As the Indian start-up ecosystem matures, there’s a growing trend among companies in cutting-edge industries to access new technologies, recruit the best talent and gain market share and advantage by buying global offshore businesses. Lack of liquidity or pressure to use resources for other purposes may, however, hinder such expansion and this is where share swaps become useful.
A share swap is an arrangement between two entities involving the exchange of one equity-based security for another. The shareholders of the target company transfer their shares to the acquiring company and in consideration for such transfer, the acquirer issues shares to the shareholders of the target. The acquirer pays no cash and the investors in the target acquire shares in the acquirer, which owns the merged business and is often in a better position to give investors an attractive return on their capital. This may be the preferred option for investors where the invested company has been unable to raise growth capital, and is unlikely to produce returns if sold for cash. Instead of liquidating their investments at a loss, the investors will have better prospects by undertaking a share swap, and acquiring a stake in the more viable acquirer.
While share swaps are not new, they have recently gained traction for the reasons mentioned above. With the Reserve Bank of India (RBI) liberalising the foreign exchange control regulations in 2015, expressly permitting share swaps under the automatic route, with conditions, Indian companies can now use share swaps to fund cross-border activity. For companies in the cutting-edge technology sector, this is especially welcome as this gives them greater access to foreign technology and markets.
The RBI set out the regulatory framework for cross-border share swaps in its Master Direction on Direct Investments by Residents in a Joint Venture (JV)/ Wholly Owned Subsidiary (WOS) Abroad (ODI Regulations), 2016, read with the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (NDI Rules). Rule B.4(1)(iii), read with rule 6 of the ODI Regulations, permits acquisition of a non-resident entity’s shares by an Indian entity with the consideration being in the form of shares issued by the Indian company, subject to the NDI Rules. Schedule 1, rule 1(d)(i) of the NDI Rules states that an Indian company may issue equity instruments to a non-resident person, if the Indian company is engaged in an automatic route sector, “against … a swap of equity instruments”.
Thus, provided the relevant Indian company is covered under the automatic route for the purposes of the NDI Rules, it can acquire a foreign target by way of a share swap under the automatic route. Such transaction must comply with the requirements under both ODI Regulations and NDI Rules including with respect to applicable thresholds, restricted sectors and regulatory filings. The issuance must also comply with preferential allotment rules under the Companies Act, 2013, read with the Companies (Share Capital and Debentures) Rules, 2014.
It is interesting to note that the NDI Rules contemplate a swap of “equity instruments”, which are defined to mean shares issued by an Indian company only. An interpretation could be that if a non-resident holds shares in an Indian company, it can swap those shares against the issue of shares in another Indian company. However, this interpretation would be inconsistent with other provisions of the NDI Rules, which state that in the case of a swap of shares, a valuation can be given by an Indian valuer or an investment banker of the host country, implying that the RBI contemplates a swap of shares of a foreign company. This reference seems to be an oversight rather than a stipulation.
While the benefits of share swaps are obvious, there is risk involved. From the acquirer’s perspective, precious equity is exchanged for a business or technology that may not add value. There is always the risk of poor integration, particularly of work cultures, and regulatory considerations in different jurisdictions may drag down the valuation of the combined entity.
Unlike a cash transaction, where the shareholders of the target are no longer in the picture, in a swap both parties are committed to the long run and exposed to the risk of a downside that could erode shareholder value. It is imperative that parties do their due diligence and clearly negotiate their post-transaction rights and obligations in order to ensure seamless continuity of the combined business.
Natasha Mahajan is a partner and Vineetha Stephen is an associate at Samvad Partners
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