Structuring M&A - Add-ons
Author: LawSphereX
Category: General Law
Published:
Updated:
STRUCTURING M&A: ADD-ONS
Adv. Ankit Thakur, LL M. (Corporate & Financial law and policy), O. P. Jindal Global University, Sonipat, Haryana
INTRODUCTION
As per the Fact Sheet on Foreign Direct Investment (FDI) Inflow published by the Department for Promotion of Industry and Internal Trade, cumulative amount of FDI inflow into India from April 2000 to September 2024 stood at USD 1,033,400 Million1. Incentives and promotion of FDI in India became the cause of rise in the level of ‘mergers & acquisitions’ (M&A) happening within India. Indian courts holding the fundamental power to consummate M&A transactions within Indian jurisdiction, yet parties often prefer contractual engagements to effectuate M&A transactions. With regards M&A transaction, control, management, indemnity, exclusivity, warranties, stand still obligations are notably the key attributes of the transaction. 2 Regardless these, undermentioned are some noteworthy aspects which can have impact on the negotiations and further on the structure of the transaction.
INDIAN ACCOUNTING STANDARDS For specified listed and unlisted companies, application of Indian Accounting Standards (Ind AS) has been made an obligation to follow as per section 133 of the Companies Act, 2013 (the Act) read with the Companies (Indian Accounting Standards) Rules, 2015. With such mandate in force for specified companies and others orienting themselves with the Ind AS too, while structuring and negotiating under M&A transactions, compliance with Ind AS should be considered as one aspect too. It becomes imperative considering the divergence in conduct and construct under the Act vis-à-vis Ind AS. Illustratively, in definitive documents, based on the nature of instrument issued, equity shares and debentures are treated differently while Ind AS also accounts for the rights conferred on the holders of such instruments instance.
For example, when a clause in the definitive document is drafted providing exit opportunity to its investors possessing equity instruments is interpreted as an ‘obligation’ on the company which classify
1 Department for Promotion of Industry and Internal Trade, ‘FDI Factsheet September 2024’ (2024)
2 IndusLaw, ‘Notable Structuring Considerations Under the Revised Framework for Overseas Direct Investment’ (2023) the equity instruments as liability and therefore, a debt instrument under Ind AS. 3 Additionally, classification of subsidiary and holding company under the Act does not categorically recognize ‘control’ of parent company over its subsidiary by distinguishing the decision making head whilst for specified matters under the Ind AS, company is identified as the ‘subsidiary’ only when such matters remain with the majority shareholders4.
FOREIGN OWNED OR CONTROLLED COMPANY & DEFERRED CONSIDERATION As per Rule 23 of the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (NDI Rules), Indian entities ‘owned’ and ‘controlled’ by “persons resident outside India” and have received “foreign investment shall comply with the entry route, sectoral caps, pricing guidelines and other attendant conditions as applicable for foreign investment. ” While there are certain obligations meant for foreign resident entities which ought to be complied with by the Foreign owned or controlled company (FOCC), permitted standards for pay-out of deferred considerations during transfer of equity instruments are not clearly set-out.
According to Rule 9(6) of the NDI Rules, payment on deferred basis could be made during transfer of equity instruments “between a person resident in India and a person resident outside India,” for “an amount not exceeding twenty five percent of the total consideration,” within eighteen (18) months from the date of agreement of such transfer. With lack of express permissibility of deferred payment, common practice involve payment on deferred basis for an amount tantamount to the fair market value of instruments with the outstanding payment made under contractual arrangement.
ISSUANCE OF ESOPs The Act while allowing issuance of Employee Stock Option Plan (ESOP) to its employees, prohibits such issuance to the promoter group and to any director who holds, directly or indirectly, more than ten percent (10%) “of the outstanding equity shares of the company”5, but further provides exception to startup company for upto ten (10) years from its incorporation. 6 3 Indian Accounting Standards (Ind AS) 32, ‘Financial Instruments: Presentation’, paras 11, 17-20, 23. 4 Indian Accounting Standards (Ind AS) 110, ‘Consolidated Financial Statements’, paras 5-8, 10, Appendix B, paras B11- B13.
5 The Companies (Share Capital and Debenture) Rules, 2014, r 12(1).
6 Ministry of Corporate Affairs, ‘Companies (Share Capital and Debentures) Third Amendment Rules, 2019’ (16 August 2019) Additionally, “a minimum period of one year between the grant of options and vesting of option” needs to be observed. 7 In case of breach of such provisions or for a company not being a ‘start-up’, alternative approach to structuring should be taken into account to incentivize the promoters or directors such as issuance of sweat equity shares, stock appreciations rights, and bonus pay-outs which are associated with gain in value of securities and performance respectively. Furthermore, director or employee of Indian entity under certain conditions may acquire shares under ESOPs offered by foreign entity as per the Overseas Investment Rules.
8 LIMITATION ON LAYERS OF SUBSIDIARY The Companies (Restriction on Numbers of Layers) Rules, 2017 were introduced for the purpose of restricting the formation of shell companies to divert funds or for money laundering purposes by limiting companies from having more than two (2) subsidiaries in India but providing an exception that during computation of the number of layers, if one layer consists of one or more wholly owned subsidiary or subsidiaries, the same shall not be taken into account. 9 Although this provision puts a limit on the number of layers but it leaves ambiguity as to the calculation of second layer – should it be in terms of Indian entity or foreign entity and another ambiguity remains with regards the applicability of exemption – if it apply at first layer or at any layer.
Such considerations should be taken into account while structuring a M&A Transaction, especially during instances where there is a creation of new subsidiary. ANTI DILUTION MEASURES When providing for an exit opportunity at a lower valuation under M&A transaction, for protection of the existing investor, anti-dilution barrier usually gets triggered under the shareholders agreement/articles of association of the company and the same might become the cause for regulatory challenge under the NDI Rules. Therefore, for proper execution of antidilution measures, pricing guidelines, conversion formula of convertible capital instruments, should be taken into account and make sure that price during conversion should not be less than fair value of such instruments. 10 In such instances, issuance of bonus shares could be
7 The Companies (Share Capital and Debenture) Rules, 2014, r 12(6)(a).
8 The Foreign Exchange Management (Overseas Investment) Rules, 2022, sch III, cl 3
9 The Companies (Restriction on Numbers of Layers) Rules, 2017, r 2(1).
10 Department for Promotion of Industry and Internal Trade, ‘Consolidated FDI Policy 2020’ (29 October 2020), Annexure 1 considered as one precautionary measure and also by providing different valuations viz-a-viz by means of preference share could also serve the purpose.2
CONCLUSION
In order to attract foreign investment and to facilitate ease of doing business in India, market regulators continue to establish and amend policies and schemes. While structuring M&A transaction, many more considerations are meant to be taken into account as well, such as tax considerations, financial aspects, legal compliance under applicable statutes, etc. Above stated are just few out of many aspects which can be considered during structuring while also at times of negotiations. The scope of M&A is extensive and therefore, multiple routes to structure and design the whole transaction exists with implementation of only the best suited one.