8/28/2014 HowDebt&EquityWorkMustKnowforaStartupFounder

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Team YS | November 03, 2011 at 2:00 pm
How Debt & Equity Work while Restructuring a Failing
Startup; Must-Know for a Startup Founder
Lawyers at iPleaders tell us how
As per industry data, at least 70% of startups fail, and a large number
of these failures shut down when they run out of capital. Startups can
fail due to reasons completely out of control of the entrepreneur,
such as a bad business cycle (recession) or low market sentiment. For
example, the chain of retail shops called Subhiksha decided to shut
down its 1600 retail stores in 2009, as it could not meet its debt
obligations during the financial slowdown. However, another
company in the same sector Vishal Retail, which faced very similar problems managed to tackle its debt problem
and turned around in 2010. The crucial detail that made the difference was Vishal Retails conversion of some of its
debt into equity. Understanding of how debt and equity work, and knowing about the weapons available with the
company to troubleshoot issues with respect to capital by juggling debt and equity is a stupendous necessity for a
startup founder.
This post explains various choices available for restructuring debt and equity of the company, which may be
necessary for an entrepreneur as the company and the business treads the path of maturity. By reading this post, a
basic understanding of concepts such as warrants, convertible debentures and convertible preference shares and
mechanisms such as corporate debt restructuring, rights issue and preferential allotment can be developed. These
concepts are connected in the sense that all of these are often used by companies in distress to push off a debacle
into the future and/ or to raise more capital to make success more likely.
Someone in a startup needs to understand the legal framework and implications which constitute the context in
which a startup operates, and no, its not always safe to rely on investors to take care of this for you. This stuff is just
too important. At least one of the decision makers in the startup requires to understand this framework and if
necessary, should be able to explain it to the rest of the team.
Signs of failure
There are some obvious signs of failure. Typically, you can tell a startup is about to fail if -
(i) It is running out of cash. Paying interest of accumulated debt can often be suffocating for a company if it does
not generate enough profit. While a startup may not have raised debt capital or any form of serious debt, but may
just not have enough money to pay for its regular operational expenses like rent, bills, salaries and as such. This is
called a liquidity crunch.
(ii) It is unable to generate sufficient profits to repay its debt. Debt could be secured by a charge over the assets or
property of the company (or the personal assets and property of the entrepreneur), or they could be unsecured
(such as credit card debt). Banks and financial institutions typically lend to satrtups only on the basis of some form
of security. In any case, when a company finds itself unable to services its debts in form of regular interest
payments, even if for a short period of few months, its a crisis since the lenders can start legal action at this point.
(iii) Its valuation is not increasing fast enough. In its early phases, a startup needs to grow at much higher growth
rates than a blue chip company. For a blue chip company, growth rates of 10-20% per annum may be acceptable,
but startups in their initial stage may even grow at rates of more than 100% for a few years. Lesser growth maybe
unsustainable.
An entrepreneur should consider restructuring his business in cases (i) and (ii) above, as it runs the risk of being
declared insolvent by a Court. If it is declared insolvent, the business of the company will be wound up, its assets
will be sold off and the proceeds will be distributed amongst its creditors. In case the valuation of his current
business is not increasing at expected rates (see point (iii) above), selling some of the business to realize its existing
value could be considered. Selling a part of the business can also provide it with cash, which can be very helpful in
starting a new business line, given that makes business sense.
I. Typical components of a restructuring plan
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A restructuring will involve a change in the capital structure, by altering the amount of loans or debentures of the
company granted by its creditors, or through infusion of additional equity into the company. This part explains the
key components of a restructuring, and the factors an entrepreneur must keep in mind while formulating a
restructuring plan. The next part explains the legal mechanisms for bringing a restructuring plan into force.
A. What must an entrepreneur bargain for, and what must he offer, in a restructuring?
The company may propose to the lenders to accept less (or deferred) payment and possibly a lower rate of interest
in the short term. Creditors are typically offered certain optional or convertible instruments, that is, (i) warrants, or
(ii) convertible preference shares or debentures in return. Creditors understand that in the long term, helping the
company will improve their chances of recovering the loan. Banks hate to write off assets as non-performing assets
(or bad loans). However, the plan proposed by the promoter/ management will have to be convincing and credible.
Mechanics of warrants and convertible instruments
(i) Warrants: A warrant gives the option to a person (the warrant holder) to subscribe to a companys shares within
a pre-determined time frame, at a particular price. Warrants are really profitable for investors if the valuation of
the company improves in future, as they can buy shares for a cheaper price. Warrants are very common for public
companies, as investors can easily sell the shares to realize their profit. For a business owner, issuing warrants
offers the advantage that if the business does not achieve a certain valuation, new shares will not be issued, and
hence his shareholding does not get diluted.
Note: Entrepreneurs often understand warrants as share warrants under the Companies Act. The warrants
discussed above are different they simply provide the holder an option, or a right to subscribe to additional
shares by payment of a particular price in the future, which he may or may not exercise. These can be issued by
private or public companies. Share warrants on the other hand directly represent shares. They can be issued by
public companies only, and entitle the holder of the instrument to dividends on the shares. They are entirely
different from the warrants discussed in above.
(ii) Convertible instruments: Convertible preference shares or debentures change their character, and convert into
equity shares from debt upon the lapse of a fixed period of time (say, 5 years), or upon the happening of a certain
event. They may be compulsorily convertible, or optionally convertible. As in the case of warrants, conversion is
very profitable if the valuation of the company increases significantly.
For conversion, it is important to note the price at which lenders will be allowed to convert in future. A lesser price
implies that the investor will be able to get a large number of shares for his initial commitment. Depending on the
performance of the company, if the market price of the share at the time of exercise of the option is higher than
that stipulated in the contract, the investor can make a handsome profit.
For a creditor, an optionally convertible instrument offers the best of both worlds. If the company is not doing well,
he may opt to treat it as debt, and hence have a superior right on the amounts due to him, over other shareholders
of the company. Further, if the company does exceedingly well, it may be more rewarding for the creditors to
convert the debt / preference shares into equity, and realize higher gains, than be paid the limited interest on the
debt.
Note that optionally convertible instruments to a foreigner are treated as debt. Such instruments may be issued
only under very limited circumstances, if the entrepreneur is operating in specified sectors (which does not include
IT or ITeS, unless they operate in Special Economic Zones). An IT entrepreneur issuing optional instruments
entrepreneur issuing such instruments must bear this in mind.
If the company does not perform as per expectations post-restructuring, lenders may choose not to exercise the
option to convert and may subsequently redeem the preference shares or debt as they would have in the first place
(as far as possible given the solvency of the company). While this kind of a situation is not very profitable for the
creditor, it is often preferred over a situation in which no restructuring is attempted since driving a company into
insolvency does not necessarily recover all the debt.
C. What is the difference between preference shares and debentures if both convert into equity?
If a company is wound up, convertible preference shareholders whose shares are unconverted shall get their due
after convertible debenture holders (whose debentures are unconverted). Thus, holders of convertible preference
shares are subordinate to holders of convertible debentures. However, convertible preference shares have the
following benefits over convertible debentures for the investors:
(i) Participation in profits If the company makes profits, the preference shareholders shall, in addition to their
fixed rate of dividend, be entitled to the same dividend as ordinary shareholders (known as participation).
(ii) Voting rights In case of private companies (most startups are private companies), preference shareholders
may be granted voting rights.
Participation and voting rights can be ensured through appropriate documents, i.e. by drafting the investment
documentation, comprising shareholder agreements and articles of association appropriately.
This is a better option for them, compared to theirs not getting the full value of money owed to them, if they opt for
a full-fledged Court insolvency route.
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D. Sell your old failing business to clean up your books and raise some money
If a company changes its line of business, it makes sense for the company to look for buyers for its existing line of
business, or to transfer the existing line of into a new company. Spinning off the existing business into a new
company helps in selling it in future. The business may be sold to the lenders, or a strategic buyer. If the business is
sold for cash, it provides the company with much needed finance to manage its operations. Further, keeping the
businesses separate also ensures that the valuation of the existing line and the new line of business is independent
of each other. The sale may be done contractually through a process known as a slump sale in legal terminology, or
through a court approved process known as a demerger. While the slump sale process is much faster, it has high
tax implications.
II. Legal Mechanisms for restructuring
This part explains the legal mechanisms for bringing a restructuring plan into effect. The restructuring plan may
either involve a restructuring of debt, or an infusion of fresh funding, or a combination of both, that is, a proposal
could simultaneously restructure debt and be coupled with fresh funding commitments from lenders.
a. Mechanisms for restructuring of debt
A company may propose (a) conversion of loans into equity, convertible instruments, or a combination of both, or
(b) requesting deferred payments dates, or (c) reduced interested rates to its existing lenders (as discussed above)
in the following manner:
1. Restructuring under the Companies Act Under the Companies Act, a company (represented by the Board) can
initiate a restructuring with any of its shareholders and creditors, to modify their rights. The company needs to
draft and propose a scheme to each class of its shareholders and creditors. Equity shareholders, preference
shareholders, secured creditors, and unsecured creditors would each constitute different classes. The scheme
must be agreed by a majority in number of each class of shareholders or creditors (as applicable), and 75% of the
shareholders or creditors by value of the shares held or debt provided. After obtaining consent of each class of
shareholders and creditors, the company needs to seek the approval of the High Court of the State in which its
registered office is based. This is the most flexible form of restructuring, but since it requires approval of the High
Court, it may take at least 7-9 months, even in jurisdictions such as Mumbai, where corporate matters are decided
relatively quickly.
2. Corporate Debt Restructuring (CDR), which is a contractual mechanism, carried out under the framework of
the Reserve Bank of India guidelines. A company can initiate a CDR only if it is supported by a bank or financial
institution that has a 20% share in its working capital or term finance. As many startup companies do not have bank
finance in their initial stages, CDR is unlikely to be used by startups. Further, foreign lenders cannot participate in a
CDR scheme.
b. Mechanisms for taking additional funding by issuing equity or convertible instruments
A company could raise additional funding by way of equity, preference shares (participating, or with voting rights),
or convertible instruments, through the following procedures:
1. Rights issue The company may raise money by issue shares to its existing shareholders in proportion to their
existing shareholding, which is known as a rights issue. Note that this strategy cannot be used sustainably to
service payments. It should only be deployed to raise finance to service payments to lenders or provide for working
capital when the market sentiment is low or when the economy is slowing down, and the company believes that it
will be able to service debts comfortably from its own operations (and not by a further issue of shares) when the
market picks up.
2. Preferential Allotment A company may also issue shares to a new investor, through a preferential allotment.
This is done by passing a special resolution of the shareholders (that is, with a three-fourths majority). Bringing in a
new investor may provide the company with much needed finance when the confidence of the existing
shareholders is low. If the new investor is a strategic investor, he may also be able to help the company with his
prior expertise and networks.
Entrepreneurs Beware:
(i) Inducting a new investor may impose severe restrictions on the way you carry out your business, and hence it is
important to carefully go through the documentation and negotiate the terms of the investment.
(ii) If shares are issued to a foreigner, the Foreign Direct Investment policy (FDI Policy) must be complied with, in
terms of percentage of investment sought in the company and compliance obligations. For the information
technology sector, 100% FDI is allowed and no approvals are required under exchange control regulations.
However, there are compliance obligations that must be fulfilled under the FDI Policy. For example, an Indian
company must file a report on the receipt of the funding amount, and file form FC-GPR (along with prescribed
attachments) with the Reserve Bank of India (through its authorized dealer bank).
Takeaways for the entrepreneur
Note that this post has highlighted some of the legal nuances to guide an entrepreneur who is planning to
restructure the business. An entrepreneur must identify the reasons that are affecting his business (pointed out at
the beginning of this post), and calculate the amounts that are payable to decide whether he needs to opt for a
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the beginning of this post), and calculate the amounts that are payable to decide whether he needs to opt for a
restructuring. This will enable him to find out the options that can be mutually beneficial for lenders and the
startup. As there are chances that the company may still not be solvent, it is important to convince the investors or
creditors of the future plans and how the company will now be able to succeed where it once failed in the past.
About iPleaders
iPleaders was born out of an idea, and a realization. The realization
came while attempting to help a few entrepreneur friends with legal
work there is no proper, insightful and affordable legal service
offered to startup companies on the growth track. Law firms largely
focus on international and blue-chip clients, and litigators who go to
Court do not have a strong grasp of business law. Therefore, startups
are unable to hire quality business lawyers. The idea was to find
solutions through technology and products (law is so far only a service
industry in India). iPleaders has worked on developing resources to make law accessible through blogging,
educational products and interactive software. At present, it offers super-cheap incorporation, trademark
registration and a diploma course (jointly offered with a top law school in the country, NUJS) that teaches
entrepreneurs how they can handle legal issues affecting their business by themselves. Please check out their
website for further details.
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