The Price is Right This article attempts to set out the rules for valuation, as prescribed in various regulations, which have an impact on M&A transactions in India. Calculation of Price - Investments Foreign direct investment in an Indian company ( FDI ) is inter alia subject to the pricing guidelines as issued by the Reserve Bank of India ( RBI ). Transfer and Issue to Persons Resident outside India: Prior to April 21, 2010, (a) the transfer or issuance of shares of a listed company made to a person resident outside India, was to be made at a price equal to or above the guidelines issued by the Securities and Exchange Board of India ( SEBI ), and (b) the transfer or issuance of shares of an unlisted company to a person resident outside India was to be made at a price equal to or above the fair value as determined by an chartered accountant using the guidelines issued by the erstwhile Controller of Capital Issues ( CCI ). The pricing guidelines for inbound investments in India provide for a floor price, which is aimed at ensuring that a minimum amount is invested into the company. In April and May 2010, the RBI made some marked changes to the method of calculating the fair value of shares of an unlisted company, viz. the move from calculating the fair value using the discounted free cash flow ( DCF ) method instead of the CCI method. The DCF method values the business by discounting its free cash flows from the explicit forecast period and the perpetuity value thereafter. The cash available for distribution to both the owners and the creditors of the business represent the free cash flows. While determining the perpetuity growth rate, it is important for the valuer to take into consideration the past growth rate as well as the future projections for the explicit period. The free cash flows and the perpetuity are then discounted by the Weighted Average Cost of Capital ( WACC ). WACC is the appropriately determined rate of discount to calculate the present value of cash flows as it considers the equity-business risk and the debt-equity ratio of the company. After discounting the future cash flows and the perpetuity value, the present value calculated is a fair indicator of the value of the business.
Under the prevailing regulations prescribed by the RBI, the following rules are applicable for identifying the price of the transfer / issuance of shares of a company: Listed Companies: The price at which shares of a listed company may be issued or transferred to a person resident outside India shall not be less than the floor price calculated in accordance with the guidelines issued by SEBI. Unlisted Companies: In the case of an unlisted company, the price at which shares of an unlisted company may be issued or transferred to a person resident outside India must not be less than the fair value of the shares, as determined by a SEBI registered merchant banker or a chartered accountant in accordance with the DCF method. Convertible Shares/Debentures: The pricing of convertible shares/debentures should be decided upfront at the time of issue of the instruments. The price at the time of conversion should in no event be less than the fair value calculated, at the time of issuance of these instruments. Qualified Foreign Investor(s) ( QFI(s) ): The pricing for all eligible transactions and investment in all eligible instruments by QFIs shall be accordance with the relevant SEBI guidelines. In addition to the above, the Companies Act effectively prescribes the face value of shares as the floor price for a transaction which is sought to be undertaken without prior approval of the Company Law Board. Section 79 of the Companies Act provides the manner in which shares may be allotted at a discount which inter alia include: (a) at least 1 year should have passed since the company was entitled to conduct its business, (b) shares to be issued at a discount should be of a class already issued, (c) sanction of the Company Law Board ( CLB ) is to be obtained, (d) the resolution must specify that maximum rate of discount, not exceeding 10%, unless the CLB sanctions a higher rate, and (e) shares should be issued within 2 months of receiving the order from the CLB. The only exception to the requirement for CLB sanction is when a company issues sweat equity shares as per the provisions of the Section 79A of the Companies Act to employees or directors of the company at a discount, or for consideration other than cash in recognition of their contribution to the company.
The key exceptions to the above RBI rules on pricing are as set out below: Rights Issue: The price of shares offered during a rights issue to the shareholders resident outside India, (a) by a listed company, shall be at a price as is determined by the company for the relevant rights issue in accordance with the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 ( ICDR Regulations ), and (b) by an unlisted company, shall be at a price not be less than the price at which the offer on a rights basis is made to the resident shareholders. Foreign Venture Capital Investor ( FVCI ): As per Schedule 6 to Foreign Exchange Management (Transfer of Issue of Security) by a Person Resident outside India) Regulations, 2000 ( FEMA 20 ), a SEBI registered FVCI can acquire or sell equity / equity linked instruments / debt / debt instruments, debentures of a Venture Capital Undertaking ( IVCU ) or of a Venture Capital Fund ( VCF ) or in units of schemes / funds set up by a VCF by way of public offer or private placement by the issuer of such securities and /or by way of private arrangement with a third party at a price that is mutually acceptable to the acquirer and the seller. However, in the event that an FCVI was to invest in accordance with the provisions of Schedule 1 to FEMA 20, the pricing guidelines as set out in relation to the listed companies and unlisted companies would be applicable, i.e. the cap / floor of the SEBI guidelines and the DCF valuation respectively. Calculation of Price with respect to Divestments by Non-Resident Investors Under the prevailing regulations prescribed by the RBI, the following rules shall be applicable for identifying price for the transfer / issuance of shares of a company Listed Companies: In the case of a listed company, the price at which shares of a listed company may be transferred by a person resident outside India to a person resident in India shall not be more than the floor price calculated in accordance with the guidelines issued by SEBI. Unlisted Companies: In the case of an unlisted company, the price at which shares of an unlisted company may be transferred by a person resident outside India to a person resident in India must not be more than the fair
value of the shares as determined by a SEBI registered merchant banker or a chartered accountant in accordance with the DCF method. However for a transfer of shares between a person resident outside India (not being an NRI) to another person resident outside India, the DCF floor price should not apply. Calculation of Price with respect to Overseas Direct Investment Under the prevailing regulations prescribed by the RBI, for the transfer of shares by way of sale, the following rules shall be applicable for identifying price at which the shares of a foreign company are to be transferred: Listed Foreign Companies: In the case of a listed foreign company, the price on the stock exchange where the shares are listed. Unlisted Foreign Companies: In the case of an unlisted foreign company where the shares are to be disinvested by a private arrangement, the share price should not be less than the value certified by a chartered accountant / certified public accountant as the fair value of the shares based on the latest audited financial statements that company Conversion of ADRs /GDRs: Shares acquired of a foreign company engaged in bona fide business activity, in exchange of ADRs/GDRs, should be valued (a) as per the recommendations of the Investment Banker if the shares are not listed on a stock exchange; or (b) based on the current market capitalization of the foreign company, which in turn is arrived at on the basis of the monthly average price on any foreign stock exchange, for the three months preceding the month in which the acquisition is committed, and over and above the premium, if any, recommended by the Investment Banker in its due diligence report in other cases. Calculation of Price with respect to ICDR Regulations and Takeover Code Any preferential allotment of shares of a listed company shall be made in accordance with the provisions of Regulation 76 of the ICDR Regulations, which inter alia provide that the price for allotment of shares shall be the higher of the average weekly high and low of the closing price of the related equity shares during the trailing twenty-six week period or the trailing two week period, preceding the relevant date. However, in the event the listed
company has not been listed for twenty-six weeks, slight modifications are applicable for calculating the method of pricing. The price as set out in Regulation 76 shall also be applicable for transfer / issuance of shares resident Indians to persons resident outside India and vice versa. The SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 ( Takeover Code ) provides that the offer price for making an open offer shall not be less than the price as calculated under Regulation 8 of the Takeover Code, for frequently or infrequently traded shares. Regulation 8 of the Takeover Code provides that: (a) if the listed company s shares are frequently or infrequently traded, then the open offer price for acquisition of shares under the minimum open offer shall be higher of the following: Highest negotiated price per share under the private arrangement / agreement triggering the offer; Volume weighted average price of shares acquired by the acquirer during fifty-two weeks preceding the public announcement ( PA ); Highest price paid for any acquisition by the acquirer during twenty-six weeks immediately preceding the PA; and Only in cases of frequently traded shares, volume weighted average market price for sixty trading days preceding the PA; or Only in cases of infrequently traded shares, the price determined by the acquirer and the manager to the open offer after taking into account valuation parameters including book value, comparable trading multiples, and such other parameters that are customary for valuation of shares of such companies. It may be noted that the Board may at the expense of the acquirer, require valuation of shares by an independent merchant banker other than the manager to the offer or any independent chartered accountant in practice having a minimum experience of 10 years.
As per the Takeover Code, all shareholders are to be given equitable treatment and no promoter or shareholder can be paid any extra price, by whatever name it may be called. Since indirect acquisitions involve acquiring the listed company as a part of a larger business, the Takeover Code has prescribed additional parameters to be taken into account for determination of the offer price. In indirect acquisitions which are not in the nature of deemed direct acquisition(s), the offer price shall stand enhanced by an amount equal to a sum determined at the rate of 10% per annum for the period between (a) the earlier of the date on which the primary acquisition is contracted or the date on which the intention or the decision to make the primary acquisition is announced in the public domain, and (b) the date of the detailed public statement, provided such period is more than five working days. Impact on M&A Transaction Issue of shares on a rights basis: The price of shares offered on a rights issue to the shareholders resident outside India, by an unlisted company, shall be at a price not less than the price at which the offer on a rights basis is made to the resident shareholders. There is a certain amount of ambiguity on the manner of calculating the price for allotment to of shares to persons resident outside India under a rights issue, in the event that there are no resident shareholders and the entire shareholding of the company is held by persons resident outside India. Transfer of shares of a listed company in an off-market transaction The price for acquisition of shares of a listed company by way of a private arrangement would require compliance with the guidelines as prescribed by SEBI from time to time. So long as the pricing for the transaction is compliant with the specific SEBI regulations such as IPO, book building, delisting, block deals, exit, open offer, buy-back, Takeover Code, there will be no requirement for the prior approval of the RBI. The price for a block deal shall not exceed +/- 1% from the ruling market price/previous day closing price, as applicable. Future Cash flows are indeterminate:
Computation of fair valuation by way of DCF is based on future projections. As there is no fixed mechanism for analyzing the future projections and since RBI has not provided any specific guidelines in relation to the mechanism for calculating DCF, there is a lot of fluidity on how DCF is computed and hence, parties may land up in a scenario where the DCF is higher or lower than the negotiated price. Parties very often agree to execute business plans in agreed form to ensure that they can achieve the desired DCF valuation at the time of exit. Definition of Control Control is currently defined in the FDI Policy dated April 5, 2013, to mean a company where resident Indian citizens and/or Indian companies have the power to appoint a majority of its directors in that company. The Cabinet Committee on Economic Affairs has recently approved the proposal of the Department of Industrial Policy & Promotion ( DIPP ) for amending the existing definition of control under the FDI Policy. This definition is still to be notified by the regulatory authorities. The revised proposal, will expand the definition of control to cover control exercisable inter alia through management and policy decisions, shareholding, management rights and shareholder agreements. The revised definition appears to be proposed to align the definition of control, with the definition as provided under the Takeover Code and proposed under the Companies Bill, 2012. As per the regulations prescribed by RBI and the DIPP, any downstream investments made by companies which are not owned and controlled by resident Indian persons / entities, are required to comply with sectoral conditions on entry route, other conditionalities and caps. It is difficult to ascertain the intent of the regulators when using the word conditionalities here. Hence, a possible view would be that downstream investments by companies which are not owned and controlled (especially in view of the new definition) by resident Indian persons / entities would require to comply with the pricing guidelines as applicable to direct investments by persons resident outside India. Tushar Raut is a Senior Associate in the Mumbai office of AZB & Partners.