Barbarians at the gate

Fundraising and planning an initial public offering (IPO) appears far more appealing to entrepreneurs now. Last week, markets regulator Securities and Exchange Board of India (Sebi) allowed for a new framework for the issuance of differential voting rights (DVR) by technology-driven companies and start-ups. With DVR, a start-up can now issue two classes of shares, of which one class will command superior rights (SR) giving the shareholder a maximum of 10 votes to every share held.

This framework is believed to benefit founders of tech-driven start-ups focused in data analytics, information technology, intellectual property, biotechnology, nanotechnology and other innovative technologies, as it allows them to raise funds while preventing any hostile takeover bids and continue to remain crucial towards the decision-making in the venture even after diluting their stake.

Generally, as start-ups raise funds, the founder stake gets diluted. Experts believe that by the time a venture has raised series B and C rounds of funding, founder stake drops to below 25% in the company. In unicorns such as OYO, Swiggy, Zomato and Ola, the founder stake is around 9.5-12%, while in Paytm, it is about 16%. BYJU's is one of the only unicorns in which the founder(s) commands a high stake, around 35-36%. With the stake dilution, a founder's influence over the company also dips significantly. But DVRs can perhaps safeguard founder interest and influence in the company, feel experts.

“DVR in start-ups that need significant scale capital will allow the executive founders to retain a level of control of their companies and steer them ahead despite having a very low economic interest in terms of percentage shareholding. It will allow founders to drive their ventures post scale up and give requisite comfort to IPO investors as well, as they really know into whom they are investing and have directorial assurance,” says Pankaj Karna, managing director of Maple Capital Advisors. 

Internationally, companies such as Facebook, Snapchat have founders exerting control even after stake dilution. Mark Zuckerberg owns around 70% of the voting shares in Facebook, even though his stake is less than 20%. In Snapchat, the class C shares which founders Bobby Murphy and Evan Spiegel hold 100%, are entitled to 10 votes per share. In Lyft and Pinterest, founders are entitled to 20 votes per share. 

According to Harshil Mathur, CEO and co-founder of fintech start-up Razorpay, which recently raised $75 million in a series C round of funding from Sequoia India and others, the Sebi move on the framework on DVRs for start-ups is welcoming. But Mathur adds that restrictions should be re-looked in order to make the best use of this development.

As per this framework, the SR shares get converted into ordinary equity shares five years post listing of the venture's ordinary shares. This can, however, be extended by another five years, subject to approval from shareholders.

But for start-ups overall, DVR provides a lot more flexibility as both founders and investors can negotiate positions on the board where economic and executive rights are potentially separated, and the interests of both parties can be protected, says Kunal Verma, chief business officer and co-founder, MoneyTap, adding that “fundraising will become far more interesting.''

But the framework might make strategic investors hesitant towards investing in start-ups, believes angel investor Anuj Golecha, who is also the co-founder of Venture Catalysts. Experts feel entrepreneurs might face challenges in negotiating with investors who typically do not like giving up their executive rights. Golecha feels investors are usually inclined towards the management of the venture and this DVR framework might pose a challenge for a start-up to actually find suitable investors.

Verma, however, thinks if an investor is opposed to DVR, it only goes to show that there is a potential misalignment between both the investor and the founder's incentives. And to manage this challenge efficiently, a smart and righteous founder should complement the ask for DVR with more transparency from his side, explains Verma. “This would give investors the confidence that those rights will not get abused or misused. Likewise, a great investor would agree to a balanced approach to DVRs while asking for increased corporate governance.”

Moreover, investor's confidence can also be gained by giving shares at a slightly lower value. ''Investors into such start-ups would benefit due to the continued involvement and interest of the founders due to the control exercised through SRs held by them,'' adds Golecha.