The initial public offering of Facebook is talked about among different people for different reasons. For members of the legal profession, the most interesting aspect of the saga was the issue of control which the promoters held, in particular Mark Zuckerberg.
The interesting thing is this: Mark Zuckerberg because of all the dilution thus far holds less than 30% equity share capital but has around 56% voting rights in the Company. This majority control has been obtained through the issue of shares with differential voting rights.
Logic behind shares with preferential voting rights
In corporate law equity shares represent ownership of a company. As a holder of an equity shares, a person is entitled to certain rights. For instance, every shareholder gets voting rights and when the Company declares dividend, is entitled to dividend payments as well.
Simultaneously, certain liabilities arise. Namely, at the time of liquidation, the claims of an equity shareholder come after the claims of secured debtors, unsecured debtors and preference share holders.
With the advancement of corporate law and finance and as business became more and more complicated with the evolution of private equity, mergers and acquisitions, strategic investments and hostile takeovers, it became necessary for promoters of companies to protect their interests from the enemies at their gates.
With each investment into a company, the interests of the promoters also reduced proportionately, making it difficult for promoters to exercise their influence in a company and also paving way for hostile takeovers.
Hence the balance was struck…
The balance was struck by promoters issuing themselves a certain class of shares which were more rewarding than the others. The holders of such class of shares had more voting rights than the holders of the normal class of equity shares. These are known as shares with differential voting rights.
How can one issue shares with differential voting rights?
This can be achieved by dividing the equity share capital of a company into two or more classes. Each class will hold a predetermined ratio with respect to voting, for example:
Class A shares, one (1) equity share is equal to one (1) vote
Class B shares, one (1) equity share is equal to two (2) votes
Class C shares, one (1) equity share is equal to three (3) votes
The law in relation to issue of shares with differential voting rights in India is governed by Companies (Issue of Share Capital Differential Voting Rights) Rules, 2001, as amended, read with the Companies Act, 1956, as amended.
Issue of shares with differential voting rights can be done, by any company, if they satisfy certain conditions including that:
(a) the company has distributable profits for three (3) financial years preceding the year on which it was decided to issue such shares,
(b) the company has not defaulted in filing annual accounts and annual returns for three financial years immediately preceding the financial year in which it was decided to issue such shares.
Companies cannot therefore upon their incorporation issue shares with differential voting rights and will have to have waited for at least three (3) years to issue such shares, provided that they have issued dividend for all those three (3) years.
The initial years are very crucial for any start-up and with each round of investment the effective holding of the promoters goes down significantly and therefore it may become necessary to issue shares with differential voting rights to protect the interests of the promoters, while at the same time it is also essential that the investors in the company are brought on board, prior to making any such decision.
[About the author: Contributed by Hrishikesh Datar, founder of vakilsearch.com, online legal services provider (Legal Advice, Legal Documents & more.]
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