DOWN ROUNDS ARE COMING - ENFORCEMENT OF ANTI-DILUTION ADJUSTMENTS

Introduction

The standstill of global economic activity and consequent market downturn caused by the Covid-19 outbreak has delivered a double whammy of capital scarcity and significant valuation correction across several asset classes. Many Indian companies will be in the race to restructure business and/or raise capital, unfortunately, at reduced enterprise valuations.

For businesses with existing venture capital and private equity investors, the looming slew of ‘down rounds’ will trigger anti-dilution rights attaching to convertible securities held by their existing shareholders.

Anti-dilution adjustments are self-executing rights that offer protection from value erosion in the form of reduction of conversion price of securities, translating into a proportional increase in the number of equity shares issuable to the investor on conversion.

Dilution correction mechanisms – Approaches

Depending on the extent of value correction negotiated between founders and investors, conversion-price adjustments can typically be structured in two ways: (a) full-ratchet adjustment, or (b) weighted-average adjustment.

A full-ratchet mechanism offers the greatest degree of value protection to investors – it resets the conversion price of existing convertible securities to the price per security issued in the down round and maintains the investor’s percentage ownership, irrespective of the size of the down round, relative to a company’s capital base. Of course, this also causes maximum damage to a founders’ stake and ability to raise future capital. For these reasons, full-ratchet adjustments are rarely seen in well-advised VC / PE deals.

A weighted average mechanism applies a mathematical formula to mark down conversion price of existing convertible securities basis the amount raised in the down round and the conversion price of the existing convertible securities. This mechanism considers the size of the down round, in addition to the lower price. Consequently, a greater number of securities issued at a lower price will result in a larger anti-dilution adjustment. Depending on the number of outstanding securities before the down round, a weighted average mechanism can be broad based (typically determined on a fully diluted basis where all securities are considered outstanding) or narrow based (only a certain subset of securities are considered outstanding, while securities like options and warrants may be ignored). Broad-based weighted average adjustments are more commonly seen in transaction documents.

Dilution adjustments and exchange control regulations

For non-Indian investors, structuring and enforcing anti-dilution rights are subject to Indian foreign exchange control regulatory[1] nuances.

As such, non-Indian investors registered as ‘Foreign Venture Capital Investors’ (“FVCIs”) with the Securities and Exchange Board of India are exempt from the regulatory nuances of valuation, and entry and exit pricing. Therefore, FVCIs will be able to freely enforce their anti-dilution rights.

Structuring Approach

  • Indian foreign exchange laws prescribe certain pricing regulations by virtue of which transaction price of securities cannot be lower than their fair market value (“FMV”) determined on the basis of an internationally accepted pricing methodology, arrived on an arm’s length basis.
  • In case of convertible securities, the following requirements have to be met:
    • at the time of entry i.e. entry price to be equal to or more than FMV of convertible security on entry date; and
    • at the time of conversion i.e. conversion price to be equal to or more than FMV of equity security as on entry date.
  • The actual entry price of the convertible securities can be higher than the FMV in lieu of the premium paid on the FMV thus giving a ‘value buffer’ equivalent to the amount of the premium paid. The FMV is to be supported by a report certified by a chartered accountant / a SEBI registered merchant banker / a practicing cost accountant.
  • The conversion price of the securities (and therefore, the conversion ratio) should be determined up-front at the time of issuance of convertible securities. By factoring in the ‘value buffer’ a maximum conversion ratio may be determined at the time of issuance.
  • The company raising capital should report the investment specifics i.e. the number, issuance price, the conversion price / conversion ratio (or the maximum conversion ratio) of convertible securities to the Reserve Bank of India (“RBI”), within 30 days from the issuance of the convertible securities (“RBI Filing”). At the time of conversion of the securities, no additional filing requirements will be triggered if there is no alteration in the reported investment specifics.

Enforcement Approach

  • Prior approval of the RBI may be required for enforcement of anti-dilution rights by non-Indian investors depending on (x) the ‘value buffer’ and its breadth, and (y) the conversion ratio reported in the RBI Filing.
  • As such, non-Indian investors looking to enforce their anti-dilution rights may not be required to take approval of RBI when:
    • there is a ‘value buffer’ on the entry price of the securities,
    • conversion ratio reported in the RBI Filings factors in the maximum ‘value buffer’ on the FMV, and the conversion ratio is higher than any mark-ups to the conversion ratio of the convertible securities as a consequence of enforcing anti-dilution rights, and
    • the lowered conversion price is above the minimum FMV of the securities.
  • On the contrary, prior approvals from the RBI will be required for non-Indian investors to enforce anti-dilution rights, if a ‘value buffer’ was not provided for, or if the conversion ratio does not factor the ‘value buffer’/ maximum conversion ratio or if the downward revision to the conversion price breaches the minimum FMV of the securities.
  • Any downward revisions to the conversion price / mark up conversion ratio which have not been recorded in the RBI Filing at the time of issuance will have to be reported to the RBI within 30 days of the price revision by filing a new Form FC-GPR. If this reporting is not completed, non-Indian investors may not be able to ‘cleanly’ liquidate a portion of their convertible securities or the additional equity securities issued pursuant to the anti-dilution adjustment (if the securities have been converted). Along with the new Form FC-GPR, the entity master form of the issuing company needs to be amended to reflect the additional equity securities being issued on conversion, in the reported paid-up capital of the issuing company on a fully diluted basis.

Recommendations and Road Ahead

Typically, investors consider various factors before proceeding to enforce their anti-dilution rights (e.g. impact of enforcement on the management team, future capital raising ability etc.). As regards non-Indian investors, proposals for enforcement of anti-dilution rights will also have to factor in RBI approvals, which proposals are assessed by the RBI on a case-to-case basis. Under the current global economic climate, the RBI’s position on granting such approvals is unclear, especially given that these rights will enable non-Indian preferred shareholders to proportionally own larger stakes in Indian companies (often to the detriment of promoters and other equity shareholders). Given this lack of clarity on enforceability, non-Indian investors can choose to leverage their anti-dilution provisions to negotiate better rights in the company (e.g. greater management rights or better exit rights).

On the other hand, founders should have a deep understanding of any anti-dilution provisions that they have signed up to and the repercussions of these provisions being triggered (including on the business and inter-se shareholder relations). For future capital raises, founders can consider alternatives like linking down round protections to ‘pay-to-play’ mechanics, which will require investors to participate in down rounds to retain their anti-dilution rights (and possibly, other preferred rights that they hold). Similarly, early stage ventures looking to raise capital during these times should carefully assess the anti-dilution mechanics that they sign-up to.

[1] Requirements as provided under the Indian foreign exchange control regulations, especially Foreign Exchange Management (Non-Debt Instrument) Rules, 2019