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– Pammy Jaiswal and Saket Kejriwal | corplaw@vinodkothari.com

Background

In recent times, the use of partly-paid shares has seen some traction^[1] where several listed companies^[2] came up with issuance of partly-paid shares^[3]. While the law provides for the issuance of partly-paid securities, it is important to understand how this instrument has not been used merely as a capital-structuring tool, but arguably, as a regulatory workaround. An analogy may be drawn to a situation where a customer is allowed to purchase a valuable by paying a token money today and pay the full consideration after a period of say 1-2 years at the same price which prevailed at the time of payment of token money. Specifically, promoters and investors appear to be utilizing partly-paid shares as a substitute for share warrants, by paying a minuscule part of the value of shares as a part of application money and the balance payment is allowed to be made at any time in the future, sometimes after an unreasonably long time.

In this article, we argue that the issue of such partly-paid shares is as good as issuing share warrants, However, circumventing the challenges associated with warrants.

Fundamentals of Share Warrants

Ashare warrant is a security issued by a company that grants its holder the right/option to subscribe to equity shares of the company (i.e. Future Equity) at a predetermined price, within  a predetermined period, upon the upfront payment of a token amount referred to as the option premium.

Legal Context

A share warrant, being marketable in nature, provides a right in securities, therefore, it is treated as a security under Section 2(h) of the Securities Contracts (Regulation) Act, 1956. Some of the relevant legal provisions would include:

• Sections 42, 62 and other relevant provisions of the Companies Act, 2013; and
  
• The SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018.

Key Features

• Right to Decide: A share warrant allows an investor to subscribe to the company’s equity shares in the future, typically at a price lower than the anticipated market price at the time of exercise. Conversely, if the market price at the time of exercise falls below the pre‑determined price, the investor may choose not to subscribe, thereby limiting their loss to the option premium paid (i.e., the upfront cost), rather than incurring the full loss arising from the difference between the initial/subscription value and the reduced market price.
• Option Premium: The upfront amount paid for obtaining this right is called the option premium i.e. if the current market value of shares is Rs.100, then the issuer may issue equity shares immediately at Rs.100, or Issue a share warrant where the investor pays Rs. 10 upfront for the right to subscribe the equity at Rs. 100 in the future. If, at the time of exercise, the market price of the share has risen to Rs. 120, the investor benefits from locking the price at Rs. 100, making the Rs. 10 upfront cost worthwhile. Conversely, if the market price falls to Rs. 50, the investor may choose not to exercise the warrant, limiting the loss to Rs. 10 i.e. option premium. This forms a part of the net worth of the company. For details on option pricing, may refer to our resource on Option Pricing Model.
• Forfeiture: If the warrant holder chooses not to exercise the right, the upfront option premium is forfeited.

Pricing

The value of option premium is generally determined by Black Scholes Model, Binomial Options Pricing Model or Monte Carlo Simulation Method. The most appropriate method for calculation of option premium, in the context of companies using warrants as a regulatory workaround, is the Simulation Method.

One of the key features of share warrants is that the longer the life of the option, there is a higher probability of its price being high. In accordance with the above models, issuing share warrants for an extended period can raise the option premium to a point where it becomes undesirable. Therefore, it is recommended that the life of a warrant should be just and reasonable, and that it should not be used as a substitute for long‑term convertible instruments such as OCDs, CCDs, CCPS, or other similar securities.

Difference between warrants and partly-paid up shares

While both partly‑paid shares and warrants involve an upfront payment towards a future right in equity shares, they differ significantly on the following points:

Why are partly-paid shares doppelgangers ?

Partly-paid shares in its usual nature when used for capital needs in tranches serves the permitted purpose for this concept was introduced, however, this benefit becomes a governance concern when it is used as an alternative to share warrants and as evident from the table above, the two differ in various aspects. The primary reason for this mirroring lies in valuation. In the case of share warrants issued with a longer tenor, the cost of the warrant, representing the right to subscribe to future equity, tends to be higher when calculated using fair value methods, making this option impractical. As an alternative, many companies have opted to issue partly-paid shares, allowing an investor to pay only a minimal upfront amount (similar to the option premium in the case of a warrant) as part of the application money and reserving the right with the investor to infuse the remaining funds for a longer period like 5-10 years which would not be possible in case of warrants as the premium will increase drastically, if calculated as per fair value methods.

Token money to secure allotment of shares

It is imperative to note that in case of share warrants, the price paid upfront is the option premium which is basically the price paid to get the equity at the current value at the future date as against in case of partly-paid shares, where the investor becomes a shareholder on the first payment date by even paying a nominal part amount reflecting the fair value (consisting of part face value and proportionate premium) as on the date of making such first payment. The catch lies in the fact that there is no legal prescription on the maximum time within which a company needs to make the final call on such partly-paid shares (except in case of IPOs) which in case of warrants runs up to 18 months for listed securities as well as size of the calls which in the case of listed companies requires at least 25% of the consideration amount calculated as per the formula for exercise price^[4] with reference date being the record date shall be received at the time of option premium. 

One may argue that, given the fundamental difference between the two instruments is that one comes with a right (warrants) and the other with the security (partly-paid shares), they can not be used as substitutes as in case of partly-paid shares the right to call money lies with the Board and the investor is obligated to pay on demand, failing which shares may be forfeited, resulting in the loss of upfront amount paid.

On the other hand, a share warrant gives a right to the investor to decide when, or even if, to make the payment. If the investor chooses not to exercise the option, the upfront money paid is still forfeited, with the key difference being that the loss occurs at the investor’s discretion.

The above argument is valid theoretically. However, in practice, this mirroring is frequently used by start‑ups, which are generally incorporated as private companies. In such cases, although the ‘right to call money’ rests with the Board of Directors, the Board itself typically comprises the promoters i.e. the very investors who subscribe to these mirrored partly-paid shares or in the case of external investors/subscribers, their appointed representatives form an integral part of the Board. As a result, the obligation on the subscriber to pay the balance can, in reality, be viewed more as a right, given that it is exercised by a Board largely aligned with the interests of the investors themselves.

Additionally, partly-paid shares provide several benefits to the investor, like proprietary rights, chances to book profits in case of transfer, etc.We have discussed the same below:

Proprietary interest of partly-paid shares

Partly-paid shares are not merely rights in equity shares but allotment of the shares itself. Once an investor pays the subscription money/ first call, the shares are allotted to the investor who becomes a shareholder immediately and gets ownership rights from day one. Having said that, while the benefits arising out of such ownership is proportional to the amount paid up on the shares, it still dilutes the stake of the other investors who hold fully paid up shares.

The investor’s economic risk is lower compared to a fully paid-up shareholder since only part of the share price has been paid, the investor’s capital at risk is limited to the amount actually contributed, while the ownership position in the company already stands created.

Chance to book profits by transfer of partly-paid shares 

If an investor who has paid only a nominal amount intends to sell such shares for reasons like liquidity or apprehension of the investee not doing well for some reason, he stands a chance to make profits on the part payment where the fair value of such shares have appreciated at the time of such transfer. A purchaser can acquire ownership interest by paying only the fair value of the amount paid-up, while the remaining payment is effectively locked in at the historical fair value. This allows the investor to benefit from future upside without proportionately funding the company at the prevailing fair value for the unpaid portion, which remains priced at the value as on the date of issuance.

Imagine a situation where Mr. A invests in the partly-paid up equity shares of XYZ Ltd. The fair value of the equity shares is say INR 150 (face value INR 10) where Mr. A invests only INR 30 as paid up amount. Thereafter he decides to sell these partly-paid shares to another investor after 2 years by which time the balance amount is still uncalled. The transfer of these partly-paid shares would be done at a fair value where lets assume the value of the shares have appreciated and as a consideration, Mr. A receives INR 80 as the sale consideration and also passes on the legacy of holding partly-paid shares to the buyer.

However, this issue does not arise in listed companies, where market mechanisms ensure fair price discovery.

An Ideal partly-paid share

Situation where a partly-paid share shall not be considered as a share warrant

In our view, partly‑paid shares should be supported by a concrete plan or blueprint specifying when the call money is expected to be raised along with its purpose. This includes:

• A defined timeline for making the call on unpaid money;
  
  
• A specific purpose for which the call money will be used; and
  
  
• An upfront subscription amount that is significant and reflects commitment, rather than being a token.

Even if an exact date cannot be determined, it is advisable to link the call to milestones/events ,such as regulatory approvals, project launches, or specific capital needs, rather than leaving it open-ended. This approach distinguishes a legitimate capital-raising intent from doppelganger design of warrants.

Situation where a partly-paid share shall be considered as a share warrant

A partly-paid share may raise regulatory concerns when above conditions do not exist. This includes situations where the initial application amount is nominal, resulting in minuscule capital infusion. Additionally, if the call structure is vague and lacks a defined timeline or commercial justification, it creates ambiguity around the company’s intention to actually raise the remaining capital. The concern is further amplified when the Board of Directors, which holds the discretion to make the call on these partly-paid shares, is influenced or controlled by the very investors who subscribed to these shares. In such scenarios, the obligation to pay the balance amount may become just theoretical.

Conclusion

The intention behind partly-paid shares is to raise capital while allowing the issuer to secure future source of funding, However, when a minuscule amount is paid at the time of subscription of partly-paid shares and the remaining calls are deferred for a long period without any definite /concrete plan, this raises concern as sighted above and from a valuation perspective may not be seen as a partly-paid shares.

^[1] Economic Times

^[2] Economic Times

^[3] Economic TImes

^[4] Regulation 67 of SEBI ICDR, 2018

Read more:

Share warrants under cloud – are companies not allowed to issue share warrants?