An early-stage start-up invariably comes across the quandary to decide amongst different modes of funding namely traditional equity financing, debt-financing and convertible equity financing. The concerns and priorities of all start-up companies lies in the following -
(i) raising the funds through a mode and instrument which is not only commercially viable in terms of returns and rights to be given to the investors, but also entails the minimum or no dilution of founders’ stakes and incurs nominal cost of compliances and of course on
(ii) how expeditiously the fund-raising rounds can be concluded and funds raised thereof can be put to use by the companies.
In light of the above, a start-up incorporated as a Private Limited company has the option to raise funds from current shareholders, promoters, and other investors namely PE/VC funds, family, and friends through varied instruments and procedures provided under the Companies Act, 2013 (“Act”). Moreover, a majority of the changes have been made to the Act since 2013 to make the process more transparent and get rid of conflicting clauses. However, there is one issue that still arises in every fundraising transaction as to when and how conditions and compliances mentioned under Section 42 and Section 62 of the Act will get attracted.
The need to interpret the distinction between the aforesaid sections of the Act is critical from the standpoint of the effective fulfillment of all the conditions and adherence to the compliances required under the Act. These sections require the undivided attention of the companies as well as the professionals advising these companies as any non-compliance in this regard can render the fundraising be construed as a public issue and can invite penalties equivalent to the value of the funds raised or ₹2,00,00,000/-, whichever is higher and the company will have to refund all money within a period of 30 days of the order imposing such penalty [Section 42(10) of the Act].
In pursuance of the same, we will analyse and clarify the ambiguities in compliances as provided under the Act as follows:
Kind of Securities - Section 42 of the Act deals with the Private Placement of securities of a company. As the name suggests, it is a method of placing the securities of the company privately to identified persons not exceeding 50 in a single offer and 200 in a single financial year. This offer has to be made only through a private placement offer letter (PAS-4) duly authorized by the board and shareholders of the company. Whereas the concept of Issuance of shares on a preferential basis which, interestingly, is not discussed in Section 62 of the Act but in Rule 13(1) of Share (Capital and Debenture Rules), 2014, which when read together with Section 62(1) (c) of the Act provides for an increase in subscribed share capital through the issuance of shares or other securities to a select group of individuals which may or may not include existing members or employees of the company. The instruments being available for issuance under aforesaid provisions are limited to “shares and other securities” which means to include equity shares, fully convertible debentures, partly convertible debentures or any other securities, which would be convertible into or exchanged with equity shares at a later date. However, the term “securities” as specified under Private Placement is to be construed as per the definition provided under Section 2(h) of the Securities Contract (Regulation) Act, 1956, which is wider in scope and does not limit to equity and convertible securities.
Period of Issuance and allotment – Rule 13 allows a period of 12 months to the company for issuance of shares on a preferential basis from the date of passing the special resolution authorizing such issue. It is significant to note that it is only upon receipt of application money within the above-mentioned period, the company is obliged to allot these securities within 60 days from the date of receipt. In case of non-allotment, it has to refund the application money within 15 days from the expiry of the above-mentioned limit otherwise a penalty of 12% p.a. [Section 42(6) of the Act] shall be imposed on the company. It is clarified that if funds are not received within a period of 12 months and as a consequence of which securities are not allotted within said 12 months, a new special resolution can be passed to complete the allotment [Rule 13(2)(f) of the Companies (Share Capital and Debentures) Rules, 2014] and there will be no penalty in case no funds are received.
Nature of consideration–A common misconception that arises while reading the two provisions relates to the nature of consideration which is allowed under both the process is that consideration in cash is allowed under the Issuance of shares on a preferential basis while being restricted under a Private Placement. Nevertheless, it is clarified that Section 42 only provides for a medium through which the subscription money can be received including a cheque, demand draft, and any other banking channels whereas Section 62 (1) (c) provides for the nature of consideration which can include cash amongst other kinds of consideration. It points out that even in a transaction where cash is to choose as a form of consideration, it has to be received by the issuer company through a channel other than by way of cash.
Separate Bank Account – Section 42 obligates the issuer company to open a separate bank account to receive funds raised through Private Placement. Though, Section 62 nowhere provides for this as a specific requirement, however Section 62 (1) (c) of the Act till mandates the company to fulfil the conditions laid down in Section 42 of the Act. Through this, it can be fairly concluded that a separate bank account is still needed in case of the issue of shares or convertible securities on a private cum preferential basis; however, this condition will not be applicable in case of a rights issue or an issue to an employee.
Valuation Report -It is pertinent to mention that the price of the shares or securities to be issued under Section 62 (1) (c) of the Act has to be determined on the basis of a valuation report made by a Registered Valuer prior to the circulation of the offer letter. On the other hand, a valuation report is not required in the case of shares under rights issues and compulsorily redeemable securities.
Analyzing the provisions and rules made thereunder, it can be concluded that:
Where a start-up intends to raise funds either through shares or any other convertible securities (CCPS, CCDs,etc.) to persons identified by the board which may or may not include existing shareholders or employees on preferential terms, then it will be construed as Issuance of shares on preferential basis and such issue will be governed by Section 42, 62(1)(c) of the Act read with Rule 13 (1) of the Companies (Share Capital And Debentures) Rules, 2014 and Rule 14(1) of Companies (Prospectus and Allotment of Securities) Rules, 2014.
Where a start-up is increasing its capital through a rights issue, it will not be construed as the Issuance of shares on a preferential basis and such issue of shares will be governed by Section 62(1)(a) of the Act.
Where a start-up is raising funds through non-convertible debentures on private placement basis, it will be governed by Section 42 of the Act read with Rule 14(1) of Companies (Prospectus and Allotment of Securities) Rules, 2014 and Rule 18 of the Companies (Share Capital and Debentures) Rules, 2014
Where a start-up desires to issue shares to its employees, it will be governed by Section 62(1)(b) of the Act and Rules 12 of the Companies (Share Capital and Debentures) Rules, 2014.
Therefore, any issue of securities that are not explicitly excluded from the definitions stipulated under explanations to Rule 13 (1) of the Companies (Share Capital and Debentures) Rules, 2014 will have to adhere to compliances mentioned in Section 42, 62(1) (c) of the Act read with Rule 13 (1) of the Companies (Share Capital and Debentures) Rules, 2014 and Rule 14(1) of Companies (Prospectus and Allotment of Securities) Rules, 2014 and other applicable rules depending upon the nature of securities and category of investors in order to avoid penalties mentioned under the Act.
Hope this article explains the interplay and distinction between Section 42 and Section 62 of the Companies Act, 2013. The compliances under both sections are amply clear in terms of conditions and procedural requirements based on the nature of securities that are being offered to raise funds.
Priya Mamgain is a Partner and Abhishek Malhotra is an Associate at Saga Legal.