Crowdfunding Startups through SARs: A Risky business

Hello and welcome to the 3rd edition of "The Governance Connect", a newsletter covering corporate governance and sustainability updates, presented in a simplified manner, with the intent to serve as an informational and educational medium for audiences interested in the domain.

The startup ecosystem thrives on the basis of funding from investors ranging from Angel investment firms, Venture capitalist firms, Private equity firms, and other financial institutions. Normally, the funding business is a bastion of the pros with deep coffers.

Now, for the general public to invest in startups, whilst staying well within their individual financial capacity, would be an exciting option. Many in the crowd would even jump head-first at the opportunity, without reading the fine print. After all, the idea of being an investor in a startup, with a 2X-5X investment return sounds enticing!

For this edition, we are diving into some regulatory grey areas around this very space of crowdfunding of startups. We will specifically cover Stock Appreciation Rights (SARs).

SARs are essentially meant to be a tool for enabling employee compensation and benefits. However, in some cases, it is being used as an underlying mechanism for raising crowdfunding.

This may seem innocuous and even innovative at first glance, but a deeper look at the legal provisions and statutes would reveal that there are regulatory nuances that startup boards and crowd-investors must not overlook.

Before we read into the risks, let's dive in a take a closer look at SARs.....

What are SARs?

Stock Appreciation Rights or SARs are the rights given to employees or backers that entitle them to receive appreciation in the value of the company's shares over a specified period.

For example, if a startup grants SARs to its backers at a value of $1 per share, and after three years the share value increases to $5, the backers can exercise their SARs and receive $4 per share in cash or shares. SARs are usually settled in cash, which means that the company does not have to issue new shares and dilute its equity.

SARs can be seen an alternative instrument to Employee Stock Option Plan (ESOPs) for making stock-based compensation. The upside for the company lies in the fact that the grant and settlement of SARs do not disturb the cap table, as the settlement is usually in cash.

In the game of SARs-based investing, the most critical piece is the fair market valuation of the organization. How you get to the valuation is in itself a complex process. The valuation methods may vary depending on the stage and nature of the company and may involve assumptions and uncertainties.

Once a backer has subscribed to SARs, they would eventually like to see a multi-fold return on their investment. So how do we get there? There are two ways to liquidate stock appreciation rights or SARs:

1. The company decides on a fair market value and liquidates existing rights while raising fresh funds.
2. SARs owners get a natural exit when the company gets acquired, merged, or listed.

In both cases, the company has the exclusive discretion to redeem the rights. The subscriber does not have the option to do so.

NOTE: Liquidating SARs will obviously result in a cash outflow.

As a growth-stage organization, it is only natural to give the lowest priority to any discretionary cash outflow. Something that investors need to be mindful of.

Risks hide in plain sight! Are you looking?

SARs are a great mechanism when granted to employees of an organization. Some would argue these are better than the Employee Stock Option Plan or ESOPs. However, when used for crowdfunding, these may create legal and regulatory challenges for the organization and huge risks for its backers:

• Zero Obligation: Companies are not bound to offer a buy-back for the SARs. The decision to give an exit to backers with SARs is totally discretionary and lies purely with the company. The company's valuation may appreciate over a period of time, which means the underlying stock value gets a bump, however, outside investors may still be left high and dry as the company may not want to liquidate the outstanding SARs as it results in cash outflow.

• Transparency of Financials: Companies that raise funding through these routes do not share their complete financials for public consideration since they are unlisted and not obligated to do so. In the recent past, there have also been a few instances of book cooking leading to inflated valuations coming to light. So, when institutional investors with an array of analysts and complete data have a hard time detecting such malfeasance, imagine the odds of an individual investor with limited information making the right investment decision.

• Shareholder Rights: SAR subscribers do not hold any shares, and hence subscribers have no shareholder rights. You don't get to vote, and neither are you on the cap table. There is no lever for the subscribers to influence the decision to liquidate SARs in any possible way.

• Regulatory Greys: While Sec 62, Companies Act, 2013 has clearly prescribed rules for the issuance of equity under stock option plans, the guidance on the grant and exercise of SARs is unclear and may be subject to interpretation. Without a clear regulation governing and protecting investor rights, investing through SARs can be potentially risky for the crowd-investors. Jumping without a parachute, are we?

• Private Issue vs Public Issue: The start-ups are unlisted organizations and therefore cannot raise funds via public issue. This means that the crowdfunding raised via SARs would essentially amount to a private placement offer. Provisions under Section 42, Companies Act 2013, specifically call out that a private issue cannot be offered to more than 200 entities in a fiscal year. In addition, the provisions also demarcate that such a private offer cannot be publicly advertised through any media or platform.

Now add the colors of crowdfunding to the mix......the greys seem to be getting darker, eh?

Conclusion:

All investment options present some form of risk for the investors. However, if we look at SARs as a mechanism for crowdfunding, it is akin to scratching your back with a Samurai sword!

Using the wrong tool for the job not only jeopardizes the favorable outcomes (in our example, a pleasant back-scratching experience) but it also puts a huge risk on the user's plate. While it may allow the organization to raise fund without any dilution of equity, the risk to the investor is huge.

SARs are a highly nuanced tool and come with their share of legal, regulatory, and financial challenges that should not be overlooked. As a principle, SARs are not a fundraising tool, and their usage as one is a regulatory grey area, at the best.

For crowd investors who do invest in such mechanisms, due diligence and a proper understanding of the contracts and associated risks are table stakes. Yes, read that multi-pager agreement before you put in the investment. Talk to your CA and/or a legal expert. Be a smart investor and know your investment alternatives. All Startup stories are not about unicorns, there are leprechauns too!

Disclaimer:

The information contained in this article is for general informational purposes only and is not intended to be a substitute for professional legal advice, investment advice, or strategy. The data referenced within the article has been researched and sourced from various sources, listed under the references section. The author of this article makes no representations or warranties of any kind, express or implied, about the completeness, accuracy, reliability, suitability, or availability with respect to the information contained in this article. Any reliance you place on such information is strictly at your own risk. In no event will the author be liable for any loss or damage including without limitation, indirect or consequential loss or damage, or any loss or damage whatsoever arising from loss of data or profits arising out of, or in connection with, the use of this article.