On May 4, 2010, the Reserve Bank of India had issued a circular, RBI/2009-10/445, A. P. (DIR Series) Circular No.49, (“New Pricing Guidelines”) amending the pricing guidelines contained in A.P. (DIR Series) Circular No. 16, dated October 4, 2004 for transfer of shares between a person resident in India and a person resident outside India.
The new pricing guidelines stipulate that transfer of shares of a listed Indian company by a person resident in India to a person resident outside India shall not be less than the price at which a preferential allotment of shares can be made under the Sebi guidelines, as applicable.
Provided that the same is determined for such duration as specified therein, preceding the relevant date, which shall be the date of purchase or sale of shares.
The preferential allotment guidelines issued by Sebi, inter alia, stipulate that the price shall be the higher of the average of the weekly high and low of the closing price of the equity shares during the six months and two weeks preceding the relevant date (“Preferential Allotment Price”).
Private arrangements for transfer of shares to which these guidelines apply, usually entail exhaustive due diligence being undertaken by the foreign investor, several rounds of negotiations and certain conditions precedent being satisfied before an actual transfer of shares is effected.
Therefore, there could exist a considerable time difference between the date of execution of the share purchase agreement and the closing of the transaction. The parties may have negotiated a particular price at the inception of the transaction which may have been in line with the then prevailing market price but may not be in line with the price prevailing at the time of closing of the transaction.
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This would, under the earlier guidelines, have resulted in the parties having to renegotiate the price to align it with the market price.
However, this situation will no longer arise under the amended framework, which provides considerable flexibility to the parties by benchmarking the minimum price to the preferential allotment price.
Pursuant to the new pricing guidelines, the price payable on transfer of shares by a person resident outside India to a person resident in India shall not exceed the preferential allotment price.
Under the earlier guidelines, sale on a stock exchange was to be effected at ruling market price and for transfers other than on stock exchange, price was to be arrived at by taking the average quotations for one week preceding the date of application with 5 per cent variation.
This distinction has been removed under the new pricing guidelines and the price for all transfers cannot exceed the preferential allotment price. Further, the flexibility of increase in price up to 25 per cent for control premium in case of transfer of control by the foreign promoter is no longer available.
The new pricing guidelines also provide that transfer of shares by a resident to a non resident of an unlisted company shall not be less than the fair valuation of shares done by a Sebi registered category-I merchant banker or a chartered accountant as per the discounted free cash flow method (“DCF”).
A transfer of shares by a non resident to a resident shall also be effected at the same valuation, the only difference being that in such a case the price so arrived at shall constitute the cap.
In this connection, it may be pertinent to mention that RBI had earlier on April 7, 2010, issued a notification providing that issuance of shares in an unlisted company to a person resident outside India shall be made at a price not less than the fair valuation of shares done by a Sebi-registered category-I merchant banker or a chartered accountant as per the DCF method.
The DCF methodology expresses the present value of a business as a function of its future cash earnings capacity. A DCF valuation is perhaps the most efficient valuation model as it helps in determining the intrinsic value of a stock.
Prior to the amendment, the valuation of shares at the time of issuance or transfer of shares by a person resident in India was required to be made as per CCI guidelines which is based on the average of the net asset value, and the profit-earning capacity value. By stipulating that the valuation would be made as per the DCF methodology, the intention of RBI appears to be to ensure that transactions are concluded at fair market value as the CCI valuation may not adequately reflect the fair market valuation.
In real life situation, transactions are concluded way above the CCI valuation and close to fair market value. However, the RBI by mandating the price arrived at using DCF valuation as the minimum price for transfer of shares/ issuance of shares to a non resident investor has removed any flexibility which was earlier available to the parties while negotiating the price. Consequently, an investor investing at the initial stages may have to invest at a premium, though the company may not have commenced commercial operations. Investments by foreign holding company in its wholly-owned subsidiaries will also now have to be at market value.
A DCF valuation presupposes a going concern. It would be interesting to ascertain how the DCF valuation would be applied for acquisition of a closed unit. Further, mandatory application of DCF methodology in such cases, may also make the acquisition costlier and thus unattractive. It is also pertinent to note that unutilized assets do not produce cash flows, hence do not show up in DCF valuation, unless they are considered separately. Therefore, even if a company has valuable assets which are unutilized, its valuation may not be very high, if the DCF method is adopted.
There is a lack of clarity under the new pricing guidelines on the issue whether the DCF valuation would have to be applied before issuance of shares in transactions where share application money had been received before the coming into force of the new pricing guidelines but shares have not yet been issued. The new valuation methodology should not be made applicable to such transactions, as it would otherwise result in renegotiation of the commercial understanding between the parties.
Further, the valuation of convertible instruments outstanding for conversion at the time of issuance of the new pricing guidelines may also get affected by the new pricing guidelines. The application of the new valuation methodology may result in a significant mismatch between the investor expectation and investor entitlement because of the higher floor price.
A convertible instrument is usually subscribed to by a foreign investor when the investor is not too confident of the valuation. Pursuant to the Consolidated FDI Policy issued by the Department of Industrial Policy and Promotion, Ministry of Commerce and Industry, Government of India, dated April 1, 2010 pricing of capital instruments has to be decided upfront. If the intention of the government is that value of equity to be issued post conversion is also to be determined upfront, in view of the new pricing guidelines, one of the main purpose for issuance of convertible instruments would get defeated.
Fixation of a floor price by RBI is important to ensure that investors do not enter India at abysmally low valuations. However, by prescribing DCF valuation for unlisted entities, RBI has removed the flexibility for commercial negotiations which may be required for a multitude of reasons. Pricing in transactions between unrelated parties may be best left for the parties to decide by way of effective negotiations based on market conditions, which are oft found to be close to fair value. Any acquisition would never crystallise unless the transacting parties are convinced that the price is based on a fair valuation of the company.
The author is Partner, Argus Partners, Advocates. Views expressed are personal