotak Committee recommendations on corporate governance while drafting the Consultation Paper, but the protection of non-voting shares and the minority shareholders are yet to be discussed. Furthermore, India’s dismal performance in the contract enforcement domain in the Ease of Doing Business report and execution of class action suits greatly affect the corporate governance norms.
The long-term feasibility of the DVRs is questionable, but the step taken was to make the Indian market more receptive to the developed economies. However, a possible alternative suggested by Professor Ashok Banerjee is that the startups resort to issuance of compulsorily convertible preference shares (CCPS) to non-promoter investors. Since CCPS are generally convertible into ordinary equity shares after a period of about 5 years, it might seem as a plausible alternative. Whereas for FR shares, non-convertible cumulative preference shares can be issued by listed firms, and the company can very easily avoid most, if not all, the requirements of issuing SR shares. However, since the desired inducement is for the asset-light and newer businesses, issue of CCPS and NCPS will require the creation of a capital redemption reserve, which may be very weighty for emerging businesses.
It is certain that the success of the framework will depend on the investors' conduct and reaction to the mechanism. The prospective investors must be completely convinced of the unique business ideas for which they are ready to trade their control in the business for the company’s independence. And if the safety nets created by SEBI to protect the investors and shareholders are able to help the execution of the framework, India will certainly witness a new paradigm of innovative startups.
 SEBI circular no. SEBI/CFD/DIL/LA/2/2009/21/7 dated 21-7-2009.