Equity Funding in India – Private Equity and Foreign Investment
We examine equity funding and private investment into India-based entities as well as compliance and reporting obligations for foreign enterprises.
Investment into companies can typically be in the form of equity funding or debt funding – the first, involves selling a portion of equity/ shares in the company while the latter involves borrowing a sum of money.
However, equity financing is often preferred by companies as it carries no repayment obligation and provides extra working capital, which can be used to expand a business. Moreover, equity funding places no additional financial burden on the company.
At the same time equity financing requires careful consideration of various laws and regulations, such as compliance under the Foreign Exchange Management Act (FEMA), the Companies Act, applicability of the International Financial Reporting Standards (IFRS), and the Reserve Bank of India guidelines, among others.
Equity financing is also an important business decision as it requires giving out a percentage of the company to the investor along with sharing of profits and consultation on decisions affecting the direction of the Indian business.
Various private equity options are available to a company and it is crucial to understand the impact of each option on shareholding and control, return on investment, repatriation options, tax benefits, and security of funds.
An introduction to private equity (PE) financing
Private equity (“PE”) has been a driver of growth in the world economy for decades. While growth and profitability remain the primary goals of the PE industry, the contribution of the PE industry to economic development is undeniable. Furthermore, the ability of timely investment to sustain and gestate ideas into economic realities has permitted the PE industry to take on a parental role in the economy.
The basic method by which PE investments work in India is not substantially different from the manner in which they work elsewhere.
A typical investment commences with the PE investor seeking out a company requiring investment or being approached by such a company. Following this, a basic document, such as a memorandum of understanding, a letter of intent, or a term sheet is executed between the investor and the company, in order to lay out the framework of the investment.
Once the initial document is in place, the investor usually conducts, at the minimum, a legal and financial due diligence on the company. This is often accompanied by a business due diligence and a background check on the promoters of the company.
Simultaneously, along with the due diligence process, the investor and the company will negotiate one or more investment documents, including share subscription agreements, share purchase agreements, and shareholders’ agreements with the company and the promoters/shareholders.
Upon the execution of these documents, and the clean-up of significant diligence issues, the investor invests in the company.
Structuring of PE and foreign investment
Incorporated entities in India are governed by the provisions of the Companies Act, 2013. The authority that oversees companies and their compliances is the Registrar of Companies (“RoC”). Companies may either be ‘private limited companies’ or ‘public limited companies’. It is relevant here to point out the distinction between private and public companies.
Private limited company
A private company has the following characteristics:
- It restricts the right to transfer shares; the number of members in a private limited company is limited to 50 members (excluding the present and past employees of the company).
- It cannot invite the public to subscribe to its securities.
- It cannot invite or accept deposits from persons other than members.
Public limited company
A company which is not a private company is a public company. A private company which is a subsidiary of a public company, is also treated on par with a public company – in some cases.
A public limited company may offer its securities to the public and invite deposits from the public. As compared to private companies, public companies are governed by a more stringent and restrictive regulatory regime.
PE and foreign investments are usually made into private companies because they permit enforcement of several standard deal terms, such as rights of first refusal/offer, tag-along rights and promoter lock-ins. It is also easier to structure different classes of securities in a private company.
Types of equity shares
The capital that a company has raised by offering shares is known as equity share capital or share capital. It is the money that company owners and investors direct towards a company’s capital and use to develop or expand the operations of their venture.
Several types of equity shares help companies generate equity share capital.
The following highlights types of equity share capital:
- Authorized share capital: The maximum amount of capital that can be issued by a particular company is known as authorized share capital. Companies can increase their permissible limit to authorize shares after they have availed permission from respective authority and have paid the required fees.
- Issued share capital: Shares which a company offers to its investors are known as issued share capital.
- Subscribed share capital: It comprises of the part of issued share capital, which the investors agree upon and accept.
- Right shares: The shares that are issued to individuals after they have invested in equity shares are known as right shares. They are issued to safeguard existing investor’s ownership.
- Sweat equity shares: As an appreciation for a job well-done, companies reward their employees or directors with shares. Such shares are known as sweat equity shares.
- Paid-up capital: It forms the part of subscribed capital, which the company invests in their business.
- Bonus shares: These shares are issued to the investors in the form of a dividend.
Regulatory framework for foreign investments in equity shares
Foreign investment in India is governed by the FDI policy announced by the Government of India and the provisions of the Foreign Exchange Management Act (FEMA) 1999. The Reserve Bank of India has issued Notification No. FEMA 20/2000-RB dated May 3, 2000, which contains the regulations in this regard. This notification has been amended from time to time.
Investing in India by non-residents requires conformity with India’s foreign exchange regulations regulated by the RBI and Central Government. Most aspects of foreign currency transactions with India are governed by FEMA and the delegated legislations thereunder.
Investments in, and acquisitions (complete and partial) of, Indian companies by non-resident entities and individuals, are governed by the terms of the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (“Non-Debt Instruments Rules”), issued in supersession of the erstwhile Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2017 (“TISPRO Regulations”), and the provisions of the annual Consolidated Foreign Direct Investment Policy Circular (“FDI Policy”) issued by the Department for Promotion of Industry and Internal Trade (“DPIIT”) in the Ministry of Commerce and Industry, Government of India.
With these new rules in place, the power to regulate equity investments in India has now been transferred to the Ministry of Finance from the central bank, that is, the RBI.
However, the power to regulate the modes of payment and monitor the reporting for these transactions continues to be with RBI.
FDI in India is permitted under the two routes:
a) Automatic route
FDI is allowed under the automatic route without prior approval either of the Government or the RBI in all activities/sectors as specified in the consolidated FDI Policy, issued by the Government of India from time to time.
b) Government route or the approval route
FDI in activities not covered under the automatic route requires prior approval of the Government, which are considered by the FIPB, Department of Economic Affairs, Ministry of Finance. The Government permits FDI on an automatic basis, except with respect to a negative list. Proposals falling under the list of activities/ sectors prohibited for FDI by GOI, are as follows:
- Lottery business, including Government/private lottery, online lotteries, etc.
- Gambling and Betting including casinos etc.
- Chit funds
- Nidhi company
- Trading in Transferable Development Rights (TDRs)
- Real Estate Business or Construction of Farmhouses
- Manufacturing of cigars, cheroots, cigarillos and cigarettes, of tobacco or of tobacco substitutes
- Activities/sectors closed to private sector investment, for example, Atomic Energy and Railway operations
In the sectors/ activities that don’t fall within ‘Prohibited Sectors’, FDI is (i) either permitted up to the limit indicated against each sector/ activity or (ii) is permitted up to 100 percent under the automatic route, subject to applicable laws/ regulations; security and conditionalities. In a few sectors, additional conditions are required to be complied with, such as minimum capitalization requirements.
The banking sector is the example of sector covered under the sectorial cap and the following are their sectorial limits:
% of equity/FDI cap
Automatic up to 49%
Government route beyond 49% and up to 74%.
Compliance requirements for a private limited company in India
Based on the understanding of the facts, below is the list of compliance requirements under FEMA, which could be applicable to a private limited company in India. The said compliance requirements are as per Master Direction issued by the RBI on “Reporting under FEMA”.
All FDI transactions have to comply with the entry route, sectoral cap, and all other conditions of the extant FDI Policy issued by Government of India. The reporting of FDI transactions have to be completed online through the ‘Single Master Form’ (SMF) within the timelines prescribed following the procedure and documentation as mentioned in the SMF User Manual released by RBI. Contravention for non-issue/late issue of capital instruments or non-transfer/late transfer of capital instruments and other contraventions of the provisions FEMA 20(R) will be proceeded against as per the procedure laid down in sections 13 and 15 of FEMA, 1999.
FDI into Indian companies may be direct or indirect. FDI norms apply to both direct and indirect foreign investments into an Indian company. In case of direct investment, the non-resident investor invests directly into an Indian company. Indirect FDI is referred to as the downstream investment made by an Indian company, which is owned or controlled by non-residents, into another Indian company. As per the FDI Policy, such downstream investment is also required to comply with the same norms as applicable to direct FDI in respect of relevant sectoral conditions on entry route, conditionalities, and caps with regard to the sectors in which the downstream entity is operating.
Key points for consideration
- All issue, transfer of capital instruments by person resident outside India, Indian entity or investment vehicle or venture capital fund etc. receiving foreign investment have to comply with provisions of extant FEMA 20(R), including pricing, sector cap, downstream investment guideline, Schedules, etc.
- Delay in submission of reporting requirement like (FC-GPR, FC-TRS, Investment Vehicle Reporting, Downstream Investment Reporting, etc.) attracts late submission fee as prescribed by RBI.
- In case of the overseas investor being different from the remitter of funds, KYC of both the remitter and investor is required in the format prescribed by RBI from the overseas remitting bank. The fact that the investor does not have a bank account is not a valid premise for non-receipt of KYC of the investor. Wherein the remitter and investor are different, a No Objection certificate will need to be furnished from the remitter, conveying that the remitter has no objection to the shares being allotted to the investor.
- In case of funds received from overseas investor towards proceeds of Rights issue floated by the investee entity, a copy of the RBI letter allotting FDI Registration number for the initial allotment to such investor must be in place prior to receipt of funds. In case instruments are CCPS, the valuation certificate of equity shares is mandatory.
- In case of transfer of capital instruments from non-resident to resident, the FDI registration number allotted by the RBI for FDI by existing non-resident shareholder is required. In case the existing non-resident shareholder earlier acquired the capital instruments from other resident shareholder, then the copy of the AD certified FC-TRS Reporting is a prerequisite, without which current transaction of FC-TRS (Remittance and reporting) is not permitted.
- The date of submission of the report complete in all respects with the prescribed documentation to the AD on SMF shall be deemed to be the date of reporting of the transaction to RBI. In case the reporting form (whether in physical or electronic form) is incomplete, then the delay will continue till such time the form is received complete in all respects.
- In case of conversion (CCPS to equity), the conversion ratio should be in format as “CCPS: Equity”. Number of equity shares post conversion should be disclosed in documents.
- Foreign direct investment from an entity of a country, which shares land border with India or the beneficial owner of an investment into India who is situated in or is a citizen of any such country, shall invest only with the Government approval.
Reporting Timelines for Equity Investments into India
DI (downstream investment)
Within 30 days of date of indirect foreign investment
FC-GPR –FDI /LLP-I/ESOP
30 days from date of issuance of capital instruments (60 days to issue capital instruments from receipt of inward remittance)
FC-TRS/LLP-II for transfer of shares
60 days from date of remittance
Refund of excess/ non-allotment of shares
To be within 15 days from the date of completion of 60 days from the date of receipt of the consideration
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