Guest Column: New Pricing Model: Cause of Concern for Private Equity Investors in India

Author - Shantanu Surpure, Managing Attorney, Sand Hill Counsel, Mumbai, Assisted by Rashi Saraf,

Associate, Sand Hill Counsel

Introduction

The recent amendments in the valuation norms of unlisted shares introduced by the Reserve Bank of

India (“RBI”) may have an adverse effect on investments by foreign private equity and venture capital

investors in India.

Previously, the issue price of shares of an unlisted company transferred by way of sale by residents to

non-residents was determined at book value in accordance with the guidelines issued by the Controller

of Capital Issues (“CCI”). The recent changes introduced by the RBI propose to value such shares using a

“Discounted Free Cash Flow” (“DFCF”) model.

Guidelines issued by CCI

In India, the office of the CCI (SEBI’s precursor) determines the minimum price at which unlisted share

issuances are to be made. The pricing of shares of listed companies is determined in accordance with

the Securities Exchange Board of India (“SEBI”) guidelines.

Under the CCI Guidelines, the “Fair Value” (“FV”) of the company’s shares was computed by averaging

the values obtained by the “Net Asset Value” (“NAV” which is the traditional book value per share

computed on the basis of the latest published annual accounts) method and the “Profit Earnings

Capacity Value” method (“PECV”) under the share valuation process under the CCI guidelines. These

computations relied exclusively on recent audited accounts.

If the average of NAV and PECV, capitalized at a specified rate, fell short of market value by less than

20%, the average was regarded as a fair value. In other words, as much as 20% undervaluation was

considered acceptable. Since revaluation of fixed assets was not ordinarily permitted for NAV

computation, the average was usually an underestimate of the true value.

DFCF method

All unlisted companies are now directed by RBI to move from the existing book value method to the

market-based valuation method. Pursuant to the recent notification issued by RBI, the pricing of shares

of unlisted companies shall not be less than the fair valuation of shares conducted by a SEBI-registered

Category – I merchant banker or a chartered accountant as per the DFCF method.

This method is based on the future earnings. It uses future cash flow projections and discounts them to

arrive at a present value, which is used to evaluate the potential for investment. Therefore, the

valuation of the shares is likely to be higher than the valuation arrived at using the earlier book building

method.

Apart from introducing new pricing norms for shares of unlisted companies, investors in Indian

companies may also have to worry about paying additional taxes while making investments. As

proposed by the Central Board of Direct Taxes, an investor who buys shares at a value which is lesser

than the fair market value of shares will have to pay tax on the difference between the two. As a result,

foreign investors (liable to pay approx. 42 percent) and domestic entities (liable to pay approx. 33

percent) will be required to pay tax on purchase of shares at discounted rates in addition to paying

capital gains tax on exit.

Impact of the DFCF method

In addition to reducing the chances of a lower valuation which was possible under the CCI guidelines,

the new DFCF method will bring parent companies investing into their wholly owned subsidiary

companies under scrutiny.

The DFCF method may encourage foreign investors to register as a Foreign Venture Capital Investor

(“FVCI”) with SEBI to benefit from the exemption available to SEBI registered FVCIs from entry and exit

pricing regulations as per the RBI notification issued in December 2000.

However, registering as an FVCI is not without its negative aspects. FVCIs are granted permission to

register with SEBI only on the condition that they invest in the following nine sectors as identified by the

Finance Act, 2007 with regard to Section 10 (23FB) of the IT Act 1961:

i) Biotechnology

ii) Information technology relating to hardware and software development

iii) Nanotechnology

iv) Seed Research and Development

v) Research and Development of new chemical entities in the pharmaceutical sector

vi) Production of bio-fuels

vii) Building and operating a hotel and convention center with seating capacity of more than 3000

viii) Dairy or Poultry industry; and

ix) Developing, operating or maintaining any infrastructure facility

Conclusion:

It remains to be seen what the impact of the change in valuation methodology has on private equity

investors in India. It raises the minimum price of share issuances and therefore impacts the ability to

structure transactions.

About the Author

Shantanu Surpure is Managing Attorney of Sand Hill Counsel, a law firm with offices in Mumbai and

Silicon Valley. Shantanu holds law degrees from Oxford and Columbia and is licensed to practice law in

India, California, New York and England and Wales. Shantanu has a general corporate law practice with

a special focus on cross-border VC/PE and M&A transactions.