The most popular way investors protect the value of their investments is by including anti-dilution rights in their investment agreements. Such rights prevent an investor’s shareholding from being diluted in a down round, that is when a company raises capital at a price lower than that paid by the investor. In such cases, investors have the right to require their original investments be repriced to ensure that they maintain their stake without having to make further contributions.
In India, anti-dilution rights are usually of two types, full ratchet or a broad-based weighted average. The full ratchet formula reprices the investor’s shares to match the price offered in the down round. The broad-based weighted average revises the price per share by calculating various factors such as the number and price of shares issued during the down round and the price at which the original investors invested. The resultant change in the company’s shareholding using a broad-based weighted average formula is more acceptable to founders and other shareholders than the full ratchet formula, which results in the heavy dilution of shareholders without the same protection.
The enforcement of antidilution rights faces legal and practical hurdles. The simplest way to give effect to antidilution rights is to incorporate the antidilution formula into the terms of the convertible securities such that the conversion price is automatically adjusted to ensure the investor acquires more equity on conversion. However, this may not be appropriate for foreign investors because, under the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (NDI rules), the conversion formula for all convertible instruments issued by an Indian company to a foreign investor must be determined upfront. Further, the NDI rules prohibit a foreign investor from subscribing to shares at a price lower than the fair market value. This prevents non-resident investors from adjusting their conversion price below the fair market value determined at the time of subscription to the securities.
Where investments are made at a premium, companies may adjust the conversion price up to the fair market value at the time of issue. Until recently, companies were discouraged from raising such investments at a premium because the companies would be liable to angel tax. The abolition of this tax from AY 2025-26 will allow companies and investors flexibility in pricing investments.
Where the conversion price cannot be adjusted, companies may honour their commitments by issuing shares via a bonus issue or, at the lowest legally permissible price, through a rights issue. However, Indian law requires that rights and bonus shares be offered to all shareholders of the company uniformly. Where anti-dilution rights are triggered for only some investors, giving effect to anti-dilution rights through rights or bonus issues may be difficult.
The NDI rules allow rights shares to be issued at a price lower than fair market value provided the same price is offered to both non-residents and residents. It is arguable that the benefit will be unavailable where only some investors participate in a rights issue leading to a disproportionate increase in shareholding, especially when such investors are non-residents.
The law requires a company to issue bonus shares from its free reserves, securities premium account or capital redemption reserve account, which may not be possible for loss-making companies undertaking down rounds to stay afloat. Further, where a bonus issue is not made proportionately to all shareholders, those benefitting from such an issue may face adverse tax consequences for having received shares at a price less than their fair market value.
Investors may try to purchase the shares of the founders at the lowest permissible price or the parties may agree that the founders will receive a lower return in any liquidation event. However, these options also attract adverse tax consequences and may be restricted under the NDI rules when the founders are residents and the investors are non-residents.
Parties must exercise caution when implementing structures for antidilution protection. When stakeholders look to enforce their rights disproportionately, building consensus and understanding the implications for the company and the various investors are key to assessing the risks involved.
Swathi Girimaji is a partner and Bhanusri Subramanian is an associate at Bharucha & Partners.
