Differential Voting Right Shares: The (Not-So Secret) Secret Ingredient For Deal-Making In India

While dual class shares are commonly used to achieve transaction goals in many jurisdictions, transaction structures where such instruments are used to facilitate mergers and acquisitions and private equity transactions in India remain less common in comparison to transactions that follow the ‘one share, one vote’ principle, which remains the preferred structure for ensuring corporate governance aiming to protect the basic rights of shareholders.

Section 47 of the [Indian] Companies Act, 2013 (the “Companies Act”) gives a right to every shareholder of a company holding equity share capital to vote on every resolution placed before the company. However, shares with differential voting rights (“DVR Shares”) would allow a company to issue more than one class of shares with different voting rights as against only one class of ordinary equity shares, with each share having one vote. Accordingly, such DVR Shares could have rights disproportionate to their economic ownership.

As we discuss in this note, although companies in India have been permitted to issue DVR Shares under the Companies Act, there continues to be, perhaps misplaced, apprehensions on the use of DVR Shares to facilitate deal-making in India. In fact, DVR Shares offer certain flexibility and benefits to creatively achieve the commercial objectives/goals of certain transactions, particularly for unlisted companies and even more so for private companies.

Applicable Legal Framework In India For The Issue Of DVR Shares

An Indian company may have a share capital of only two kinds: equity and preference share capital. If such a company wishes to issue equity share capital with differential rights, it would be required to follow the provisions under Section 43 of the Companies Act, read with the Companies (Share Capital and Debenture) Rules, 2014 (the “Share Capital and Debenture Rules”). 

In accordance with Section 43 of the Companies Act, a company may offer equity share capital with ‘differential rights as to dividend, voting or otherwise in accordance with such rules as may be prescribed’. Rule 4 of the Share Capital and Debenture Rules prescribes various conditions for the issuance of equity shares with differential rights. While issuing DVR Shares, a company would be required to ensure, inter alia, that: (i) the articles of association of the company (the “Articles”) provide for the issue of DVR Shares, and if not then they must first be amended to permit the company to issue DVR Shares; (ii) the voting power of the DVR Shares should not exceed 74% of the total voting power of the company; (iii) there should not have been any default in filing the annual returns by the company for the previous three financial years; and (iv) there should not have been any default in the repayment of loan borrowed or deposits or payment of declared dividend by the company.

In 2019, the Securities and Exchange Board of India (the “SEBI”) introduced a framework for the issuance of DVR Shares by companies whose equity shares are already listed on the stock exchange or companies with equity shares not listed on the stock exchange but proposed to be offered to the public. However, given the SEBI’s emphasis on ensuring corporate governance, additional restrictions are applicable for issue of DVR Shares by listed companies (for instance, the SEBI framework related to DVR Shares allows listed companies to offer superior right shares carrying 2:1 to 10:1 voting power, restricts the issuance of inferior voting right shares and prescribes certain sunset periods) and only a handful of listed companies in India have so far issued DVR Shares. The SEBI restrictions would not extend to unlisted companies.

Additional Flexibility For Private Companies

Pursuant to the notification issued by the Ministry of Corporate Affairs, dated June 5, 2015 (the “Exemption Notification”), Section 43 and Section 47 of the Companies Act are not applicable to private companies “where memorandum or articles of association of the private company so provides”. Accordingly, the Exemption Notification offers private companies greater flexibility as to classes of shares (and the terms or rights attached to such shares) they may issue. If a private company exempts itself from the application of Sections 43 and Section 47, it may issue shares without being subject to the restrictions under Sections 43 and 47 of the Companies Act. Even the provisions of the Share Capital and Debenture Rules relevant to differential rights (as discussed above) will then not be applicable to private companies.

If a private company elects to abide by the requirement of having only two kinds of share capital, then to issue equity shares with differential rights as to dividend, voting or otherwise, it would be required to follow the provisions under Section 43 of the Companies Act read with the Share Capital and Debenture Rules (as discussed above). However, a private company may choose to rely on the Exemption Notification and state in its memorandum of association or its Articles that the requirement of having only two kinds of share capital will not apply to it. 

Effective Secret Ingredient

Transactions involving DVR Shares are most commonly seen in promoter/founder-led companies where founders are considered to be critical for the success of the company, have a high amount of pre-initial public offer funding and are averse to any change of control. DVR Shares may permit promoters/founders to implement long-term strategies by retaining operational and management control through a golden share that gives them higher voting power than ordinary equity shares or by issuing DVR Shares to other shareholders with inferior/fractional voting rights, which helps the founder retain voting control. For unlisted companies (and particularly for private companies), there are many other instances where DVR Shares may be considered in deal-making, including: 

1. DVR Shares with higher voting rights could also be issued to a private trust created for the benefit of a particular family, who then collectively control the operations and management of the company.

2. If a transaction involves a legal or regulatory constraint that requires a particular shareholder to retain a certain prescribed shareholding, DVR Shares may be issued to maintain such shareholding percentage. For example, to avail the benefits under Section 47 of the [Indian] Income-tax Act, 1961 at the time of conversion from a partnership firm to a company, the aggregate shareholding in the company of the partners of the firm must continue to be no less than 51% of the total voting power in the company for a period of five years from the date of the succession, which would restrict the ability of the partners to transfer their shares beyond 51% to a third-party. In such cases, the company could issue DVR Shares to the original partners with superior voting power but perhaps reduced dividends, such that their voting rights are above 51%, but their economic interest in the company is lower.

3. A company wanting to raise additional capital without diluting its existing shareholder or triggering the pre-emptive/anti-dilution clause in its shareholders’ agreement, may decide to issue DVR Shares with zero or fractional voting right shares (as may be relevant for that company) which carry lower voting power than the ordinary equity shares.

4. An investor could acquire economic interest by acquiring DVR Shares with zero voting rights to comply with the provisions of any sectoral thresholds under India’s foreign exchange regulations.

5. DVR Shares may be issued with terms that provide zero rights until the occurrence of a trigger event (such as an event of default or merger, etc.) and the voting rights, dividend rights or economic interest at the time of liquidation get triggered only upon the occurrence of the trigger event.

6. The DVR Shares may be issued with staggered voting rights. For instance, for up to 25% of the total shareholding, the shares will have one vote each; however, any shareholding beyond 25% will have much lower votes per share.

7. The DVR Shares can offer higher dividend rights or economic interest at the time of liquidation. Such DVR Shares may be useful for retail investors, who are largely unconcerned about their power to exercise their control over the company and are more concerned about higher earnings.

8. DVR Shares may be issued contingent upon certain performance metrics. For instance, the DVR Shares held by the promoters/founders may initially have equal voting rights; however, after meeting a minimum profit threshold for a few years, their voting rights may be increased to reward their performance. 

So, What Is Holding Back The Issue Of DVR Shares?

One reason DVR Shares are not part of structuring discussions in every transaction is the perception that they offer voting rights that are superior for one class of shareholders, compared to the other, and may be detrimental to the interests of all stakeholders involved, such as the founder/ promoter group, shareholders (which includes retail investors, angel investors, institutional investors, each having different interests), creditors, and banking institutions, etc. 

While DVR Shares offer an effective way for promoters/founders to retain operational and management control, if the objective is to only achieve operational and management control, a simpler way to achieve that may be through contractual reserved matter/veto rights over specific items. However, where stakeholder concerns can be managed and, in fact, help bridge the commercial expectations of one party without adversely impacting the other party, DVR Shares may be effective.

Another reason for the less frequent use of DVR Shares has been the challenge of valuing them correctly. For transactions involving non-residents, pricing requirements under foreign exchange regulations must also be complied with, and investors tend to adopt a conservative approach to pricing DVR Shares. However, by determining the value attributable to the voting share premium and the linked economic rights, valuers have been able to effectively distinguish between the valuation of ordinary equity shares and DVR Shares.

Conclusion

Even after issuing DVR Shares, a company retains significant flexibility to restructure its share capital in accordance with its evolving business needs, subject to the required regulatory framework. For instance, a company may subsequently decide to alter its authorised share capital and convert DVR Shares into ordinary equity shares. In a recent instance, an Indian company approved a restructuring proposal involving the reclassification of its Class A equity shares (i.e., DVR Shares) into ordinary equity shares prior to filing for an initial public offer. This would result in the termination of all special rights previously attached to the DVR Shares, and the DVR Shares would be granted the same rights, preferences, privileges, voting rights, and restrictions as those attached to the ordinary equity shares, with these equity shares ranking pari passu in all respects with the ordinary equity shares of the company.

The flexibility available, in particular to private limited companies, concerning the kinds of share capital they may have, is attractive. However, such flexibility must be evaluated based on the legal landscape, which would become applicable should the company change its status to an unlisted public or a listed public company, and attendant tax implications. In order to enhance the appeal of DVR Shares in boardroom deliberations and to ensure wider adoption of DVR Shares in corporate structures, the recommendations below could be considered.

Firstly, before issuing DVR Shares, a company should provide details of the special rights offered and how these would impact the concerned stakeholders. Carrying out a detailed stakeholder impact assessment prior to issuing DVR Shares would enable greater transparency for various stakeholders and would allow them to identify the impact of a potential decision to issue a particular variety of DVR Shares to different shareholders. For instance, the impact on the other rights and restrictions applicable to DVR Shares, such as transfer restrictions, right to attend shareholder meetings, etc., should also be clarified.

Secondly, to enhance corporate governance, the company can also incorporate various provisions detailing situations where DVR Shares would be treated at par with ordinary shares. This may include situations such as voluntary winding-up of the company, related party transactions with holders of DVR Shares, changes in the Articles of the company that impact DVR Shares, etc.

Lastly, the DVR Shares could also have a valid sunset clause, which can be time-based or event-based. Upon the occurrence of such an event, the DVR Shares could have the same voting power as ordinary equity shares or even be selectively reduced by the company once their purpose in facilitating a transaction is over. Similarly, an event-based sunset clause may include conditions such as the demise or resignation of the promoter/founder (as the holder of the DVR Shares), the merger or acquisition of the company, or the unauthorised sale of the DVR Shares, etc.

(The article is written by Mohit Gogia, who is a partner at Cyril Amarchand Mangaldas. He can be reached at mohit.gogia@cyrilshroff.com. The article is co-authored by Nityesh Dadhich, Associate, Cyril Amarchand Mangaldas)

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