The news of Ashneer Grover’s resignation is being added to the list of celebrated promoters of tech startups who lost control over the very companies they founded. The list also includes Binny and Sachin Bansal of Flipkart. Whether or not the allegations against Ashneer are true, it is certain that founders of tech startups have the risk of losing their brainchild.  Why do these founders have to face such a fate?

Dilemma Faced by Founders

Tech companies usually have an asset light business model, which means they have fewer assets and much of their capital is invested in personnel and operations. For this reason, they have difficulty seeking loans from financial institutions since they don’t have assets to be used as collateral. Therefore, to finance their expansion and growth, these companies have to resort to raising equity capital. However, upon issuing shares to investors, the investors gain control through voting shares while the founders lose their share of control. Hence, the founders of tech startups risk losing their position in the company.

Importance of Founders’ Control in the economy 

The typical argument in favour of the removal of founders is that since investors have paid for the share capital, they should be the ultimate decision-makers in the company, not the founders. However, we should not ignore the macro-economic effect this phenomenon of founders’ losing control will have on our economy. Starting a company involves lots of painstaking effort in turning innovative ideas into reality. Every person would like to reap the fruits of their own brainchild and would like to have control over the company they started. Therefore, if founders realise that they will soon lose control over their startup, they will be hesitant to expand the company. This could adversely affect the Indian economy by losing out on many potential tech giants. Thus, it is important that founders retain adequate control over their companies and, at the same time, not be hesitant to expand their businesses.

Differential Voting Rights to Rescue

Differential Voting Rights Shares, or DVR shares, are a tool which can solve the issue of control by founders. In 2019, SEBI released a consultation paper on the issuance of DVR shares, especially focusing on tech startups. Later, it came up with a framework that allowed for the giving of shares with superior voting rights to the promoters of the company. A promoter’s share can have up to 10 votes and a minimum of 2 votes per share. These shares cannot be transferred by one promoter to another promoter and will be converted into ordinary equity shares upon the demise of the holder. Superior Rights Shares can have up to 74% of the total voting power, which means people who have SR shares can collectively exercise 74% of the control. This would ensure that promoters exercise due control over the company. 

Safeguards in DVR Framework. What’s in it for Investors?

At first glance, it might appear that DVRs would be very risky for investors. However, the picture is not all gloomy. First of all, the loss of control of investors is generally compensated by higher dividend. Secondly, there are still some aspects where the investors can exercise due control. There are “coattail provisions” whereby all the shareholders would have votes proportional to the shares held by them. These issues include the appointment or removal of independent directors and/or auditors, related party transactions with parties having SR shares, voluntary winding up of the company, changes in the Memorandum of Association and Articles of Association etc. Thirdly, the SEBI framework requires all companies who wish to issue DVR shares to have 2/3rds of all their board members filled with independent directors and the audit committee to be fully comprised of independent members.

Sunset Clause: Watering down the Framework 

SEBI has put forward a time-based ‘Sunset Clause’ of five years, which means the right to have a superior vote will only last for five years. It can be extended at most for another five years if the rest of the ordinary equity shareholders agree. This waters down the potency of the entire framework, since it provides protection from losing control for just a mere five years. No promoter would like to make painstaking efforts to establish a company where he would be guaranteed leadership for just five years. Similarly, the promoters of startups would not make an effort to re-organize the company to have DVRs just for five years. Thus, the time period of the sunset clause acts as a major disincentive to having DVRs.

Coattail provisions and the corporate governance safeguard of appointing independent directors are strong safeguards to make sure promoters and founders do not misuse investors’ money. Therefore, a longer period of 20 years should have been granted by the SEBI to the promoters to exercise superior voting. This has been requested by some promoters, but SEBI has not heeded to their demands. The earlier framework of DVRs, which allowed for fractional voting shares (less than one vote per share), was much better since it was for an indefinite period of time. However, that framework has been done away with. To enable the protection of founders, SEBI needs to extend the time period in the Sunset Clause.

Agency Costs in DVRs

At the same time, the state should ensure that there are other structural measures taken to prevent the misuse of these DVR shares. From a ‘law and economics’ perspective, the misuse of DVR shares can be termed “agency costs.” Agency costs are expenses incurred as a result of a misalignment of an agent’s interests with those of the principal. In this case, the principals are the equity shareholders of the company who are the actual owners, while the board of directors and top management would act as agents. When the top management works in their own interests, which would conflict with the interests of the shareholders they represent, it is said to incur agency costs.

There are usually two ways to reduce agency costs. The first method is to give shareholders the power to vote to hold the agents accountable. Principals (shareholders) have the power to remove agents (directors) who are not working in the interests of the principals. Similarly, the agents are obligated to follow the decisions taken by the principals through voting, and all major decisions of the company are taken through voting. This is known as the “Voting Safeguard.”

The second method to reduce agency costs is through laws. The state would enact laws that prohibit or mandate the agent to act in a certain way. The state here assumes that this prohibition or mandate would always be in the shareholder’s general interest and, therefore, enacts a law for the same. For example, the punishment for fraud under Section 447 of the Companies Act 2013 is a “Legal Safeguard”. 

The DVRs curb the first method to reduce the agency cost, i.e., the Voting Safeguard. As a result, the legal safeguard is the second option. To empower it as a safeguard against agency cost, it is essential that the state takes appropriate measures to facilitate access to justice. Access to justice should not be costly, time-consuming, or cumbersome. 

Class Action: A powerful legal safeguard 

The class action suit against a company under Section 245 of the Companies Act, 2013 is a beneficial provision to facilitate access to justice. Under this, either a hundred members or 5% of total members or any member with at least 2% of shareholding (for listed companies) can file a suit against any director of the company or the company itself in the NCLT. The tribunal can provide any requisite remedy that it thinks is appropriate. The cost of the application is also borne by the company. Investors can make use of this provision to restrain misuse of DVRs.

This might lead to a rise in cases of NCLT since, in the words of Charles Elson, “when you have dual-class shares, what you are doing is exporting the monitoring function to third parties—to the government, the courts, and the regulators.” Looking from the perspective of Cathedral Rule Models by Guido Calabresi, DVRs make the removal of directors a liability rule model from a property rule model. ‘Property Rule’ model consists of remedies where an entitlement holder can himself take action and exercise control. ‘Liability Rule’ model consists of remedies where one approaches an institution of the state, such as a tribunal, to preserve their entitlement.

This would be a burden that the state should be willing to carry for the sake of the growth of tech startups in the economy. Another alternative to this, perhaps, would be to create an internal body with independent directors, where shareholders can address their grievances against directors in cases of fraud, and if satisfied, it can remove the director. SEBI can put forward the creation of such a body as a prerequisite to issuing DVR shares.

Conclusion

The impact of the loss of control of founders of tech startups is highly underestimated by the government, regulators, and academia. We cannot even quantify the potential loss that the Indian economy would face due to curbing the growth of tech startups. We are losing potential tech giants to India due to this. Differential Voting Rights, if their sunset clause is extended for a long period, can be a good solution to this problem. The state can also consider making necessary changes with regard to access to justice to overcome the limitation of voting safeguards in DVRs.

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ABOUT THE AUTHOR

Jerrin B. Mathew

Jerrin is a fourth-year (B.A., LL.B. Hons.) student at the National Law School of India University Bangalore. He has a keen interest in Corporate law, with a focus on the functioning of the capital market regulator SEBI. Apart from Corporate law, he is interested in Legal Disability Studies and is a part of the Disability Support Group of the National Law School of India University.