Equity Shares versus CCPS: What Should Founders Know?

Editorial
Feb 9
5 min read

This article was written by Akshay Vasantgadkar, Senior Associate.

When a company is started in India, the first thing a founder issues to themselves (and to their co-founders) are equity shares. As the company grows and raises money from outside investors, a founder will quickly hear about another instrument: CCPS (Compulsorily Convertible Preference Shares), among other instruments that we touched on in our previous note.

For many first-time founders, the difference between these two is blurry, especially because CCPS ultimately convert into equity. However, understanding them is critical because the type of shares you issue determines how ownership, control, and rights are distributed between founders and investors.

This note breaks down the fundamentals of equity shares and CCPS in simple terms, so you can make sense of what is in front of you when a term sheet arrives.

Equity shares – The building blocks of ownership of your company

What are Equity Shares?

Equity shares are the simplest form of ownership in a company and represent a slice of the company’s ownership “pie”. For example, if X owns 1,000 equity shares in a company with 10,000 total shares, X owns 10% of the company.

Legally, equity shares are governed by Section 43(a)(i) of the Companies Act, 2013, which defines them as shares with “voting rights or differential rights as to dividend, voting, or otherwise”.

Economic Character of Equity Shares (How They Work Financially)

Equity holders are residual claimants. In liquidation, they receive payment only after all creditors and preference shareholders have been satisfied.[1] However, they also participate proportionally in profits (as dividends) and valuation gains.

Thus, equity embodies the highest-risk, highest-reward form of capital.

Governance of Equity Shares (How They Give Control)

Control in a company flows through voting rights. Equity shares usually carry one vote per share, ensuring a direct alignment between ownership and control. This makes equity ideal for founders and employees, but perhaps suboptimal for external investors who seek additional protective covenants and preferential returns at the early stages of a new company.

Also, this might not be ideal for founders, who wish to retain control over decisions at the early stages. While Indian law does provide for shares with inferior voting rights, this is only under very limited circumstances and requires a company to have a consistent track record of distributable profits for the last three years,[2] which may not be suitable for early-stage companies.

Limitations of Equity Shares

Equity, while conceptually simple, poses doctrinal and commercial challenges for investors. Venture capitalists and private equity funds invest substantial sums in early-stage entities with high uncertainty and limited collateral. Taking pure equity means:

a) Being last in line for repayment;

b) Bearing high risk without substantial control;

c) Lacking anti-dilution and liquidation preference rights.

From a legal standpoint, attaching other safeguards or rights to equity shares can breach various statutory provisions and regulations.[3] Therefore, investors might prefer instruments that confer contractual protection without disruption the basic features of equity shares.

This is where preference shares become relevant.

Preference Shares

What are Preference Shares?

Preference shares are governed by Section 43(b) of the Companies Act and carry preferential rights regarding dividend payments and capital repayment on winding up. These rights create a seniority over equity shareholders but remain subordinate to creditors.[4]

Section 55 of the Companies Act is also relevant in this context, which governs their issuance and redemption. Importantly, preference shares must either be redeemable within twenty years (or, alternatively, compulsorily convertible – discussed below).

Governance of Preference Shares (How They Give Control)

Preference shares typically do not carry voting rights, except in limited circumstances.[5] Therefore, the trade-off is the increased safeguards vis-à-vis equity shares, but a lessened ability to participate in governance.

Investor Perspective

Compared to equity shares, preference shares carry lower risk due to their fixed dividends and priority in the event of liquidation. However, while preference shares provide fixed dividends, they do not offer the same potential for capital appreciation as common equity shares.

Therefore, preference shares retain the basic features of equity with an additional safety cushion. Much of the protective rights that investors may want, are best attached to preference shares to ensure that they are able to effectively hold on to their safeguards. However, while being “low risk”, they are also relatively “low reward” compared to equity shares.

Types of Preference Shares

1. CCPS - The near-gold-standard investor preferred instrument

Compulsorily Convertible Preference Shares (CCPS) are preference shares that must mandatorily convert into equity upon a predetermined event – for instance, an IPO, acquisition, or expiry of a specified period. They combine features of equity and debt, providing downside protection in early stages and full participation in upside upon conversion.

Breaking down the name:

- Compulsorily Convertible: These shares must mandatorily convert into equity shares at a certain trigger event.

- Preference Share: Until they convert, they carry special rights like liquidation preference and anti-dilution protection, while retaining the basic characteristics of equity shares.

So, a CCPS is essentially a temporary safety net for investors that later becomes equity. Also, founders can retain control over the company by issuing CCPS, as they do not involve voting rights pre-conversion. Thus, CCPS are mutually beneficial to both the founders and the investors.

CCPS are also statutorily backed and fall within Section 55(2) and Rule 9 of the Share Capital and Debentures Rules.

Investor Perspective

1) CCPS rank senior to equity in liquidation, but below creditors. Therefore, CCPS holders can get paid even before founders do.

2) Through flexibility in contractual terms, investors can secure various safeguards, like anti-dilution.

3) Conversion ratios can be adjusted to account for valuation changes or milestone-based triggers.

2. Why Founders Should Care

As a founder, it is tempting to dismiss CCPS as legally complex and technical. But the choice between equity and CCPS impacts many crucial aspects, including:

1. Dilution control: Many a time, the terms of CCPS could carry sneaky clauses that allow for conversion ratios to be tweaked in a manner that can be undesirable to a founder, from a dilution perspective (such as a “full ratchet” anti-dilution clause, not exempting dilution from ESOP roll outs/sweat equity roll outs).

2. Exit Scenarios: In a liquidation event, investors with CCPS may get their money back before founders see a single rupee. While this is perhaps akin to the market practice, terms could include underwriting multiples on the investment.

That does not mean CCPS are bad – they are the industry standard for a reason. However, founders should enter these conversations with eyes open and keep an eye out for the finer details and employ the contractual flexibility in a manner that safeguards their interests as well.

Conclusion

To recap:

(b) Equity shares imply pure ownership. Great for founders and employees, but risky for outside investors.

(c) CCPS refer to investor-friendly preference shares that eventually become equity, combining downside protection with upside potential.

For early-stage Indian startups, CCPS is perhaps the default investment instrument. Founders should know this upfront and must understand that the key aspect is to be prepared to negotiate the rights attached to those CCPS through contracts, rather than arguing about the structure itself (of equity versus CCPS).