Historically, companies have primarily relied on debt and equity as their main funding methods, where equity carries higher risk for investors, and debt entails greater risk for the entity. Nevertheless, the evolving landscape of capital requirements, along with limited risk tolerance, particularly in the realm of start-up finance, has given rise to innovative financing approaches. Among these, hybrid financial instruments fall under the category of structured financial instruments that combine the characteristics of various financial instruments, presenting returns that result from the amalgamation of these instruments.

Compulsorily Convertible Preference Shares (“CCPS”) is a form of hybrid financial instruments, which are initially preference shares that, under the provisions of a mutually agreed-upon time period, convert into equity shares of the company.  CCPS gives the holders precedence over equity shareholders in two ways. One, prior to paying any dividends to equity shareholders, CCPS holders receive dividends on a priority basis. Second, in the event that the company goes bankrupt and has to sell off its assets, the CCPS holders will receive a return on their capital on a priority basis when compared to the other shareholders. CCPS are typically issued through private placement basis.

The issuance of CCPS follows a structured procedure. It starts with a board meeting to approve the CCPS terms, followed by a shareholders’ meeting to pass a special resolution authorizing the issuance. If needed, the company’s Memorandum of Association is updated. An e-form MGT-14 is filed with the Registrar of Companies to report the special resolution. The offer letter in Form PAS 4, is then circulated to intended parties. After receiving funds from investors, another board meeting is held to allot CCPS, issue share certificates, and e-form PAS-3 is filed with the Registrar of Companies to complete the CCPS issuance process in accordance with the Companies Act, 2013 and the rules made thereunder.

The voting rights of preference shareholders, including CCPS holders, are generally limited to specific matters only, such as those affecting their rights as a shareholder or matters affecting the rights of the class of shares that they hold, resolution for winding up of the company. These include resolutions for winding up the company, repayment, or reduction of equity or preference share capital. However, under section 47 of the Companies Act 2013, preference shareholders who have not received any dividends from the company for two years or more can acquire the right to vote on all resolutions, similar to equity shareholders.

During the funding stage of a growing start-up, CCPS are commonly used by both, the start-up founders and investors to ensure mutual benefits and protect their interests. CCPS provide investors with fixed income in the form of dividends and is designed to convert into equity shares of the company after a predetermined period, with the conversion terms agreed upon at the time of issuance.

CCPS are preference shares that can be converted into a specific number of equity shares upon the occurrence of certain events such as IPO, qualified financing or within 20 years from the date of issuance or at the option of the holder. Investors choose to opt for CCPS when the valuation of the company is low. This helps them pocket a substantial amount of dividend that is compulsorily payable by the company and also mitigates their risk in terms of the company underperforming. However, when the valuation and the price per equity share increases, the investor can choose to convert the CCPS to equity shares. In such a scenario, each CCPS is converted into equity shares as per the terms of the issuance agreement executed between the company and the investor.

In conclusion, CCPS play a crucial role during the funding stage of a growing start-up. They serve as a mutually beneficial tool for both start-up founders and investors, offering fixed income and the conversion into equity shares at a later date. CCPS provide investors with protection and income when a company’s valuation is low, while also allowing them to participate in the company’s growth when its value and share price increase. This financial instrument strikes a balance between safeguarding interests and reaping rewards in the dynamic world of start-up investments.