Startup founders face reclassification dilemma

The startup ecosystem has grown steadily over the past few years, raising a record USD42 billion for more than 1,500 deals in 2021 alone. Raising debt is expensive, and often impossible, for most startups, so founders primarily look to investors for funding. As startups mature into million- and billion-dollar enterprises, they progress to the next phase of initial public offerings (IPO) of shares.

Investors in these companies, such as venture capital funds and private equity investors, typically subscribe to separate classes of preference and equity shares, over multiple funding rounds. This is relevant to an IPO, as a listed company is permitted to have only one class of ordinary equity shares. This requirement leads pre-IPO companies to clean up their cap-tables and standardise their securities. It is here that pre-IPO companies encounter legal hurdles if varied classes of equity shares have been allotted.

Unlisted companies are not prohibited from issuing different classes of equity shares, but listed companies are permitted to have only one class of ordinary equity shares. Convertible securities, such as compulsory convertible preference shares, can always be converted into ordinary equity shares; equity shares, however, do not enjoy such flexibility. Companies with different classes of equity shares that are looking to go public therefore have to reclassify different classes of equity shares, such as class A, class B and class C as a single class of ordinary equity shares.

It was once standard practice for pre-IPO companies to alter their share capital in accordance with section 61 of the Companies Act, 2013. This meant securing the approval of the shareholders to reclassify different classes of equity shares as a single class of ordinary equity shares. This was then followed by filing form SH-7 with the Registrar of Companies (RoC) for approval. This online form recognised the concept of reclassification of a company’s issued share capital. Even though section 61 does not explicitly prescribe reclassification of issued share capital as one of the ways of altering share capital, the market viewed it as permissible, given that form SH-7 specifically recognised it. This changed in December 2020, when form SH-7 was amended to exclude, among other matters, the reclassification of issued share capital. Various regional registrars, citing a change of stance by the RoC, then began raising objections when companies applied to reclassify their existing share capital.

Pre-IPO companies that have issued different classes of equity shares now face the problem of creating a single class of ordinary equity shares. Some have taken creative, but legally questionable means to do so. Although the Securities and Exchange Board of India has not yet ruled out such methods, there is the risk of future regulatory action.

Companies looking to raise funds from investors should stop issuing multiple classes of equity shares. Apart from being advantageous for an eventual listing, this benefits investors from the perspective of their tax liabilities, as reclassification of existing shares may be considered a taxable event. Unlike the case of a conversion of convertible preference shares, tax authorities may deem reclassification to be a taxable event in which new shares are issued to the shareholder as replacements for the original shares held.

Given that the fair market value of such new shares would, in most cases, be higher than the acquisition value of the original shares, shareholders may be liable to capital gains tax on the difference in valuation. Investors looking to become shareholders in a company that has already issued multiple classes of equity shares should require it to unify the classes at the time of, or before, the acquisition of shares to avoid any tax impact.

Multiple classes of equity shares may not only disrupt a company’s listing plans, but also impact the tax exposure of investors. Investors and companies should, therefore, weigh the risks against the commercial, but mostly illusory, benefits of structuring the cap-table to include multiple classes of equity shares.

Aayush Kapoor is a partner and Harjas Singh is an associate at Shardul Amarchand Mangaldas & Co. Partner Puja Sondhi also provided inputs for the article.

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