In the previous blog, we talked about unlisted shares and looked at the canvas of unlisted shares in detail. We have seen that many companies remain private, and their shares are not easily tradable. Private limited companies are closely held with less than 200 shareholders. A private limited company is considered to be a “closed” entity and is guided by the article of association (AOA). Private limited companies have restrictions on transfer of shares and are prohibited to invite the public to subscribe to any securities of the company (as per section 2(68) of Companies Act, 2013). Private companies have the privilege of restricting share transfers, allowing them to control ownership.
In a private limited company, shareholders hold the authority to determine the ownership of the company, which is governed by the AOA. Shareholders ability to sell a portion or all their stake in the company is based on conditions in the AOA governing transferability of shares, pre-emptive rights, and directors' power to deny. In this blog we will explore the process and considerations involved in transferring shares within a private limited company.
Secondary Transactions of Private Limited Companies
While the companies are governed by the AOA, Shareholders Agreement (SHA) is a comprehensive definitive agreement entered into by shareholders and the company and outlines the rights, preferences, and obligations of all the shareholders. A Share Purchase Agreement (SPA) is executed between parties when one party is buying or ‘purchasing’ shares from existing shareholders. The transfer of the title of a share by one party to another is referred to as the transfer of shares. While there are certain restrictions imposed on the transfer of shares in a Private Limited Company, it is still possible. This often refers to secondary transfer of shares or secondary market transactions. A secondary market transaction is when shareholders of a company sell their stock to another investor. There are several reasons why secondary transfers of shares may happen (liquidity needs, diversification of portfolio, fundraising for the company, Merger and Acquisitions (M&A), and/or change in company strategy). While the reasons could be any, secondary market transactions are limited, as unlike the public stock markets there is no centralized market infrastructure for secondaries. Thus, the matching of the demand and supply in secondary markets is more opaque, less accessible, and less liquid than public markets. Despite these challenges and the restrictions on transfer of shares in the AOA or SHAs, secondary transactions feature regularly among early investors, founders, and VC/PE funds.
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How to Invest via Secondary Transaction in Private Companies?
These are the steps involved in investing via a secondary transaction.
- Intention to Sell – There are companies looking to give exits to their early investors or provide liquidity to Employee ESOPs (Employee Stock Option) via secondary transactions and there are investors (early investors into companies) looking for liquidity. An existing shareholder chooses to sell their shares, driven by their own specific reasons. This seller gives a notification to the company about the transfer of shares. Subject to the rights owned by the shareholders in the SHA (ROFO/ROFR and other shareholder rights), other existing shareholders of the company are notified about the availability of shares and the price at which it is available and the time limit within which they should communicate their willingness to purchase. If none of the existing shareholders come forward to purchase the shares, the company is bound to go ahead with the transfer. Given the restrictions there are only a few sources of private companies shares viz., Investment banks and a few closed online platforms (with restricted access).
- Discovery & Termsheet – For investors seeking investments into private companies, the process begins with identifying potential companies and a mandate from a willing seller. Investment banks, brokers, and a few invite-only online platforms act as intermediaries, possessing mandates from companies or investors seeking exit opportunities for investment. Most of these opportunities tend to be bigger ticket size and are usually restricted to Institutional Investors, Family Offices, or High Net-worth Individuals (HNIs). Investors can evaluate the companies working with intermediaries. These intermediaries should help with the evaluation process for buyers, interact with sellers, negotiate, and deal. Further, upon signing the NDA (Non-Disclosure Agreement) investors may be able to get access to in-depth information about the company comprising deal collaterals. Deal collaterals may include company information, market data, public data and comparables to help you make an informed investment decision. Often a Term-sheet is signed between buyer and seller to express the intent to transact. A Term sheet is generally only a ‘firm intent to invest’ by the investor with the defined terms. It is an abridged and non-binding version of the eventual SPA/SHA that the parties would sign. There is a maximum period of acceptance of a termsheet when an investor issues it. There is also a maximum time to close the deal (in many cases it is the execution of definitive documents) which could be 8 to 12 weeks. If sellers do not accept or close the deal in these cases, the termsheet becomes invalid and buyers have the right to walk away.
- Share Purchase Agreement (SPA) - The second step is to finalize the transaction by signing a Share Purchase Agreement (SPA). After identifying the appropriate company and willing seller, the agreement becomes a crucial document in the buying process. It is a binding contract between the investor seeking to purchase shares in a private company and the existing shareholder(s). The SPA is a legally enforceable agreement outlining the share sale's terms and conditions. Furthermore, the document covers warranties and representations provided by the seller, ensuring that the information about its shares is accurate and reliable. This section safeguards the buyer's interests by minimizing potential risks and uncertainties associated with the purchase. The SPA encompasses other essential transactional details, such as payment terms, dispute resolution mechanisms, confidentiality clauses, and any additional covenants or agreements between the parties. Within the SPA, several key components are detailed to ensure clarity and protection for both parties. These include specifying the exact number of shares to be transferred, along with the agreed-upon price per share. The completion procedure, outlining the steps required to finalize the transaction, is also included. Conditions precedent, which are specific requirements or events that must occur before the agreement becomes effective, are addressed in the SPA. By signing the SPA, both the buyer and the seller confirm their commitment to the terms stipulated in the agreement, providing a legally sound framework for the share purchase. It is crucial for both parties to thoroughly review and understand the SPA before signing, seeking legal counsel, if necessary, to ensure a smooth and transparent transaction process. Watch out for this space for a more detailed explanation of SPA and its key components.
- Share Transfer Execution - As the next step the seller and the buyer execute a share transfer deed and stamp duty may be paid in accordance with the consideration & mode (physical or demat) at which shares are being transferred. And the transfer deed along with other supporting documents of the transfer are shared with the company.
- Board Approval and Share Issuance - Once the company receives the documentation of the transfer, it verifies the transfer deed along with other documents and convenes a board meeting to pass a resolution. If the documentation for transfer of share is in order, the board shall register the transfer by passing a resolution. And the name of transferee is entered in the register of members as the beneficial owner of such shares. Within a month of passing board resolution the company issues the share certificate to the transferee. Necessary regulatory filings are done by the company.
Also Read: Navigating the Funding Winter: Unlocking Liquidity through Secondaries
Residential status of buyer and seller
While we have outlined the general steps for secondary transaction above, we have not specifically delved into the resident status of buyer and seller. Our assumption above was both buyer and seller were residents (Case 1 - of Resident-to-Resident transaction). However, in any secondary transaction, the residential status of buyer and seller has a bearing on the process. For cases where either of the parties is Non-resident, one must make sure to comply with FEMA, RBI, and SEBI (Securities and Exchange Board of India) regulations alongside FDI policies. While the process remains the same by and large, there are some additional compliances and regulatory filings needed in such cases. Case 2 - of a resident to non-resident transaction, the minimum bar on price is set. The price cannot be less than the price determined from the valuation report. Further, there are requirements to obtain the FIRC (Foreign Inward Remittance certificate) and KYC (Know your customer) of person residing outside India from AD (Authorized Dealer) Category-I bank. And filing of FC-TRS (Foreign Currency Transfer of Shares) on FIRMS (Foreign Investment Reporting and Management System) RBI Portal with all the documentation prescribed needed. Getting the FC-TRS approval from RBI is mandatory. There are also some sectorial stipulations by the Government where it becomes mandatory for the parties to get Government approval. Case 3 - of a non-resident to resident transaction, the upper cap for price is set. The price cannot be more than the price determined by the valuation report. Here again the FIRC/Outward Remittance Certificate and KYC of person residing outside India from AD Category-I bank, including the FC-TRS approval. Case 4 - of a non-resident-to-non-resident transaction, happens similar to case-1 provided that company is engaged in a sector which does not require government approval. However, if the company is engaged in a sector which requires Government approval, prior approval is needed. There are further approvals from RBI are needed in-case the non-resident is a NRI (Non-Resident Indian) or an OCI (Overseas Citizen of India).
The liquidity of shares for private limited company shareholders is limited due to opacity in pricing, the absence of trading on the open market, and limited accessibility. Nonetheless, they have the option to sell their ownership stakes through secondary transactions, adhering to essential regulations. This process involves collaboration with the company and intermediaries, allowing existing shares to change hands between current shareholders or new investors. This exchange does not involve issuing new company shares and requires adherence to regulations such as FEMA, RBI, SEBI, and FDI policies, especially if non-resident parties are involved.