You just have raised a new round of financing for your company at a rich valuation. It has been a particularly hard and well-fought negotiation with your investors. Before the celebrations can begin, however, you should pause and look closely at the exit waterfall in your shareholders’ agreement.
Companies and founders are required, often on a best-effort basis, to provide an exit to investors by conducting an initial public offer, or facilitating a trade sale (that is finding a willing buyer for investors’ securities) before the expiry of a predetermined period. As fallback, the exit waterfall, among other exit rights, requires the company to buy back investors’ securities, often at the prevailing fair market value. If this sounds innocuous you should think again, this time considering the implications of accounting standards. Under generally accepted accounting principles compulsorily convertible preference shares (a type of financial instrument that a company issues to a non-resident investor) form part of the company’s share capital and are recorded as equity in the balance sheet. This well-established position could now be undone because of the provisions of Indian Accounting Standard 32 (IndAS32).
IndAS32 applies to any unlisted company with a net worth of at least ₹2.5 billion (US$34.9 million) and a maximum of ₹5 billion. If a company meets this threshold in any financial year, compliance with IndAS32 will be mandatory from the following financial year in producing its financial statements. IndAS32 classifies financial instruments into financial liabilities, financial assets or equity instruments. These terms have been comprehensively defined in IndAS32, but the following simple explanations will be sufficient. A financial liability is the existence of a contractual obligation to deliver cash or another financial asset to another entity. An equity instrument means any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. Emphasis has been placed on looking at the substance of a financial instrument rather than its form when classifying such a financial instrument as either an equity instrument or financial liability in the company’s balance sheet.
Moreover, financial instruments containing contingent settlement provisions are classified as financial liabilities under IndAS32. In this regard, a company’s obligation to buy back investors’ securities, as specified in the exit waterfall of a shareholders’ agreement, is a contingent settlement provision for two reasons. Firstly, the company has a contractual obligation to deliver cash to investors and to buy back investors’ securities based on the outcome of uncertain future events that are beyond the control of the company and the holders of the financial instruments. Examples would be the completion of an initial public offering, or trade sale, both of which would depend on market conditions among other factors. Secondly, the company does not have an unconditional right to refuse payments to the investors and to buy back their securities.
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Siddharth Seshan is a counsel and Tushar Gogoi is an associate in the Bengaluru office of Samvad Partners.
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