Why differential voting rights are a step in the right direction for the Indian startup ecosystem
For a long time now, Indian entrepreneurs have been demanding differential voting rights (DVR) to fend off hostile takeover bids and avert mounting pressure from investors. And yesterday, the Indian startup ecosystem entered a new era of corporate governance as capital markets regulator Securities and Exchange Board of India (SEBI) approved a new framework for issuance of DVR by tech companies, starting July.
Under the new framework, a tech company with superior voting rights shares (SR shares) "can do an initial public offering of only ordinary shares to be listed on the main board," SEBI chairman Ajay Tyagi said on Thursday.
Indian startup founders and investors welcomed the latest move by SEBI, saying greater clarity around DVRs framework will provide a further boost to the Indian entrepreneurial ecosystem and encourage fast-growing Indian tech startups to go public.
Bhavish Aggarwal, Co-founder and CEO of Indian transportation major Ola, said, “(We) welcome SEBI's move to allow differential voting rights for Indian tech companies. I’m certain this will encourage Indian companies to list within the country, backed by our own people. Made in India businesses and entrepreneurs can control their destiny and build for the world!”
Echoing Bhavish, Harshil Mathur, Co-founder of Bengaluru-based payments startup Razorpay, said,
"Overall, we welcome the move by SEBI to approve the framework on Differential Voting Rights (DVR) for startups. However, we believe the restrictions will need to be relooked at over time to make the best use of this development. This is something we have always been advocating, especially for tech companies.”
The founders of Razorpay, which this month raised $75 million as a part of its Series C funding from Ribbit Capital and Sequoia India, have reportedly amended their board rights so that each of them holds two votes for each of their board seats, while investors hold one vote per board seat. This gives founders Harshil Mathur and Shashank Kumar majority control of their board for every resolution, including removal or appointment of a CEO.
A recent report by Reserve Bank of India (RBI), Expert Committee on Micro, Small and Medium Enterprises, hinted at a dual class share structure. The panel on SMEs suggested that most technology or high-growth startups are often loss making, which is why there should be no profitability requirement to list.
The panel, led by former SEBI chairman UK Sinha, also said that SEBI should facilitate “dual class share structure”, which is popular with tech startups across the world.
What are DVR shares?
But what exactly are DVR or SR shares, and how do they impact startups?
Differential voting rights (DVR) are similar to ordinary equity shares, except for one important difference: DVR shareholders have fewer voting rights as compared to the rights of an ordinary shareholder.
This is important in companies where founders are keen not to dilute control over their businesses. DVR will ensure that startups can raise capital without putting themselves at the risk of a hostile takeover. This is much needed, according to startups, as typically founders would have diluted their stake during a fund raise.
SEBI’s new framework is only applicable if:
- the issuer company is a tech company intensive in the use of technology, information technology, intellectual property, data analytics, bio-technology , or nano-technology to provide products, services, or business platforms with substantial value addition.
- the SR shareholder is a part of the promoter group, whose collective net worth does not exceed Rs 500 crore.
- the SR shares have been issued only to promoters/founders who hold an executive position in the company.
- the SR shares have voting rights in the ratio of minimum 2:1 to maximum 10:1, compared to ordinary shares.
So, why is it important now?
Earlier this year, the Indian IT sector saw engineering major Larsen and Toubro (L&T) launching a hostile takeover bid for Bengaluru-based software services provider Mindtree Ltd.
Mindtree rejected L&T’s hostile takeover bid, saying the deal would not create value for its shareholders of the company. However, just this week L&T gained a controlling interest in Mindtree, Ltd, raising its stake to 60 percent concluding India’s first hostile takeover of a software developer. L&T now has complete control over the company’s board and management.
L&T adopted a three-pronged approach to acquire a controlling stake of 66.15 percent in Mindtree for around Rs. 10,700 crore:
- It agreed to buy the 20.30 percent stake owned by Café Coffee Day Founder VG Siddhartha, Mindtree’s largest stakeholder
- It placed an order with brokers to buy an additional 15 percent stake from the open market
- On May 14, it will launch its open offer for another 31 percent stake.
While the takeover was playing out, Krishnakumar Natarajan, Executive Chairman of Mindtree, in an exclusive interaction with YourStory Founder and CEO Shradha Sharma, spoke candidly about founders’ inability to hold superior voting rights after going public.
“Entrepreneurs need to make a conscious choice about the investors they choose; they should focus on exit clauses and they should protect their and the company’s interest. If an investor is making an exit (for the enterprise), the entrepreneur should get the right of first refusal. Even in Mindtree’s case, when we raised (capital) the clauses were there, but when you become public these clauses end. While principally the clause is there, practically they cease to exist.”
He added that the startup ecosystem needs to offer protection to the founder, who is the “steward of the company”, versus the investor, who is just the “economic owner” of the enterprise.
“To me, the investor is the economic owner and he comes for returns and economic value, but the founder is the steward of the company. It cannot be that the economic owner ousts the steward unless things are going visibly wrong,” Krishnakumar said.
He added that “any external intervention that takes away any piece of that will in turn result in not such great value being delivered for our shareholders”. However, despite his stance, in the absence of DVR, Mindtree had no option but to acquiesce to L&T.
Entering a new era
But the clouds over the startup ecosystem have now parted to reveal a silver lining, and entrepreneurs believe that DVR will usher in a new era of corporate governance in Indian startups.
Like Ola’s Bhavish Agarwal and Razorpay’s Harshil Mathur, startups across the board have welcomed SEBI’s decision.
Amit Kumar, CEO and Co-founder of real estate startup NoBroker, said,
“This is a significant and positive move for startups in India. All of us know DVR helps startups in US. Now, it will enable Indian founders of tech startups to retain voting control while they raise capital.”
NoBroker this month announced that it had raised $51 million as a part of its Series C round led by General Atlantic and with participation from existing investors SAIF Partners and BEENEXT.
However, it is also important to understand scenarios where the DVR mechanism should kick in, say experts.
Sanjay Swamy, Managing Partner, at early-stage venture capital firm Prime Venture Partners, said:
“In principle, this is a positive move for the Indian founder and it is a step in the right direction. But as an ecosystem now we need to come and understand where DVR makes sense and where it doesn’t. It's time the ecosystem comes together and forms standard terms, and provides founders with what is fair and reasonable.”
He added: "Additionally, the legal ecosystem (for Indian startups) has come together to set and publish best practices based on fairness, common sense, consistency and transparency. Too much happens based on what one can negotiate, and where it makes sense and where it is really required should drive the exceptions."