Background
India Inc’s initial public offering (“IPO”) landscape has witnessed significant growth in recent years, with numerous companies entering the capital markets to fund their growth and offer exits to existing investors. An IPO in India requires navigating a complex regulatory framework, complying with various provisions, and addressing stakeholders’ interests, including employees with stock options. In our post[1], we had assessed companies’ eligibility to undertake an IPO in situations where any individual holds rights entitling them to acquire equity shares of the company, or where there are any outstanding convertible securities that can be converted into the company’s equity shares.
To recap, the Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2018 (“ICDR”), states the following[2]:
“An issuer shall not be eligible to make an initial public offer if there are any outstanding convertible securities or any other right which would entitle any person with any option to receive equity shares of the issuer”.
The proviso to Regulation 5(2) of the ICDR provides for an exception to the rule and states that:
“…the provisions of this sub-regulation shall not apply to: (a) outstanding options granted to employees, whether currently an employee or not, pursuant to an employee stock option scheme in compliance with the Companies Act, 2013, the relevant Guidance Note or accounting standards, if any, issued by the Institute of Chartered Accountants of India or pursuant to the Companies Act, 2013, in this regard.”
To have a clear and uncomplicated equity structure, which is crucial for IPO attractiveness, Regulation 5(2) of ICDR governs IPO eligibility, if there are outstanding convertible securities or any other right that would entitle any person with any option to receive equity shares of the issuer. However, the proviso to this regulation grants an exception for outstanding options granted to employees under employee stock option scheme.
In our post referenced above, we had assessed the Securities and Exchange Board of India’s (“SEBI”) position in relation to companies that have adopted instruments other than ESOPs. According to SEBI, only ESOPs are specifically carved out under Regulation 5(2) of the ICDR because other share-based benefits such as stock appreciation rights (“SARs”), employee stock purchase schemes (“ESPS”), performance stock units (“PSUs”), management stock options (“MSOP”), are not enabled/ regulated under the Companies Act, 2013 (“Act”).
Regulatory development: Attempt towards harmonisation
SEBI had constituted an expert committee on August 24, 2024 (“Expert Committee”), to further improve ease of doing business and align ICDR with the Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements) Regulations, 2015 (“LODR Regulations”).[3] The Expert Committee had deliberated on a contemporary proposition and had stated that the capital structure of a company prior to an IPO must be ascertainable. It had accordingly recommended permitting SARs to remain outstanding until the date of filing of the red herring prospectus (“RHP”). The Expert Committee’s recommendations included a condition that all outstanding SARs shall be mandatorily exercised before RHP. The rationale provided was that the number of resultant equity shares upon exercise of SARs would depend on the appreciation in the price of equity shares from the date of grant of each option, which may lead to uncertainty in the company’s capital structure.
In a recent development, and based on the recommendations of the Expert Committee, by way of ICDR amendments, the SEBI has added another proviso to sub-regulation (2), which seeks to include SARs within the purview of permissible outstanding convertible securities. The inserted clause is reproduced below:
“(b) outstanding stock appreciation rights granted to employees pursuant to a stock appreciation right scheme, which are fully exercised for equity shares prior to the filing of the red herring prospectus (in case of book-built issues) or the prospectus (in case of fixed price issues), as the case may be, disclosures regarding such stock appreciation rights and the scheme and the total number of equity shares resulting from the exercise of such rights are made in the draft offer document and offer document.”
Potential roadblock
Prior to the Expert Committee’s recommendations, there was ambiguity regarding the inclusion of only ‘employee stock option scheme/ ESOP’ within the purview of Regulation 5(2) of the ICDR. Such ambiguity emanates from the regulator’s hesitation to recognise various equity-based incentive instruments such as SARs, ESPS, PSUs, MSOP, etc., particularly considering the absence of express recognition of such instruments under the extant laws.
Lately, companies have been structuring various forms of equity-based instruments basis their commercial needs and objectives. This includes migrating their SAR schemes into ESOP plans to qualify as eligible issuers of IPO. This process has, however, become burdensome for many new age companies aiming to go public. Thus, with a view to bridge the regulatory gaps and lay the foundation for an inclusive regulatory restriction, SEBI has amended ICDR by including SARs under the proviso to Regulation 5(2) of the ICDR and provide for treatment of SARs as an instrument equivalent to ESOPs. While this a welcome move and a step towards recognition of increased adoption of other equity-based instruments, the qualifier of ‘which are fully exercised for equity shares prior to the filing of the red herring prospectus’ under the proviso may create a roadblock for effective implementation of SAR schemes for IPO-bound companies.
The primary concern is the continuity of incentive schemes framed prior to an IPO to be implemented post IPO. Under the extant ICDR, an ESOP scheme framed by a company (prior to its IPO) can survive IPO and continue to have unallocated or unvested stock option pool under its scheme. However, a similarly placed design/ proposal for SARs may not achieve the intended objective on account of the wordings of the proposed exclusion. The qualifier of outstanding SARs being fully exercised and converted into equity shares prior to the filing of RHP shall place obligations on companies having SAR schemes (and considering IPO) to grant all units and have them exercised on or before filing of RHP or alternatively, wind up the SAR scheme prior to filing RHP.
Separately, the action of the securities markets regulator for providing such qualifier in case of SARs (and not for ESOPs) and consequently providing for settlement of all SARs (i.e., conversion to equity shares prior to RHP stage) is based on the assumption that there cannot be determination of the resultant equity shares owing to appreciation in the price of equity shares, and therefore, there shall be uncertainty in the companies’ capital structure pre-IPO. Further, since SEBI recognises and regulates SARs through SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021, limited recognition for IPO bound companies has not met market expectations with these amendments.
However, SEBI has failed to factor in contemporary SAR schemes, which include the issuance of equity shares, wherein an upper limit is set for the maximum number of shares that can be allotted under the SAR scheme as a whole and also the maximum number of shares that can allotted to individual employees. Hence, concerns related to potential dilution being unknown is mitigated, ensuring that the appreciation value does not exceed what shareholders had approved at the time of adoption of the SAR schemes.
Conclusion
While the underlying principle of the proposed reforms is to recognise other forms of equity instruments, and considering the objective of ease of doing business, a half-baked recognition may be futile and may not help achieve the stated objectives of business ease and/ or even relax the regulatory requirement for IPOs.
Considering the rapid expansion of the IPO market, and the resultant increase in scrutiny and requirements by the SEBI and stock exchanges, manoeuvring the dynamic regulatory regime vis-à-vis the current equity instruments has become difficult for companies. This assumes significance now on account of the wide usage and structuring of various types of equity instruments by companies, with a view to reward employees and gear up for IPOs, specifically since such schemes usually link the vesting and/ or exercise to IPOs and create expectations of having a big pay day (in the minds of employees) on the listing date.
For further information, please contact:
Bharath Reddy, Partner, Cyril Amarchand Mangaldas
bharath.reddy@cyrilshroff.com
[1] Our post is accessible here: Proposal to make Companies with Outstanding Stock Appreciation Rights (SARs) eligible to undertake an IPO | India Corporate Law.
[2] Regulation 5(2) of the ICDR.
[3] The recommendation of the expert committee are available here: Expert Committee report on ICDR and LODR-new_p.pdf.
