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

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 company's 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.

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 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.