Introduction

One of the features of today’s private market is that PE/VC backed companies raise several large rounds of funding in quick succession – or aim to do so. This is a function of business models becoming capital intensive due to high burn, and promoters / investors sometimes viewing capital itself as a ‘moat’. As a result, the promoter stake in these companies could be significantly diluted over a short period of time.

The dilution could be amplified by the COVID-19 driven recapitalization and consolidation that the market is seeing.

Due to this dilution, promoter economics are negatively impacted. This could result in promoters being insufficiently incentivized / aligned with investors on economic outcomes – note that promoter economics are usually ‘buried’ under multiple series of investor liquidation preferences and share transfer restrictions. Another negative outcome for promoters is a perceived loss of control over their companies due to the rapidly diluting stake.

These trend calls for promoters and their advisors to closely examine the promoter economics and rights in a given deal, with an eye on how dilution could continue in the future. A few thoughts on these issues are set out below.

Economics

Promoters and investors can implement equity ‘top-ups’ or other similar incentives to mitigate the effects of dilution. These can – but need not necessarily – be linked to performance and/or to delivering a good exit.

From a legal and tax perspective, there are challenges to structuring these incentives. For example, stock options may be tax inefficient, and the law may not permit awarding stock options to promoters. The simpler ‘upside sharing’ or ‘promote’ arrangement that has been in use for a while in the Indian market comes with its share of tax issues, and may only partly address the concerns highlighted above. Issuing warrants, bonus shares, partly paid shares and/or convertibles to promoters to achieve the ‘top-up’ can also be explored – but each of these require careful legal structuring and tax planning. Phantom shares have been used as incentivizing tools recently in PE/VC funded companies as well.

What are the other issues to solve for when structuring a ‘top up’? Close attention should be paid to the commercials of the performance milestones. For example, setting optimistic unit economics milestones for awarding the ‘top up’ could clash with the promoter’s vision to aggressively expand the customer base. Further, promoters will typically prefer a structure that does not require them to pay cash for their ‘top-up’.

An equally important ‘economics’ issue is mapping out a path to liquidity for promoters – though resisted by investors, it is helpful if shareholder agreements do not effectively ‘lock-in’ promoters perpetually, but provide reasonable liquidity baskets/tag rights from time to time.

Rights

How can the governance rights in a company be structured to address the negative effects of excessive dilution of promoters?

Firstly, promoters can seek ‘veto rights’, to ensure that the majority of the cap table does not push through key decisions without the promoters’ buy-in.

Secondly, depending on the cap table dynamics, promoters may even benefit from a governance mechanism where key decisions are broad based amongst the investor group, or gated by a few large & active investors who are aligned with the promoter.

Thirdly, it should not be possible for investors to easily remove promoters from their executive positions – and this involves thinking through the fine print on relatively ‘market’ concepts such as ‘event of default’ and ‘termination for cause’.

Promoters can also consider asking for shares with differential (read: increased) voting rights. This is an option that has recently been liberalized (previously, ‘DVR’ shares could be issued only by companies that had a 3 year track record of profits, which was acting as a barrier in the present ecosystem). That said, since the Indian private market has not yet embraced ‘dual-class’ share structures often seen in the USA, issuing DVR shares to promoters may not be commercially palatable for investors right now.

Thinking out loud: as companies mature, promoters and investors need to think about the nature of the partnership – need it always be ‘bi-polar’, with investors on one side and promoters on the other? Should any one investor have blocking rights over an M&A or a pivot? It is interesting that in other leading markets (such as Silicon Valley or Israel), investors’ blocking rights appear to be more focused on actions that may have an adverse effect on that investor, and on price protections – which is somewhat narrower than the blocking rights seen in standard Indian shareholders’ agreements.

Debt

Depending on the amount of funding required, the issue of outsized promoter dilution can be addressed to a limited extent by raising venture debt instead of equity – this was a strong trend in 2019, and it may see continued momentum in 2020/2021 if promoters are hesitant to dilute at today’s valuations, as more venture debt players are joining the market. Needless to add, when exploring funding with a mix of equity and venture debt, it is important to keep in mind the ‘debt like’ implications of venture debt.

In a similar vein, in mature companies, promoters could also try to leverage their shares in order to increase their shareholding with borrowed funds. It is therefore important to ensure that shareholder agreements give promoters this flexibility (within reasonable limits).

Conclusion

The options suggested above should be tailored for each company, promoter / founder & cap table, and must find commercial acceptance within each deal’s context.

To conclude, in growth stage companies where there a significant promoter dilution, it is important to have a conversation – and then design balanced solutions – to ensure that promoters / founders are strongly aligned with investors and well incentivized, and have at least a minimum of protective rights where required.

The views and opinions expressed in this article are those of the authors alone and do not necessarily reflect the official position of AZB & Partners or the position of any other agency, organisation, employer or company.

Author:

Vishal Achanta, Associate