Revisiting and Deciphering the Issue of Private Placement Vs. Issuance of Shares on Preferential Basis

Published on: 08-Aug-23

Read On: Bar & Bench

An early-stage start-up invariably comes across the quandary to decide amongst different modes of funding namely traditional equity financing, debt-financing and convertible equity financing. The concerns and priorities of all start-up companies lie in the following -

(i) raising the funds through a mode and instrument which is not only commercially viable in terms of returns and rights to be given to the investors, but also entails the minimum or no dilution of founders’ stakes and incurs nominal cost of compliances and of course on

(ii) how expeditiously the fund-raising rounds can be concluded and funds raised thereof can be put to use by the companies.

In light of the above, a start-up incorporated as a Private Limited company has the option to raise funds from current shareholders, promoters, and other investors namely PE/VC funds, family, and friends through varied instruments and procedures provided under the Companies Act, 2013 (“Act”). Moreover, a majority of the changes have been made to the Act since 2013 to make the process more transparent and get rid of conflicting clauses. However, there is one issue that still arises in every fundraising transaction as to when and how conditions and compliances mentioned under Section 42 and Section 62 of the Act will get attracted.

The need to interpret the distinction between the aforesaid sections of the Act is critical from the standpoint of the effective fulfillment of all the conditions and adherence to the compliances required under the Act. These sections require the undivided attention of the companies as well as the professionals advising these companies as any non-compliance in this regard can render the fundraising be construed as a public issue and can invite penalties equivalent to the value of the funds raised or ₹2,00,00,000/-, whichever is higher and the company will have to refund all money within a period of 30 days of the order imposing such penalty [Section 42(10) of the Act].

In pursuance of the same, we will analyse and clarify the ambiguities in compliances as provided under the Act as follows:

  • Kind of Securities - Section 42 of the Act deals with the Private Placement of securities of a company. As the name suggests, it is a method of placing the securities of the company privately to identified persons not exceeding 50 in a single offer and 200 in a single financial year. This offer has to be made only through a private placement offer letter (PAS-4) duly authorized by the board and shareholders of the company. Whereas the concept of Issuance of shares on a preferential basis which, interestingly, is not discussed in Section 62 of the Act but in Rule 13(1) of Share (Capital and Debenture Rules), 2014, which when read together with Section 62(1) (c) of the Act provides for an increase in subscribed share capital through the issuance of shares or other securities to a select group of individuals which may or may not include existing members or employees of the company. The instruments being available for issuance under aforesaid provisions are limited to “shares and other securities” which means to include equity shares, fully convertible debentures, partly convertible debentures or any other securities, which would be convertible into or exchanged with equity shares at a later date. However, the term “securities” as specified under Private Placement is to be construed as per the definition provided under Section 2(h) of the Securities Contract (Regulation) Act, 1956, which is wider in scope and does not limit to equity and convertible securities.

Analyzing the provisions and rules made thereunder, it can be concluded that:

  1. Where a start-up intends to raise funds either through shares or any other convertible securities (CCPS, CCDs, etc.) to persons identified by the board which may or may not include existing shareholders or employees on preferential terms, then it will be construed as Issuance of shares on preferential basis and such issue will be governed by Section 42, 62(1)(c) of the Act read with Rule 13 (1) of the Companies (Share Capital And Debentures) Rules, 2014 and Rule 14(1) of Companies (Prospectus and Allotment of Securities) Rules, 2014.

  2. Where a start-up is increasing its capital through a rights issue, it will not be construed as the Issuance of shares on a preferential basis and such issue of shares will be governed by Section 62(1)(a) of the Act.

  3. Where a start-up is raising funds through non-convertible debentures on private placement basis, it will be governed by Section 42 of the Act read with Rule 14(1) of Companies (Prospectus and Allotment of Securities) Rules, 2014 and Rule 18 of the Companies (Share Capital and Debentures) Rules, 2014

  4. Where a start-up desires to issue shares to its employees, it will be governed by Section 62(1)(b) of the Act and Rules 12 of the Companies (Share Capital and Debentures) Rules, 2014.

Therefore, any issue of securities that are not explicitly excluded from the definitions stipulated under explanations to Rule 13 (1) of the Companies (Share Capital and Debentures) Rules, 2014 will have to adhere to compliances mentioned in Section 42, 62(1)(c) of the Act read with Rule 13 (1) of the Companies (Share Capital and Debentures) Rules, 2014 and Rule 14(1) of Companies (Prospectus and Allotment of Securities) Rules, 2014 and other applicable rules depending upon the nature of securities and category of investors in order to avoid penalties mentioned under the Act.

Hope this article explains the interplay and distinction between Section 42 and Section 62 of the Companies Act, 2013. The compliances under both sections are amply clear in terms of conditions and procedural requirements based on the nature of securities that are being offered to raise funds.