INTRODUCTION
The Indian startup ecosystem has grown from strength to strength in the past decade. Foreign investment has been a major catalyst in driving this growth. In 2019-23, Indian startups have raised $100 billion, with 15% of the said investment sourced by domestic investors and the remaining 85% sourced by the foreign investors. The heavy dependency on foreign capital demands a conducive legal framework to fuel this growth or at least maintain the status quo.
The landscape of foreign investment in India is governed by a complex interplay of regulations. Within the bounds of law, the foreign investors employ various tools of investing to mitigate the risks, bridge the gaps, and maximize the return. One such tool is tranche investment, a strategic approach adopted by foreign investors to stagger their capital infusion. Foreign investors seeking to invest in India often encounter complexities in structuring their investments, particularly when it comes to timing capital infusions. Tranche investments offer a flexible approach to mitigate these challenges. However, understanding the nuances related to Indian foreign investment regulations is crucial to ensure compliance and maximize investment benefits.
TRANCH INVESTMENT—MEANING
Tranche investment is a form of investment wherein funding is provided to the company and/or startups in a staggered manner subject to the fulfilment of certain conditions that may be linked to the revenue/EBITDA of the company, or some approval from a relevant governmental body, or related to the hiring of some key official equipped with some unique talent. The conditions could be anything and/or could be a mixture of various commercial terms.
During a tranche investment, the total committed amount by the investors is often spread into 2, 3, 4, or as many tranches as investors and companies deem fit to support their investment thesis. There can be time gaps between each tranche, which could range from 1 month to 48 months, subject to the commercial viability of the investment.
In the case of a foreign investor, this time frame poses certain challenges, and breaking investment into tranches can lead to some additional compliance or working on tight timelines.
INDIAN EXCHANGE CONTROL LAWS
Foreign investments in India are primarily governed by (a) the Foreign Exchange Management Act, 1999 (FEMA) and the regulations issued by the Reserve Bank of India (RBI) thereunder (which include the Foreign Exchange Management (Non-Debt Instrument) Rules, 2019); and (b) the consolidated policy on Foreign Direct Investment (FDI Policy) issued annually by the Department of Industrial Policy and Promotion (collectively “Indian Exchange Control Regulation”).
Types of instruments that can be issued to a foreign investor
In accordance with the Indian Exchange Control Regulations, foreign direct investment (“FDI”) by a non-resident can be made only through the acquisition of capital instruments of an Indian company. Capital instruments are equity shares or instruments that are fully, mandatorily, and compulsorily convertible into equity shares of a company, such as compulsorily convertible debentures and compulsorily convertible preference shares.
Pricing Guidelines
Investment can be made by acquisition of capital instruments issued by the Indian company, subject to compliance with the pricing norms on entry and exit price for foreign investors under the Indian Exchange Control Regulations (“FMV Rule”).
A foreign investor cannot acquire capital instruments of an Indian company (through a subscription or purchase from a resident) below the fair market value (“FMV”) and cannot exit (by way of a sale to a resident) above the FMV. Pricing guidelines do not generally apply to transfers amongst foreign investors. The FMV (for private companies) should be certified by a Securities and Exchange Board of India-registered merchant banker or a chartered accountant and computed as per any internationally accepted pricing methodology.
Valuation Report
As per Indian Exchange Control Regulation, the valuation certificate issued by a Chartered Accountant or a SEBI-registered Merchant Banker or a practicing Cost Accountant, for application of pricing guidelines, must not be more than 90 days old as of the date of the investment (“Valuation Requirement”).
Other Restrictions
Foreign investment in a number of sectors is permitted up to 100% under the automatic route, subject to conditions specifically prescribed under the Indian Exchange Control Regulations. However, in some sectors it is completely prohibited. The onus of complying with the foreign investment limit is generally on the Indian company receiving the foreign investment.
There are further government approval requirements under the Indian Exchange Control Regulations on investments from certain non-resident investors that are residents of or are incorporated in a country that shares land borders with India, or where the beneficial owner of such investments in India is situated in such a country.
Deferred Payment
The Indian Exchange Control Regulation allows, in the case of a transfer of equity instruments between a person resident in India and a person resident outside India, an amount not exceeding 25% of the total consideration, may be paid by the buyer on a deferred basis within a period not exceeding 18 months from the date of the transfer agreement.
STRUCTURING TRANCHE INVESTMENTS
Scenario 1
The foreign investor acquires 1000 shares of an Indian company and pays 75% of the consideration upfront with a deferred earn-out component of 25% payable in 18 months from closing.
Let’s assume the commercially agreed price of the 1000 shares is INR 10,000, and the FMV of the share is INR 8,000 as per the valuation report. The following becomes relevant.
- As per the regulatory extracts produced above, any transfer between a resident and a non-resident cannot be less than FMV.
- The valuation report determining the FMV cannot be older than 90 days as of the date of investment.
- Therefore, the first tranche of investment for acquiring the shares shall not be less than INR 8,000, as that is the FMV in accordance with the valuation report. Irrespective of the fact that 75% of the commercially agreed price would be INR 7,500.
Let’s assume the commercially agreed price of the 1000 shares is INR 10,000, and the fair market value of the share is INR 6,000 as per the valuation report. The following becomes relevant.
- The FMV Rule and Valuation Requirement continue to apply.
- However, since the FMV is INR 6,000, the deferred amount cannot be INR 4,000. It could be 25% of the commercially agreed price, i.e., INR 2,500. Hence, the first tranche shall be of INR 7,500 and deferred consideration of INR 2,500.
Scenario 2
The foreign investor acquires 1000 shares of an Indian company. In the first tranche, the foreign investor will acquire 900 shares, and in the second tranche, it intends to acquire the remaining 100 shares.
Let’s assume the FMV of 1000 shares of the Indian company is INR 10,000, i.e., INR 10 per share, as per the valuation report. The FMV of 900 shares is INR 9,000, and the remaining 100 shares are INR 1,000.
If the foreign investor decides to acquire 900 shares in the first tranche and the remaining 100 shares in another tranche on a commercially agreed price of INR 10,000. The following becomes relevant:
- The FMV Rule and Valuation Requirement continue to apply.
- The foreign investor will be required to make a payment of INR 9,000 to acquire the 900 shares.
- If the remaining 100 shares are acquired within 90 days of the issuance of the valuation report, then the pricing of the remaining 100 shares would be INR 1,000.
- If the remaining 100 shares are acquired after 90 days of issuance of the valuation report, the following becomes applicable:
- A new valuation report shall be obtained to determine the fair market value of the remaining 100 shares.
- The fair market value of shares acquired in the first tranche will operate as a floor, i.e., INR 10, due to regulatory guidelines that ensure Indian residents cannot sell shares to non-residents below the prevailing FMV at the time of the transaction. Therefore, if the revised FMV, after the new valuation report, is INR 12. The remaining 100 shares shall be transferred at a price of INR 1200, i.e., INR 12/shares.
Scenario 3
The foreign investor acquires 1000 shares of an Indian company upfront and decides to make the payment for those shares in a staggered manner over four tranches.
Let’s assume the FMV of 1000 shares of an Indian company is INR 10,000, i.e., INR 10 per share, as per the valuation report. The commercially agreed price for 1000 shares is INR 13,000. The foreign investor decides to make the payment in four tranches.
The foreign investor will make the payment for 1000 shares in the following manner:
- First Tranche: INR 10,000
- Second Tranche: INR 1,500
- Third Tranche: INR 500
- Fourth Tranche: INR 1,000
In the aforementioned instance, the following becomes relevant:
- The FMV Rule and Valuation Requirement continue to apply.
- The foreign investor has made payment equivalent to FMV, i.e., INR 10,000, in the first tranche.
- With respect to each of the subsequent three tranches, since this would be a payment above the FMV, there is no regulatory floor price applicable on such payments. Hence, the payment made in the remaining tranches is in compliance with Indian Exchange Control Regulations.
CONCLUSION
There can be various ways of financing an investment, and various combinations can be used to achieve a desired result. However, the basic tenet of law shall not be violated while undertaking those creative methods. The Indian Exchange Control Regulation is based on a fundamental principle that the outward flow of money shall not be above the regulatory fair market value and the inward flow of money shall not be below the regulatory fair market value. These rail guards protect investments in India and Indian investors.
The investors are often tempted to predetermine the value of the company for the next two years in the term sheet dated as of today. Such practices are not legally kosher and shall be avoided at all costs. It is advisable that a fresh valuation shall be undertaken at the time of making the investment, and the investment shall be made as per the said valuation report and in accordance with the applicable law.
While working on creative solutions, it shall be understood that “what cannot be done directly cannot be done indirectly.”.
About the author:
Chaitanya Kumar Verma is an advocate, licensed to practice in India. Chaitanya has more than 3 years of experience with leading tier I law firms like Shardul Amarchand Mangaldas and Trilegal. He has executed various cross border merger and acquisition deals which are available in public domain. Chaitanya currently works as a legal manager for Guild Capital, a US based venture capital firm. Chaitanya continues to leverage his extensive knowledge and strategic acumen to navigate the evolving realms of venture finance.
