Exit Strategy- How Startups can use buyback for Investor Exit

Case Study- Promoters of Unicorn Startup Private Limited (referred to as “the Company”) started with 80,000 shares of Rs 10 each. On 2017-18, it raised seed fund of Rs. 1 crore at a valuation of Rs 5 crore from Mr. A, an Individual Angel Investor residing in India. It issued 20,000 equity share having face value of Rs. 10 each at a premium of Rs. 490/- per share amounting to Rs. 1 Crore thus taking the paid up capital to Rs. 10,00,000 divided into 1,00,000 equity shares of Rs. 10 each.

During the financial year 2019-20 the Company received Rs. 5 Crore from Mr. B at a valuation Rs. 25 crore. Now, Mr. A now wants to exit form Unicorn Startup Private Limied and want the promoters to provide him with exit strategy.

Exit Strategy- How Startups can use buyback for Investor Exit

 

How can Mr. A exit from the company?

There are 2 ways by which Mr. A can get exit from Unicorn Startup Private Limited

1. A can voluntary transfer his Shares to one or more existing Shareholders or to any person agreed to purchase shares of Unicorn Startup Private Limited. In this case, Mr. A has to report to the Company and should get into an agreement of sale of shares with other party. Along with that Mr A. has to follow the process of executing share transfer form.

2.Unicorn Startup Private Limited can make selective buy back of its shares from existing shareholders. Buyback is one of the most common option but to comply with it we need to understand and follow certain legal nuances of the regulations around this.

 

What is buyback?

Buyback means repurchase of shares. In this case Company purchases its own shares from existing shareholders. However, it is to be noted that buy back can happen only from specific fund.

 

 Why Buyback is gaining popularity?

1. Buyback gives a smoother exit option to the existing investor as they don’t have to search for any third party VC Firm to buy out its stake.

2. If the Company has excess reserves but doesn’t have any foreseeable utility of these funds, this process helps the company use its excess money without the hassles of finding a buyer for the shares.

3. Buy back of shares and securities helps the promoters to formulate an effective defensive strategy against hostile takeover from competitive firms or from organization with whom the promoters are not comfortable working.

 

Sources of fund through which a company can pay out the investors for buyback:   

A Company can purchase its own shares or other specified securities (referred to as buy back) only out of-

1.Its free Reserves;OR
2.the Securities Premium; or
3.the proceeds of the issue of any shares or other specified securities:

However, no buy back shall be made out of the proceeds of an earlier issue of the same kind of shares or same kind of other specified securities.

 

Conditions to be considered by Unicorn Startup Private Limited

1.Percentage of Buy back of shares should not exceed 25 % of the aggregate of the total paid up capital and free reserves of the Company.

2.Ratio of the aggregate of secured and unsecured debts (like loan from bank, creditors, directors) owed by the company after buy back should not be more than twice the paid up capital and free reserves (Debt Equity Ratio shall not be more than 2:1)

3.Shares or other specified securities for buy back should be fully paid up.

4.In case the company opts to go for buy back out of free reserves/securities premium account a sum equal to nominal value of the shares so purchased shall be transferred to the capital redemption reserve account and appropriate disclosures should be made in the Balance Sheet. In this case 2,00,000 (20,000 shares X Rs 10) should be transferred by the company so as to buy back shares of Mr A.

5.Every Buy back shall be completed within a period of one year from the date of passing of the Board/ Special resolution.

6.Articles of Association of the Company shall contain an enabling provision for buy back of shares

7.A special resolution must be passed at the general meeting of the company. 
Special resolution is not required, provided [proviso to sec. 68(2)(b)]:

8.buy-back is 10% or less of the total paid-up equity capital and free reserves of the company; and

9.buy-back is authorised by a board resolution passed at its meeting.

 

Restrictions on Buy-Back:

Unicorn Start-up Private Limited will not be permitted Buy-back if buy back is made:

1.through any subsidiary company,
2.through any investment company or group of investment companies, or
3.the company has defaulted in repayment of deposit or interest thereon, in redemption of debentures or preference shares or in payment of dividend to any shareholder, or any term loan or interest payable thereon to any financial institution or banking company;

However the buy-back is not prohibited, if the default is remedied and a period of 3 years has lapsed after such default ceased to subsist;

4.if the company has not complied with the provisions of sections 92 (annual return), 123 (declaration of dividend), 127 (dividend declared but not paid) and 129 (financial statements) of the new act.

 

Procedure of Buyback to be followed by Unicorn Startup Private Limited:

A.The company which has been authorized by a special resolution shall, before the buy-back of shares, file with the Registrar of Companies a letter of offer in Form No. SH.8 (to be signed by 2 directors), along with the fee

B.Filing of Form MGT-14 for Board / Special Resolution authorizing Buy back.

C.Along with the letter of offer, a declaration of solvency in Form No. SH.9 along with the fee and signed by at least two directors of the company, one of whom shall be the managing director, if any, and verified by an affidavit as specified in the said Form.

D.The letter of offer shall be dispatched to the shareholders or security holders immediately after filing the same with the Registrar of Companies but not later than 21 days from its filing with the Registrar of Companies.

E.The offer for buy-back shall remain open for a period of not 15- 30days from the date of dispatch of the letter of offer.  [“Provided that where all members of a company agree, the offer for buy-back may remain open for a period less than fifteen days.”]

F.The company shall complete the verification of the offers received within 15 days from the date of closure of the offer and the shares or other securities lodged shall be deemed to be accepted unless a communication of rejection is made within 21 days from the date of closure of the offer.

G.The company shall immediately after the date of closure of the offer, open a separate bank account and deposit therein, such sum, as would make up the entire sum due and payable as consideration for the shares tendered for buy-back in terms of these rules.

H.The company shall within 7 days of the expiry of 21 days from the date of closure of the offer, has to:

(a) make payment of consideration in cash to those shareholders or security holders whose securities have been accepted; or

(b) return the share certificates to the shareholders or security holders whose securities have not been accepted at all or the balance of securities in case of part acceptance.

I. The company shall ensure that—

(a) the letter of offer shall contain true, factual and material information and shall not contain any misleading information and must state that the directors of the company accept the responsibility for the information contained in such document;

(b) the company shall not issue any new shares including by way of bonus shares from the date of passing of special resolution authorizing the buy-back till the date of the closure of the offer under these rules, except those arising out of any outstanding convertible instruments;

(c) the company shall confirm in its offer the opening of a separate bank account adequately funded for this purpose and to pay the consideration only by way of cash;

(d) the company shall not withdraw the offer once it has announced the offer to the shareholders;

(e) the company shall not utilize any money borrowed from banks or financial institutions for the purpose of buying back its shares; and

(f) the company shall not utilize the proceeds of an earlier issue of the same kind of shares or same kind of other specified securities for the buy-back.

J.The company, shall maintain a register of shares or other securities which have been bought-back in Form No. SH.10

K.The Company, after the completion of the buy-back under these rules, is required to file with the Registrar, a return in the Form No. SH.11 along with requisite fees, within 30 days of such completion. Further, a certificate in Form No. SH.15 duly signed certifying that the buy-back of securities of the company has been made in compliance with the provisions of the new Act and the rules made there under is required to be annexed to the return filed with the Registrar in Form No. SH.11.

 

Is there any compliance post Buy Back of Shares?

1.Shares and other securities certificate so bought back has to be extinguished and physically destroyed within 7 days of the last date of completion of buy-back.

2.Further issue of same kind of shares or other securities cannot be made by the company for a period of 6 months except for:

a.bonus issues, or
b.discharging subsisting obligations like conversion of warrants, stock option schemes, sweat equity or conversion of preference shares or debentures into equity shares.

 

What Tax implications will fall on the Unicorn Startup Private Limited and Mr. A?

 

Applicability of Income Tax on Company – Unicorn Startup Private Limited

  1. As per Section 115QA the domestic company shall be liable to pay additional tax at a rate of 20% on any amount of distributed income by the company within fourteen days from the date of payment of any consideration to the shareholder on buy-back of shares. Now, the question arise “What is distributed income?”

“distributed income” means the consideration paid by the company on buy-back of shares as reduced by the amount which was received by the company for issue of such shares.” 

 

Applicability of Income Tax on Shareholder – Mr. A

In case shares are unlisted then the capital gain becomes exempted from any sort of taxes as per provisions under Section 10(34A) in the hands of the shareholders.

 

Through this case study we have tried to highlight the various tax and legal implication of buyback. If you want us to help you in regards to buyback or designing your exit strategy please reach out to info@taxmantra.com

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