IPO Exits Demystified: The Legal Architecture and Strategic Considerations

The authors are Sahil Lathwal and Agrim Mor, final year students at NMIMS, Kirit P. Mehta School of Law, Mumbai.

1. Introduction

Initial Public Offer (“IPO”) is the transition process of a private company to a public listed company by offering securities in the primary market for the first time. Shareholders become the company’s owners by virtue of their participation in the IPO, and have ownership rights in such a public listed company. Investors, in the present investment landscape, plan their exit from the company even before finalizing their investment in the company. Exits are now no longer the events which occur on the company’s failure to perform as per initial expectations.

Exit clauses in the SHA are generally structured to provide an exit to the investors within a specified time frame. Exit waterfall in Shareholders’ Agreement (“SHA”) generally includes a specific order of exit modes to provide the investors an exit. The IPO exit is an ideal option for private equity and venture capital investors, because it provides free share transferability besides infusion of capital in the company, however, an IPO may not always be feasible considering market uncertainties.

Exit clauses in the SHA are often met with various impediments, including but not limited to enforceability, feasibility, and market uncertainties, making it imperative for the company and the promoters to structure the exit clauses in a manner to avoid any future hindrance. IPO clauses in the SHA are no exception to such impediments and are often met with similar legal and regulatory hurdles.

2. Analysis

2.1. Conflict between Articles of Association (“AoA”) and SHA

When opting for an exit via IPO, aligning the AoA with the SHA is essential and not merely a general practice. For instance, in the case of V.B Rangaraj v. V.B. Gopalakrishnan (“V.B. Gopalakrishnan”), the Court dealt with the conflict between the AoA and the SHA. The Supreme Court held that share transfer restrictions are authorised only upon being incorporated in the AoA, even when such restrictions comply with Companies Act, 2013 (“Companies Act”). 

However, the Supreme Court in Vodafone International Holdings v. Union of India, while taking a different view, observed that omission to include shareholders’ rights under SHA in the AoA will not render the shareholders’ rights automatically unenforceable. The Delhi High Court further discussed this issue in WPI Private Limited v. WPI Group Inc., and while relying on the V.B. Gopalkrishnan, J. held that, “the existence of an affirmative vote cannot be recognized without a corresponding amendment to the AoA.”

Therefore, when there is conflict between the SHA and the AoA, courts prefer to not allow a complete liberty of contract. Even if SHA clauses adhere to the Companies Act, courts have held that SHA clauses are required to be incorporated in AoA to be enforceable. Essentially, while structuring the exit rights, investors holding IPO rights under the SHA need to include such rights in the amended and restated AoA.  

2.2. Reasonable and Best Efforts

An exit involving an IPO is mutually beneficial to the shareholders and the promoters, and is therefore, generally included in the SHA as the first mode of exit. The result of an IPO is highly dependent on external factors such as market conditions. Thus, SHAs require the company to make reasonable or best efforts while seeking an exit via going public, rather than imposing rigid commitments on the company.

The interpretation of the terms “best effort” and “reasonable efforts” have come under the judicial radar in several legal disputes. The Calcutta High Court, in Smt. Manika Seth v. Sett Iron Foundry, literally interpreted the term “every effort” while equating it to “best effort” and held that parties have to take every effort possible, if the clause in SHA mentions for the company to take “every effort”. The Court while referring to an English judgment, held that a“reasonable efforts” clause in a contract only requires the parties to make one reasonable effort and a “best effort” clause requires the parties to make all reasonable efforts. 

In view of the foregoing, the standard of proof needed for disputes involving “best effort” clause is higher than what is necessary for a “reasonable effort” clause. For example, “reasonable efforts” clause would require the parties to follow standard procedures of the IPO and meet deadlines without an obligation to go beyond industry norms. Whereas, the “best efforts” clause would require the parties to exhaust all possible options, including alternatives.

In a dispute pertaining to an IPO exit, the company may be required to demonstrate that its efforts align with the agreed level of commitment under the SHA. The burden of proof falls on the company to prove “reasonable efforts” or “best efforts” basis the agreed standard under the SHA. Additionally, disputes over a “reasonable efforts” clause would require demonstrating that either the approach taken by the company or promoters: (a) did not align with the procedure outlined in the SHA, or (b) was not carried out by them altogether.

Hence, the manner of drafting the IPO clause becomes crucial. Parties should assess the stringency of the IPO obligation and define an appropriate ‘efforts’ standard. The exit clause’s obligations should be in alignment with investment timelines. However, some flexibility should be maintained as a precautionary measure against market conditions or a change in law which may affect the IPO. Investors may benefit from negotiating terms that grant them strategic advantages during the IPO process, such as prioritization in share sale offerings or veto rights on procedural matters. These provisions do not guarantee the direct enforceability of an IPO clause as an exit right but instead serve as mechanisms to enhance investor control and participation in the IPO process.

2.3. Ineligibility under SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018

Another critical aspect to consider is the regulatory constraints that could impact IPO exits, as outlined in the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (“ICDR”). Regulation 5 of the ICDR restricts companies from making an offer to the public for sale of securities if any director on its board of directors, promoters or any member of the group are prohibited from accessing capital markets by SEBI. The restriction will also apply if the company’s promoter or director is a promoter or director of a debarred company.Further, if the issuer company or its promoter or director is a fraudulent borrower, wilful defaulter, or a fugitive economic offender, the issuer cannot offer its securities to public.

The aforesaid restrictions may cause a problem if, post-filing of the offer document, an independent director (who is also a non-executive director) appointed by the issuer becomes a wilful defaulter.  The Reserve Bank of India vide its master circular dated July 1, 2015,provided that a ‘wilful default’ must be “intentional, deliberate, and calculated.” 

Regulation 2(1)(pp)(iv) of the ICDR also includes a company in which 20% (twenty per cent)or more equity shares are owned by the promoter, or a company that owns 20% (twenty per cent) or more equity shares in that promoter in the definition of ‘promoter group’. Further, the definition also contains a company in which an entity or a group of individuals, which owns 20% (twenty per cent) or more in the issuer company, owns 20% (twenty per cent) or more equity shares. A wide nature of the definition of ‘promoter group’ will bring under its umbrella companies which have no relation to the issuer company. Pursuant to that, disclosures pertaining to those unrelated entities will be made by the issuer company. 

2.4. Conversion of Convertible Instruments

In addition to regulatory constraints, another key factor that affects the feasibility of IPO exits is the treatment of convertible instruments. Regulation 5(2) read with Regulation 2(1)(k) of the ICDR require the issuer company to convert the convertible instruments held by pre-IPO investors into equity shares before filing the offer document or on the same date. Investors holding convertible securities often have special or additional rights attached to theconvertible securities. Therefore, if in case the IPO fails, the investors lose such additional or special rights.

The parties can agree to a contractual arrangement to restore the rights attached to the convertible instruments to pre-IPO investors. However, such restoration may not be practically feasible in case of foreign investors due to the applicability of reporting and pricing requirements under the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019. 

3. Concluding Remarks

The growing trend of IPO exits highlights the increasing preference for IPO as the primary exit route for private equity and venture capital investors. Therefore, to avoid legal or regulatory hurdles, investors need to ensure replication of SHA rights in the AoA. In light of recent judgments, while negotiating or drafting IPO clauses, parties must impute “efforts” standards on the basis of the stringency. Investors may negotiate with the company terms providing strategic benefits, for example, priority in offering shares for sale or veto rights on procedural matters relating to the IPO. Additionally, investors may consider having acontractual arrangement with the company for reinstatement of special rights, revoked pursuant to conversion of convertible instruments, upon failure of the IPO.