Anti-Dilution Protection To Foreign Investors Navigating The Regulatory Minefield

Foreign investors must carefully assess the actual enforceability of their negotiated rights before investing in India – and should not simply agree to rights in the subscription documentation(s) that are considered standard for a transaction of this nature

Introduction

A fundamental safeguard that every investor seeks is the protection of their investment, and one of the most common safety mechanisms sought is ‘anti-dilution protection’. In simple terms, anti-dilution protection is a right granted, usually to early-stage investors, to preserve their stake or investment in the event of a down round. A down round occurs when new securities are issued to a future investor at a lower price than the previous investor. With anti-dilution protection, the original investor is shielded from dilution and can minimize the loss on their investment.

Anti-dilution protection comes in two primary forms: full ratchet and weighted average. While full ratchet protection is ideal for investors because it adjusts the original investment price to match the down round price, increasing the number of securities held, it leads to disproportionate dilution for the founders and other shareholders, putting them at greater risk. In contrast, weighted average protection offers a more balanced solution, considering factors like the number and price of securities issued during a down round and the original investment price. This makes weighted average protection the most common and accepted form of anti-dilution in transactions. Weighted average protection can be negotiated further to be either broad-based (calculated on a fully diluted basis) or narrow-based (where options and warrants are not considered outstanding and are excluded).

What is the Enforcement Enigma?

Even if a foreign investor has a contractual entitlement to anti-dilution rights, Indian foreign exchange laws impose additional requirements when such rights are exercised. Under the pricing guidelines of the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (NDI Rules), if convertible equity instruments are issued to a non-resident, the price or conversion formula must be determined upfront at the time of issuance. Moreover, the conversion price cannot be lower than the fair market value established at the time of issuance, and for unlisted companies, the fair market value must be certified by a Chartered Accountant, SEBI-registered Merchant Banker, or a practicing Cost Accountant.

This requirement prevents foreign investors from fully exercising and benefiting from anti-dilution adjustments if the conversion price ends up being lower than the fair market value of the securities, thus limiting the anti-dilution protections initially negotiated.

How can a Foreign Investor safeguard their Investment?

Investing in established and stable entities offers a degree of comfort to investors, enabling them to take on more risk. However, investing in early-stage startups comes with its own set of risks. A key factor for foreign investors is the valuation of the investment - if an investment is made at a premium over the fair market value, the premium serves as a cushion when anti-dilution rights are triggered in the event of a down round, enabling the investor to enforce their rights.

For instance, a foreign investor may consider subscribing to securities at a 10-15% premium above the fair market value determined under the NDI Rules - this premium creates a buffer that allows the conversion price to be adjusted downward without breaching the NDI Rules. This is particularly useful if the fair market value is determined to be reasonably below the subscription price at the time of issuance.

Can a Rights Issue be an Alternative to a Down Round?

A rights issue is another potential alternative to a down round for raising capital. Under both the NDI Rules and the Indian Companies Act, 2013, a rights issue can be made below the fair market value of the securities. However, rights issues cannot be made to non-residents at a price lower than the price offered to resident Indians.

Additionally, if a foreign investor subscribes to securities renounced by a resident as part of a rights issue, such subsequent subscription of such renounced securities must comply with the pricing guidelines and other conditions outlined in the NDI Rules, primary of which is the regulation that such issue should be, at minimum, at the fair market value of such securities.

Our Two Cents

Investing in India as a foreign investor can be complex and challenging in terms of enforcing rights. In addition, non-compliance with Indian foreign exchange regulations can lead to penalties of up to three times the investment amount.

While anti-dilution protection is often a key right sought by investors, the enforceability of anti-dilution is not alike for resident and non-resident/ foreign investors. Therefore, foreign investors must carefully assess the actual enforceability of their negotiated rights before investing in India – and should not simply agree to rights in the subscription documentation(s) that are considered standard for a transaction of this nature. Without this foresight, the rights given to foreign investors may become unenforceable, partially or completely.

Disclaimer – The views expressed in this article are the personal views of the authors and are purely informative in nature.