Start-ups, in the beginning, are not stable, there is usually a lack of assets and cash flow among the entrepreneurs. This makes it difficult to arrive at an accurate valuation of the company, but the valuation of the company is an essential prerequisite for investors who pool their resources. This is when the investors opt for the securities.
Over the years, a recent development has emerged in equity financing to balance the interests of startup entrepreneurs as well as investors. Financing is done by subscribing to Convertible Instruments such as Compulsory Convertible Preference Shares (CCPS) and Compulsory Convertible Debentures (CCD). These hybrid options are preferable as compared to equity due to the reason that shareholding does not ensure a fixed return on investment and does not offer any special rights or preferences. Additionally, by issuing convertible securities, the founders are able to retain their control over management and decision-making in the venture. Investors prefer hybrid securities due to their secure nature.
The most eminent instruments are discussed below-
Compulsory Convertible Debentures (CCD):
CCD or Compulsory Convertible Debenture is a hybrid security that is neither entirety debt nor equity since it’s neither purely a bond nor purely a stock. These debt instruments have to mandatorily get converted.
As per the Company Act, CCDs are often considered deferred equity instruments. A CCD holder automatically becomes a shareholder in the company and acquires all the rights of a shareholder.
Here are two scenarios where founders tend to use CCDs:
Very early when founders and investors don’t have a value to peg on the startup
Typically, many ‘bridge rounds’ take place via CCDs because founders don’t want a certain valuation number to affect the larger round valuation by a VC.
If the start-up fails to deliver, the investors are still secured as they are bound to receive interest with a future promise of receiving dividends on the equity shares. Furthermore, they promote foreign investment as opposed to certain other hybrid securities. Thus, their subscription proves beneficial to both parties most of the time.
However, there are certain downsides to the subscription of CCDs due to which investors shift to other hybrid securities. While the initial purpose of this instrument was to curb the difficulty of valuation, the ventures are now required to obtain a ‘Valuation Certificate’ from the appropriate certifying officer at the time of investment. They also have to keep up with FEMA Guidelines, SEBI rules, FDI Regulations and Tax procedures. This severely increases the compliance requirements to follow, which makes the investment procedure complicated.
Compulsory Convertible Preference Shares (CCPS):
CCPS which refers to Compulsory Convertible Preference Shares is preferred amongst investors for two main reasons:
- The dividend is first paid to preference shareholders.
- According to the Reserve Bank of India (RBI), the compulsorily convertible preference shares or CCPS must be treated at par with equity shares.
Also, in case the business turns out successful, the preference shares get converted to equity shares thereby increasing the scope of capital growth and profit retention of the investors. The main advantage of these shares is their conversion is directly linked to the performance of the company.
In this case, the investors put in their resources when the company is at a lower valuation and eventually convert their shares to equity, which yields them a higher dividend, without pooling in additional resources when the venture has a higher valuation. Additionally, it benefits the start-ups to prevent the exhaustion of cash flow, as contrary to CCD, this security is not a ‘debt’ or ‘loan’ which needs to be paid off with interest. This strikes a balance in the interests of the investors as well as the entrepreneurs.
However, like convertible debentures, this hybrid security is also infamous for its hefty load of compliance requirements and paperwork that is involved, mainly the pre-requisite for a valuation certificate.
The issue of these shares is regulated by Sections 42, 62 and 55 of the Companies Act, 2013. Additionally, since the instrument is eventually converted into equity, foreign investment is permitted which makes it mandatory to adhere to FDI policy and FEMA Regulations. Similarly, the compliances under the Income Tax Act 1961 have to be followed. Issuance of these shares also provides certain rights to the shareholders, thus restricting the promoters of the venture in their decision-making process.
All things considered, CCPS is the most used instrument for start-up investments currently, due to the liquidity advantage and repayment of share capital in an event of failure.
Equity Shares Capital:
An equity share, normally known as the ordinary share is part ownership where each member is a fractional owner and initiates the maximum entrepreneurial liability related to a trading concern. These types of shareholders in any organization possess the right to vote.
Equity share capital remains with the company. It is given back only when the company is closed.
Equity Shareholders have voting rights and they also select the company’s management. The dividend rate on the equity capital relies upon the obtainability of the capital. However, there is no fixed rate of dividend on the equity capital.
Equity shares do not create a sense of obligation and accountability to pay a rate of dividend that is fixed. It is a perpetual source of funding, and the enterprise has to pay back; an exceptional case – is under liquidation.
Equity shareholders are the actual owners of the enterprise who possess voting rights.
Difference Between Equity Shares and Preference Shares:
Equity shares and Preference shares are the two types of shares that a company issues. An equity share is an ordinary share. Preference shareholders enjoy the benefit of the dividend distribution first. The equity stockholders get the opportunity to cast their vote in major business decisions.
The company preference share receives the dividend at a fixed rate. Whenever there is an issue with the company, the preference share gets the right to return the capital before the equity share.
I hope after reading our blog on CCD, CCPS and Equity shares you would be clear regarding what options to provide to your angel investor. Make the decision carefully as it directly affects the capital of your company. For any query, simply email us at firstname.lastname@example.org.