Equity Investors v. Financial Creditors – Whose haircut is it anyway?

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If retained earnings are negative you probably want to run for the hills on most investments.”

It is evident that private equity investors are always apprehensive to lighten their pockets and invest in startups or companies, especially where they intend to acquire a substantial stake or majority stake in the equity shareholding of such company.

There is always a lurking fear of whether such private equity investors will recover their investment let alone earning a profit. This article aims to discuss the concept of negative shareholder’s equity and concerns of equity investors in dealing with their investments.

What is Negative Shareholder’s Equity?

Shareholder equity is the difference between a company’s total assets and its total liabilities. It reveals what the equity shareholders will be left with if all the company’ assets were sold and debts repaid. Negative equity refers to having a negative balance of equity share capital in the balance sheet and is regarded as a red flag issue for other potential investors and is regarded as a deal breaker in a potential investment transaction.

Causes and Implications:  

Causes:

While there are many causes and actions taken by companies that result in a negative shareholder’s equity, the most common of the lot faced by Indian companies are listed below. Private equity Investors have to be mindful and carefully evaluate each of the below taking into consideration the long-term wellbeing of the company and not treat the below concepts as a passing decision in order to nourish the current needs of the company.

  • Accumulation of Losses:

Continuous accumulation losses over long periods of time result in negative shareholder’s equity, especially when reserved and equity capital is used to offset these losses in the balance sheet. Such offset of equity capital results in negative shareholder’s equity.

  • Companies being over-leveraged:

When companies acquire losses as stated above, it results in outgoings from the company. Such outgoings are often funded by borrowings resulting in debts. Many companies in India usually believe that borrowings are beneficial in order to curb losses and minimise outgoings, without realising the impact that debts have on the company’s balance sheet. When a company is over-leveraged, i.e. when it has a huge amount of debt, shareholders equity is often affected, resulting in negative shareholder’s equity.

  • Buy-back of shares:

It is safe to say that 100% of private equity investors and other equity investors insert this concept in their definitive agreements at the time of investment, and a large number of them enforce these provisions as an exit mechanism. It is pertinent to note for companies and other shareholders that a buyback results in a reduction of equity share capital and thereby also results in having a negative shareholder’s equity in the books of the company. Enforcement of such a provision must be calculative and in the best interests of other shareholders and the company.

  • Payment of Dividends:

In the eagerness to enjoy returns, many companies declare dividends to their shareholders at the behest of the shareholders without properly evaluating the pros and cons of such declaration and payment thereof. Negative shareholder’s equity arises in case more cash dividends are paid than profits earned, and it’s wise for a company to along with its board and shareholders, decide if such payments of dividends are required and if so, at what stage of the company’s growth.

  • Creation of Provisions:

Prevention is not always better than cure.

Another cause of having a negative shareholders equity in the books of the company is due to the fact that most shareholders want to create reserves for various provisions assuming that they will require it to meet future liabilities, if any, that arise during the life of the company. Often, such liabilities are not predictable and a company following good corporate governance and business ethics, will not require to create such hefty provisions, thereby resulting in a lesser valuation of the shareholder’s equity.

Implications:

Negative shareholders equity results in the following implications:

  1. Lesser credit period offered by creditors;
  2. Higher interest rates by banks;
  3. Difficulty in securing further rounds of investment through potential investors;
  4. Lower valuations of the company;
  5. Threat of the company being qualified as a ‘sick entity’; and
  6. Loss of reputation.

Difference between Insolvency and Negative Shareholder’s Equity:

When a company’s assets are lesser than its liabilities, it results in negative shareholder’s equity. In the event the company’s assets are greater than its liabilities, then such value, albeit on paper, illustrates what belongs to the company’s owners, i.e. the equity shareholders. While this concept is more theoretical, i.e. it features in the financials of the company as an undesirable entry, it may not be the case at all and may revive itself in the coming years to appear, not only positive but extremely progressive.

On the other hand, insolvency[1] is when the company is unable to pay its debts and/or has no cash, assets and savings to pay the debts. This means that the company’s option of borrowing money is no longer available. In such cases, we have seen many equity investors injecting the company with equity infusions – after all, no new investors will invest in a company that cannot meet its financial obligations. This becomes overly burdening on the existing equity shareholders, as they infuse surplus in the company which usually, does not meet the debt obligation of the company.

With the introduction of the Insolvency and Bankruptcy Code, 2016, [“IBC”] any creditor is able to file a suit/legal proceeding against the company, i.e. corporate debtor and in the event such suit is filed, the equity shareholders have no option but to comply with all such terms and conditions imposed, being owner’s of the company, and hence, face several challenges, which is dealt with briefly in this article.

 Challenges faced by equity shareholders in IBC proceedings:

  1. Inability to file suits/legal proceedings against the company:

Unlike secured creditors and other creditors who are granted special powers to file suits and/or legal proceedings under the IBC[2], equity shareholders are not allowed to do so and shall rely only on the orders passed by the National Company Law Tribunal [“NCLT”]. This is detrimental to equity shareholders as they are not able to pursue any other modes of recovery of their dues and/or file suits to this effect once an IBC proceeding is initiated.

  • Inability to amend the ranking:

Section 53 of the IBC[3] prescribes the waterfall mechanism for distribution of assets to creditors and thereafter to equity shareholders. There is no scope for equity holders to amend the ranking as prescribed by the IBC and hence, equity shareholders shall always rank last in line to recover any amounts available, and if not, have the fear of going back empty-handed.

  • Cessation of shareholder’s rights in the company and over the shares:

On initiation of an IBC proceeding, equity shareholders shall cease to have rights as shareholders of the company and their equity shall be deemed to be cancelled in favour of the financial creditors/secured creditors.

Conclusion:

Per the above observations and analysis, it is the financial creditors who would take the haircut for a negative shareholder’s equity resulting in an insolvency proceeding with the NCLT. For the various reasons cited above, it is highly recommended that shareholders, especially those that hold substantial stake or majority stake in a company, apprise themselves of facts prior to conduct of a shareholder’s meeting, and/or request the company to provide clarifications to queries, if any, as well as be cautious in approving certain resolution that have financial impacts such as the ones stated above.

Contributed By – Aurelia Menezes
Designation – Principal Associate, Corporate.


[1] Governed by the Insolvency and Bankruptcy Code, 2016

[2]

[3] 53. (1) Notwithstanding anything to the contrary contained in any law enacted by the Parliament or any State Legislature for the time being in force, the proceeds from the sale of the liquidation assets shall be distributed in the following order of priority and within such period and in such manner as may be specified, namely:—

(a) the insolvency resolution process costs and the liquidation costs paid in full;

(b) the following debts which shall rank equally between and among the following :— (i) workmen’s dues for the period of twenty-four months preceding the liquidation commencement date; and (ii) debts owed to a secured creditor in the event such secured creditor has relinquished security in the manner set out in section 52;

(c) wages and any unpaid dues owed to employees other than workmen for the period of twelve months preceding the liquidation commencement date;

(d) financial debts owed to unsecured creditors;

(e) the following dues shall rank equally between and among the following:— (i) any amount due to the Central Government and the State Government including the amount to be received on account of the Consolidated Fund of India and the Consolidated Fund of a State, if any, in respect of the whole or any part of the period of two years preceding the liquidation commencement date; (ii) debts owed to a secured creditor for any amount unpaid following the enforcement of security interest;

(f) any remaining debts and dues;

(g) preference shareholders, if any; and

(h) equity shareholders or partners, as the case may be.

King Stubb & Kasiva,
Advocates & Attorneys

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