REVERSE FLIPPING A GROWING TREND: HOMECOMING FOR INDIAN STARTUPS

INTRODUCTION

The trend known as “reverse flipping” or “internalisation” refers to the process in which startups that were first registered in offshore jurisdictions decide to move their holding companies to India, has gained popularity in recent times. Businesses in industries including fintech, e-commerce, stock broking, healthcare, and edtech are among them.

Established businesses like PhonePe, Pepperfry and Groww have recently returned to India and many startups, including Razorpay, Flipkart, Pine Labs, Zepto, Meesho, Eruditus and Udaan, are actively considering or have begun the process of shifting their domicile to India.

This trend indicates a change in the perception of the Indian startup ecosystem and highlights the Indian market's increasing maturity and appeal.

In this article we discuss this growing trend and certain key legal considerations to note, for entities considering a reverse flip into India in the near future

THE FLIPPING PHENOMENON

In order to understand what reverse flipping is, it is important to understand the erstwhile practice of “flipping” in the Indian startup realm. “Flipping” refers to a trend that involves the transfer of an entire Indian entity to a foreign entity, along with the transfer of key assets such as intellectual property/technology. This results in an Indian company becoming a wholly owned subsidiary of a company domiciled in a foreign country, such as Singapore or the United States of America (USA), with operations continuing to be conducted in India. Essentially, the ownership of the entity is relocated abroad, while the value remains vested with the Indian entity.

The primary drivers behind the development of these structures were the attraction of international investors, access to deeper venture capital pools, and a favorable tax environment. These factors enabled startups to develop a distinct international brand identity, making them more attractive to global talent and clients.

Further, at the time, India's regulatory system was not robust, especially when it came to investor protection. Additionally, startups believed that a company based in USA or Singapore would be better positioned to secure higher valuations during an exit or listing, due to the perceived credibility and reputation of these jurisdictions.

THE RISE OF REVERSE FLIPPING

Contrary to the trend of flipping, where startups had relocated their holding companies outside India, there is now a growing trend of reverse flipping, where companies are considering strategic moves to return to India.

In our perspective the following are the motivating factors for startups to shift their domicile back to India:

? The Indian startup ecosystem has matured significantly in recent years with significant talent and internet/technology accessibility.

? A significant pool of untapped domestic retail investors eager to invest in emerging companies they believe have the potential for significant growth.

? The Indian government has been taking steps to make it easier for startups to go public, which could make it more attractive for startups to reverse flip.

? Despite the significant tax outflow during the domicile shift, companies are still considering the benefits of relocation to India due to the attractive valuations in the Indian markets.

? Strength of the growing customer base in India.

KEY CONSIDERATIONS

Some of the key considerations for startups, their management, investors and other stakeholders to analyse in case of an internalization include:

Structure

It is essential to select an appropriate structure that is not only commercially beneficial but also is compliant with the legal, regulatory, and tax regimes in the relevant jurisdiction(s). Each structure is subject to specific legal and regulatory constraints, and failure to comply can result in adverse consequences. Therefore, it is essential to carefully consider the implications of each structure and choose one that aligns with the business’s goals and objectives while ensuring compliance with all relevant laws and regulations. The most popular structures for reverse flipping are the following:

Inbound Merger: In an inbound merger, a foreign entity merges into an Indian entity, resulting in the Indian entity owning and controlling the assets and operations of the foreign entity. As consideration, the shareholders of the foreign entity receive shares of the Indian entity. Transactions involving mergers and de-mergers are generally tax-neutral, provided certain conditions are met. Fintech start-up Groww has structured their reverse flipping (USA to India) through this route.

Share Swap: In a share swap, shareholders of the foreign entity swap their shares in the foreign entity for shares in the Indian entity. While this route takes lesser time as compared to inbound mergers the foreign shareholders will be taxed in India based on the difference between the value of the Indian entity's shares during the reverse flip and the original cost of the foreign entity's shares. Walmart backed PhonePe, completed its shift back to India (Singapore to India) through a share swap structure, incurring significant taxes in India.

Foreign Exchange Laws

Issuance or transfer of securities to non-residents through in-bound mergers or otherwise must adhere to the pricing guidelines, entry routes, sectoral caps, attendant conditions and reporting requirements for foreign investment as laid down under Foreign Exchange Management (Non-debt Instruments) Rules, 2019, along with the provisions of the Foreign Exchange Management (Overseas Investment) Rules, 2022.

It may be notes that in-bound mergers in compliance with the Foreign Exchange Management (Cross Border Merger) Regulations, 2018 (Cross Border Regulations) shall be deemed approved by the Reserve Bank of India (RBI). If not compliant, cross-border merger transactions shall require prior RBI approval.

Additionally, all guarantees and outstanding borrowings of the foreign company which are obtained from foreign lenders and become the borrowings of the resultant entity in India, the Cross Border Regulations prescribe that such guarantees and borrowings will have to comply with external commercial borrowing / trade credit norms or other foreign borrowing norms (as applicable) within two years from the date of the in-bound merger.

Press Note 3 - 2020 Series (PN3) approvals

As per PN3, prior approval is required when an investing entity is situated in a country sharing land borders with India, or where the beneficial owner of an investment into India is situated in or is a citizen of any such neighboring country.

A reverse flip may result into the entry of foreign investors in India, startups should therefore assess the applicability of PN3 to each of their foreign retail and institutional shareholders well in advance.

It must be noted that currently there are uncertainties associated with the PN3 like the lack of clarity about the scope of “beneficial owner” and no clear timelines for the processing of PN3 applications. Further individuals who are the nationals of a country sharing land borders with India will require prior security clearance from the Ministry of Home Affairs prior to accepting a directorship on the board of the Indian company.

The application of PN 3 can significantly affect the timeline for the structuring of the reverse flip and potentially even jeopardizing the internalization process and delaying its successful implementation..

Other regulatory and sectoral approvals

Other regulatory and sectoral approvals may be triggered depending upon the sector that the startup is operating in. Basis the nature of the business, sector specific approvals including approvals for change in control, ownership and shareholding structure (along with a likely change in the management) of such entity, will have to be procured. For example, prior approval of the RBI may be required for a “change in control” of non-banking financial companies, payment aggregators may also need to notify the RBI about any change in control or management, and the RBI may impose restrictions upon the business and management of the entity basis its evaluation of such notification/declaration.

Mergers are a court-driven process in India and needs to be approved by the National Company Law Tribunal (NCLT). As per the Companies Act, 2013, entities desirous of effecting a merger need to seek a prior approval of the NCLT by providing all material and relevant facts and information relating to the merger in a ‘scheme’. During the review of the scheme, the NCLT may convene meetings of all members/creditors of the entity and issue notices to relevant regulatory authorities for their comments and/or objections and will accordingly analyse and approve the scheme. The process of obtaining the approval for such schemes is long-drawn and takes at least 6-9 months.

The requirement to intimate or seek an approval of the Competition Commission of India (CCI) as a result of the internalisation will also need to be evaluated. Depending on the structure finalized, a notification under the Competition Act, 2002, may be required to be provided to the CCI, not only by the entities involved but also the foreign investors (being acquirers).

In addition to Indian laws, internalization also includes another layer of complexity in terms of an analysis of necessary conditions that may be required to be complied with under the laws of the country in which the foreign holding entity is domiciled. For example, (i) in Singapore, prior approvals of the regulators may be required before effectuating an outbound merger with an Indian entity. Fintech firm Pine Labs was required to obtain the approval of courts in Singapore for the merger of the company’s Singapore and India entities; (ii) in Cayman Islands, the dissolving entity is to satisfy the domestic registrar of companies that the merger pursuant to which it is to dissolve: (a) is not prohibited by its constitution documents; and (b) there is no petition for winding up / liquidation of the company pending in any other overseas jurisdiction. Further such company is also required to formulate a written plan of the merger, approved by its board of directors and submit all relevant documents for issuance of a ‘strike-off’ certificate indicating dissolution of the entity under Cayman company laws.

All the regulatory and sectoral approvals that will be required, not only in India but also in the host countries of the offshore entity, will have to be carefully analysed while assessing the structure and timelines for undertaking an internalisation into India.

Employee Stock Option Plans (“ESOPs”)

In case of employees engaged with the offshore entity prior to internalization who decide to continue their employment with the Indian domiciled entity, any stock options granted to such employees (outside India) will need to be structured as per the requirements under the Indian laws and fresh stock options will need to be issued by the Indian company instead.

Additionally stock options granted by the Indian company to its non-resident employees/directors/officers will also be subject to the entry routes, sectoral caps, attendant conditions and reporting requirements for foreign investment as laid down under Foreign Exchange Management (Non-debt Instruments) Rules, 2019.

Further as per the Companies Act, 2013 and the rules made thereunder there must be a minimum cliff of one year from the grant of an ESOP before such ESOPs are vested. Employees will not be able to exercise their vested options for such additional period until the statutory requirements are met, upon the migration of the ESOP plan into India.

Although this may not impact the structure of the reverse flip, startups will need to consider potential objections that they may receive from their employees/key managerial personnel /directors and/or the possibility of an attrition due to the dis-incentivisation of employees.

Viability of Initial Public Offerings (IPOs)

For existing institutional investors, a timely exit is crucial to unlock the value of their investment. As an IPO remains a popular choice for exit strategies, it is essential for companies to outline their plans to list on the primary market within a defined timeline. This will enable them to demonstrate their commitment to a clear and achievable exit strategy, providing investors with confidence in the company’s future prospects.

Existing investors need to be aware of the transfer restrictions imposed by the Securities Exchange Board of India (SEBI) regarding their shares. As per the SEBI (Issue of Capital and Disclosure Requirements) Regulations 2018, existing investors who hold shares before the IPO will have to observe a 6-month lock-in period from the date of allotment in the IPO, for all shares held by them.

CONCLUSION

The shift towards the reverse flipping movement signals a significant paradigmatic shift in the Indian and global startup ecosystems, marked by a fundamental transformation in the way entrepreneurs approach business.

With more founders choosing to locate in India, the focus will shift towards addressing the unique challenges and opportunities that are specific to the Indian market. This will likely lead to a surge in innovation in industries including wealth management, lending, insurance, and digital payments, which will be tailored to cater to the distinct needs and preferences of Indian consumers and businesses.

While the possibility of attractive valuations is a powerful motivator and a huge incentive, startups and established businesses must be mindful of the dynamics and complexities of reverse flipping as well as the significance of compliance, and risk management while analyzing the feasibility of internalization.

Disclaimer: This article is authored by Sonal Rangnekar (Partner) and Henna Kapadia (Associate). This article is for informational purposes only and does not constitute legal advice. For any queries or opinion please reach out to [email protected].