Foreign listing of Indian startups: Whether exit window for Chinese investors?

On April 22, 2020, the Indian government amended its Foreign Direct Investment (FDI Circular) policy barring investment without official clearance from any bordering countries – China, Myanmar, Bhutan, Nepal, Pakistan, and Bangladesh – in what is widely seen as a move to curb opportunistic takeovers and acquisitions by Chinese firms. It should be noted that until early 2020, China had invested close to $4 billion in approximately 90 startups in India. Several unicorns such as Zomato, BigBasket, Paytm are backed by Ali Baba, while Tencent has invested in other unicorns such as Byju’s, Ola, and Swiggy.

From the FDI Circular, it appears that the Indian government has a right to approve any transaction in which a Chinese investor may have any beneficial ownership interest. To ensure that the powers of the Indian Government are not fettered, the term “beneficial ownership” has not been defined in the said FDI Circular. Accordingly, any transaction involving a Chinese investor whether as a direct investor or as an investor in a pooled investment vehicle or through a step-down structure will attract the scrutiny of the Indian government.

Given the above and keeping in view the strained relationship with China over the incidents at the LAC, it may happen that Indian startups and/or the Chinese investors may face increasing pressure to disengage from each other. Given the current situation especially influenced by Covid-19, it may not be apt for Indian startups to give the desired exit to Chinese investors. Further, it is possible that existing global investors in these startups may not want to exercise their rights under existing agreements to acquire the stake of exiting Chinese investors.

Most investment agreements will ensure that an exit opportunity is provided to investors through an initial public offering (IPO) within a specified time. Typically, from a valuation perspective, IPO is the preferred exit option for an investor. Further, certain investors identified on the basis of ownership interest in the startup will have rights under the investment agreement to cause the founders and the start-up to conduct an IPO.

Many a time, such a provision in the agreement does not come into play especially if the ownership structure is in India, as under Indian IPO norms the conditions for listing may be challenging especially the “profitability” test, that is, at least minimum average pre-tax profit of Rs 150 million during the three out of the last five preceding years. This condition and a few others (such as availability of 75 per cent of finance for a specific project other than the IPO funds) will be beyond the capacity of any startup to satisfy. For offer for sale, that is, existing shareholder offering its shares in an IPO additional conditions will be required to be fulfilled. Further, special dispensations given to technology companies to access institutional capital through stock exchanges in India have not resulted in any tangible results.  Accordingly, the avenues available for Indian startups to give exit to Chinese investors seem limited.

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Keeping the above in view, it appears that the intent of the Indian government to permit the direct listing of securities by Indian public companies in permissible foreign jurisdictions announced by the Ministry of Finance on May 27, 2020, and further reflected in the amendments made to Companies Act 2013 under the Companies (Amendment) Act, 2020, which was assented to by the President of India on September 28, 2020, may come to the rescue of Indian startups to provide an exit to the Chinese investors.

Hence, if a direct listing is permitted for Indian startups in mature markets such as the US, the UK, Japan without the obligation of first listing the startup in India, Indian startups may benefit significantly as they will get access to capital at a better valuation as various technology companies have already been listed in these countries. Further, global investors will become aware of the potential of Indian startups which will certainly benefit the sector as a whole.

The Indian government is currently drafting the rules and regulations for permitting such listings. Amendments may also be required in Indian foreign investment laws and laws enacted by SEBI. It will be interesting to see the nature of Indian start-ups that may be eligible for this direct listing opportunity. Eligible Indian startups may welcome such opportunities, even if such start-ups are under no pressure to give exit to their Chinese investors as they will get access to capital at better valuations.

Indian startups eligible to raise fund through this route should also take into account timelines within which they can list as typically listing a company requires preparation time and satisfactory disclosure of information. Further, corporate governance standards are required to be at its best. Liabilities for flouting disclosure norms or corporate governance norms are heavy! Further, as founders may cease to have substantial ownership interest post an IPO, founders need to be well aware of risks associated with shareholder’s activism in the chosen jurisdiction and strategies to avoid ceasing to have control over their companies.

Accordingly, though startups may conduct an IPO in a foreign jurisdiction to give an exit to its Chinese shareholders, however, the key drivers for such a listing need to be centered around accessing long term capital and gaining global investors’ confidence. Mere exit to Chinese investors should not be used as the driver to list Indian startups abroad!

Souvik Ganguly is the Managing Partner of Acuity Law. Research for this article was assisted by Altamash Qureshi, Associate, Acuity Law. Views expressed are the author’s own.