Hybrid securities to propel Startups

The startup culture in India can propel significant economic growth in the Indian economy. Recent emphasis on a digital economy as well as technical innovations such as cashless transactions, digitisation of consumer services, etc. have revolutionised the entire functioning of the country’s economy.

Considering this and contemplating the shape of things to come, the Indian government is focussing on coming up with new initiatives which would be conducive to the growth of India startups. From allowing FDI in startups to simplifying the company registration process, the government has taken a number of steps to encourage entrepreneurship.

The biggest dilemma a promoter faces while raising capital from outside sources is the dilution of control in a venture culminating out of his blood and sweat and the looming threat of a hostile investor taking over.

Therefore, the government is keen to introduce hybrid instruments which would help in raising funds without the startup promoters having to give up on control.  Thus, a promoter may still be able to retain control over his company even with a minority stake.

Let us discuss the meaning of hybrid instruments and examine how they can assist startups in raising secure funding without the fear of losing out on their company’s control altogether.

What Are Hybrid Instruments?

Hybrid instruments in simplistic terms are financial instruments which combine the characteristics of more than one financial instruments. For instance, an instrument which contains the features of both debt and equity would be a hybrid instrument. Debt is fixed price and does not provide control, whereas equity would provide proportionate control to the holder. This would dilute the amount of equity shares being issued to the investor and hence would reduce the amount of control which goes in the hands of the investor. Some examples of hybrid instruments are optionally convertible debentures and partially convertible debentures. Hybrid instruments provide the following advantages:

a)     They give greater returns on capital

b)     Diversify risk

c)     Provide profits from both interest rates and equity share prices.

Government’s Proposal

Currently, FDI is permitted through equity shares and debts. Partially convertible bonds are treated as debt and can be issued in accordance with External Commercial Borrowing guidelines. The government in addition to these instruments is proposing to bring a new instrument by which FDI may be infused in the country. This would be the hybrid instrument which would reflect features of both equity and debt. Government’s earlier proposal of introducing optionally and partially convertible preference shares and optionally and partially convertible debentures was scrapped as it appeared restrictive and not innovative.

A separate policy may be framed for these instruments. This move on the part of the government is laudable as this would provide more flexibility to promoters especially those of startups. It would enable them to raise money without compromising on control. Such instruments are highly prevalent in developed markets.

How Would Hybrid Instruments Help Startups

Currently, startups can raise funds either through debt or equity. High interest rates make debts not a very viable option, hence leaving startups with the sole option of equity as a means of raising money. This essentially means giving the financer / investor a significant stake in the startup and in most cases, losing control over the company.

Presently, as a norm, equity shares in India do not carry differential voting rights, hence selling off huge amount of equity in return for cash would ultimately drive out the startup founder from his own company. In such a scenario, hybrid instruments which apart from having features of both debt and equity also come with differential voting rights, would be a source of great relief for startup founders. This could be the key for startups to raise funding while retaining control with themselves.

Conclusion

The introduction of hybrid instruments as an instrument of FDI in India would be a boon to innovations and entrepreneurship in the country. External financing would not eliminate the incentive of innovation. Moreover, this would expand the scope of foreign investment in India and further enhance economic development.

However, what remains to be seen is that in a situation where equity would be a win-win situation for investors, how many of them would opt for hybrid instruments and to what extent can the startups bargain for an alternative hybrid instruments route. 

Research inputs by Soumya Shekhar