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WHY IS BUYBACK CLAUSE THE “STARTUP EATER”?

The authors are Gautam Pareek and Ajith Kale, final year students at School of Law, CHRIST(Deemed to be University), Bangalore.


INTRODUCTION


India possesses the world's third-largest ecosystem for startups, experiencing a substantial surge in numbers from 73 in 2016-17 to 14,000 in 2021-22. This flourishing startup landscape has attracted a diverse range of domestic and foreign investors seeking to participate in this burgeoning market. These investors typically adopt an equity-based investment approach, aiming to generate profitable returns by selling their equity holdings during the exit phase.


An exit strategy in the context of startups refers to the method employed to ensure a return on investment for the investor through the monetization of their equity stake. Investors consider the exit strategy when making investment decisions in startups. Various exit strategies include initial public offerings (IPOs), acquisitions, buyouts, and buybacks. Among these, the inclusion of a buyback clause in the Shareholders' Agreement (SHA) stands as a controversial method for providing an exit to the investor, potentially resulting in the disappearance of their investment.


This article examines how the inclusion of a buyback clause in the SHA may lead to the erasure of investments from investors' books, thus posing potential risks as per the guidelines outlined in the Indian Accounting Standards.


WHAT IS BUYBACK UNDER THE COMPANIES ACT, 2013?


In accordance with the provisions of the Companies Act 2013, a "buyback" entails the repurchase of a company's own shares from its shareholders. The regulatory framework for buybacks is governed by Section 68, Section 69, and Section 70 of the Companies Act 2013, along with the Companies (Share Capital and Debentures) Rules, 2014.


A "buyback" in the context of corporate governance involves the repurchase of a company's own shares from its shareholders. The authority to conduct a buyback must be explicitly stated in the company's Articles of Association. The financing for a buyback can be derived from the company's free reserves, securities premium account, or the proceeds of specified securities. However, it is important to note that funds from prior issuances of the same shares cannot be utilized for the buyback process.


A buyback clause, referred to as a share buyback provision, is an integral part of a shareholder agreement. It delineates the terms and conditions that govern the circumstances in which a company has the ability to repurchase its own shares from its shareholders.


WHAT IS IND AS 32?


In the context of a Shareholders' Agreement (“SHA”), the inclusion of a buyback provision offers investors the opportunity to exit their investment through a repurchase of their securities. It is crucial to carefully consider the specific language employed in the buyback clause, as it will determine the classification of these securities as either an "equity instrument" or a "debt instrument" under Ind AS 32 (Indian Accounting Standard 32).


To ensure compliance with the relevant regulations, the investee entity must ensure that the buyback clause explicitly states that the decision to proceed with a buyback rests solely with the Board. The Board's evaluation of the commercial and legal feasibility, along with adherence to the prerequisites for the buyback of securities as outlined in Section 68 of the Act, should guide the buyback process.


CONTINGENT ASSET AND TECHNICAL WRITE OFF


A contingent asset refers to a potential asset that arises as a result of past events and whose existence can only be verified upon the realization or non-realization of one or more uncertain future events that are beyond the complete control of the entity. On the other hand, a technical write-off refers to the accounting treatment of recognizing an asset or investment as having no recoverable value. It usually occurs when the asset's value has significantly declined or the likelihood of recovering the investment is minimal. A technical write-off allows the investor to remove the asset or investment from their books and reflect the loss in value.


Ind AS 37, para 33 states that: -

“Contingent assets are not acknowledged in financial statements due to the potential risk of recognizing income that may never materialize. When the possibility of economic benefits arising from a contingent asset is likely, the entity should disclose relevant details regarding the contingent asset. However, if the realization of income is considered highly probable, the associated asset is not considered contingent, and its recognition becomes appropriate.”


As per the guidelines outlined in Ind AS 37, the term “contingent” is used to describe liabilities and assets that are not recognized because their existence hinges upon uncertain future events that are not entirely within the entity's control.


WHAT IS THE RELATIONSHIP BETWEEN A BUYBACK CLAUSE IN THE SHA AND THE POTENTIAL TECHNICAL WRITE-OFF OF THE INVESTMENT?


If a buyback clause categorizes an instrument as debt, it results in the corresponding amount being recorded as a liability in the company's financial statements. This can lead to inadequate bookkeeping practices, ultimately rendering the company less attractive for future investments, potentially making it "uninvestable."


For a startup, securing funds is crucial for its survival and growth. However, the presence of a buyback clause could render the startup unattractive to potential investors, hindering its ability to obtain the necessary funds and impeding its prospects for survival.


Furthermore, due to the inherent uncertainty surrounding the future of a startup, such investments would be considered contingent . As a result, investors may need to write off their investments in their financial records, incurring a complete loss. While the investor may retain the right to pursue legal remedies based on contractual obligations, a startup with an uncertain future may face challenges in fulfilling its repayment obligations to the investor.


It is important to note that this situation would result in a technical write-off for the investor, indicating the investor's ability to pursue legal recourse if deemed necessary. However, for a startup facing an uncertain future, meeting repayment obligations to the investor may pose significant challenges.


IBC AND BUYBACK CLAUSE


The only recourse available for the company would involve initiating insolvency proceedings under Section 7 of the Insolvency and Bankruptcy Code (“IBC”) through the Corporate Insolvency Resolution Process (“CIRP”). However, a precedent set in the case of Hubtown Limited v. GVFL Trustee Company Ltd. by the National Company Law Tribunal (“NCLT”) clearly established that a shareholder does not qualify as a financial creditor under the IBC. Consequently, the obligation to repay the shareholder would not be recognized as a financial debt.


This implies that the enforcement of the debt obligation against the company is contingent upon the company's solvency. In the event of the company becoming insolvent, the shareholder's debt obligation arising from the buyback clause would not be acknowledged, and as a result, the shareholder would not have the right to claim repayment alongside other financial creditors.


Consequently, the option of pursuing insolvency proceedings is also eliminated.


THE INFO EDGE SAGA


Info Edge, a prominent Indian technology startup investor, has made a complete write-off of its investment in Bijnis, a B2B fashion and lifestyle product marketplace, amounting to Rs 76.6 crore ($10.4 million). The decision was motivated by Bijnis' ongoing cash burn and restricted cash availability, casting doubt on the startup's ability to secure future capital.


This write-off represents a setback for Bijnis, which had successfully raised over $43 million from notable investors, including Sequoia India, Matrix Partners India, Waterbridge Ventures, and WestBridge Capital. The move by Info Edge reflects the challenging environment faced by numerous Indian startups, profoundly impacted by the global economic slowdown and the ongoing conflict in Ukraine.


Nevertheless, Info Edge has affirmed its unwavering commitment to investing in Indian startups, emphasizing a robust pipeline of investment opportunities. Despite the prevailing difficulties, the company maintains confidence in the resilience and eventual recovery of the Indian startup ecosystem.


CONCLUSION


The option of buying back shares from investors can indeed serve as a favourable method for providing an exit, as it allows the company to retain its equity and potentially utilize it for future funding purposes. Conversely, treating the investment as a debt instrument could prove detrimental, as it may burden the startup with excessive debt and result in the complete eradication of the investment from the investor's records. This outcome would prove disadvantageous for both the investor and the startup.


The buyback of shares remains a viable exit option only when it is classified as an equity instrument. While it does not guarantee a return, it at least safeguards the startup from facing potential insolvency. Therefore, meticulous attention must be given to differentiating between buyback clauses that describe equity and debt instruments, thereby emphasizing the exclusion of buyback clauses while formulating a Shareholders' Agreement.


In conclusion, it is crucial to prioritize the distinction between equity and debt instruments in buyback clauses, ensuring that the startup's integrity and investors’ interests are protected.

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