(The following post is from Tanmay Amar, senior associate at Luthra & Luthra. Tanmay discusses a significant change to the minimum pricing norms for issue of shares by Indian companies to foreign investors. This change is bound to affect the manner in which valuations are to be arrived at, especially for investments by financial investors such as private equity funds. It is not clear as to what the motivation behind this change is, but it is likely to place restrictions on the flow of foreign investment into unlisted companies)
The Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000 (the “FEMA Regulations”) have been recently amended to include a significant change regarding minimum pricing norms. The Reserve Bank of India (“RBI”) has altered the mechanism for computing the base price for issue of shares by an Indian unlisted company to a non-resident. The same was notified in the Official Gazette on April 21, 2010, although the Gazette notification or the amendment itself is apparently yet to be made available on the RBI website.
Until now, the price for issue of shares of unlisted Indian companies to a non-resident could not be less than the price computed by a chartered accountant (“CA”) in accordance with the guidelines issued by the erstwhile Controller of Capital Issues (“CCI value”). As the CCI value was based on historical performance parameters, it often tended to be relatively moderate.
Post this amendment, for a new issue by an unlisted Indian company to non-residents, the base price would be the higher of (i) the fair value computed by a CA/ Merchant Banker, as per the discounted free cash flow method (“DCF Value”), and (ii) (where the issue of shares is on a preferential allotment basis) the price applicable to transfer of shares from a resident to a non-resident, as per guidelines notified by RBI. The relevant provision is as follows:
In Schedule 1 [of the FEMA Regulations], for paragraph 5, the following paragraph shall be substituted, namely:--Since the base price for issue of shares is linked to the price for transfers, it is necessary to note that currently the price applicable to transfer of shares (for unlisted companies) from a resident to a non-resident is the CCI Value. As yet, no amendments seem to have been announced to such pricing guidelines for transfers, and even assuming any amendments have been effected, they have not been widely publicized.
“5. Issue price
Price of shares issued to persons resident outside India under this Schedule, shall not be less than—
(a) the price worked out in accordance with the SEBI guidelines, as applicable, where the shares of the company [are] listed on any recognised stock exchange in India;
(b) the fair valuation of shares done by a SEBI registered Category-I Merchant Banker or a Chartered Accountant as per the discounted free cash flow method, where the shares of the company [are] not listed on any recognised stock exchange in India; and
(c) the price as applicable to transfer of shares from resident to non-resident as per the pricing guidelines laid down by the Reserve Bank from time to time, where the issue of shares is on preferential allotment.”
Till such time that RBI amends the pricing guidelines for transfer of shares of an Indian company from a resident to a non-resident, an anomaly will remain, whereby the issue of shares to a non-resident will be subject to a base price which is the higher of CCI Value and DCF Value. However, it may be possible for an Indian company to issue shares to a resident entity, which entity may immediately thereafter transfer the shares to the non-resident, at a price which is subject only to the CCI Value and not the DCF Value, and therefore frustrate the intention behind this amendment.
While the CCI Value was computed as per a given set of regulator-issued guidelines which were fairly detailed, I believe that there is much scope for ambiguity in computing the DCF Value. Perhaps an accounting professional may be able to elaborate.
DCF Value is generally likely to be higher than CCI Value and could challenge private equity valuations in on-going deals, as well as closed private equity deals or joint ventures, which provide for multiple investment tranches or other scenarios where a non-resident is to be issued further shares at a subsequent point of time.
Certain news reports speculating on the amendment seem to indicate that it may have been RBI’s intention to replace the base price for issue of shares from CCI Value to DCF Value. However, going by the drafting, it appears that (in all cases involving preferential allotments) two separate computations for the CCI Value and DCF Value will be required and the higher of the two will be the base price. Perhaps this may be to guard against the ambiguity in DCF Value computation, which could possibly be exploited, in certain cases, to obtain a DCF Value which is lower than CCI Value.
- Tanmay Amar
(Update: Please see further developments in this subsequent post)