Issuance of Preference Shares in an Unlisted Company: Complete Legal and Compliance Guide under the Companies Act, 2013
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Introduction
Fund raising is very difficult and critical for any business. But it is also important for expansion and growth of business. There are two modes of raising the funds, First issuing of equity shares and second issuance of preference shares. The equity shares routes are common but due to flexible nature preference shares are also gaining importance. Preference shares offer investors preferential rights over equity shareholders regarding dividend payments and repayment of capital during winding up, while allowing promoters to raise funds without significant dilution of control.
Preference shares are very useful tool for unlisted company in private equity investment and family-owned business. It is generally used at the time of capital restructuring.
It is governed by the Companies Act, 2013 and the Companies (Share Capital and Debentures) Rules, 2014, and where shares are issue to foreign investors then FEMA rule and regulations will also be applicable.
We will cover under this article issuance of preference shares by an unlisted company, covering legal provisions, procedural requirements, compliance obligations, valuation aspects, and practical considerations.
What is Preference Share?
It has certain preferential right over equity shares. Preference shares are a class of shares that carry certain preferential rights over equity shares in terms of dividend and repayment of capital.
Section 43 of the Companies Act, 2013 recognizes preference share capital as a separate category of share capital.
The holders of preference shares generally enjoy:
Preferential right to receive dividends before equity shareholders.
Preferential right to repayment of capital upon winding up of the company.
Priority over equity shareholders regarding distribution of assets during liquidation.
However, preference shareholders generally have restricted voting rights and do not participate in the management of the company unless specific circumstances arise.
Types of Preference Shares
1. Cumulative Preference Shares
If dividends are not declared in a particular year due to insufficient profits, the unpaid dividend accumulates and becomes payable in future years.
2. Non-Cumulative Preference Shares
The right to receive dividend exists only for the current financial year. If dividend is not declared during a particular year, shareholders lose their entitlement for that year.
3. Redeemable Preference Shares
These shares are redeemed by the company after a specified period. Under the Companies Act, 2013, only redeemable preference shares can be issued. Irredeemable preference shares are prohibited.
4. Participating Preference Shares
Apart from fixed dividends, these shareholders may participate in surplus profits and assets after payment to equity shareholders.
5. Non-Participating Preference Shares
Shareholders are entitled only to fixed dividends and repayment of capital.
6. Convertible Preference Shares
These shares may be converted into equity shares according to predetermined terms and conditions. Convertible preference shares are commonly used in startup and private equity transactions.
Legal Framework Governing Preference Shares
The issuance of preference shares by an unlisted company is governed by:
Companies Act, 2013
Section 42 – Private Placement
Section 55 – Issue and Redemption of Preference Shares
Rule 9 of Companies (Share Capital and Debentures) Rules, 2014
Companies (Prospectus and Allotment of Securities) Rules, 2014
FEMA Regulations (for foreign investment)
Secretarial Standards issued by ICSI
Conditions for Issue of Preference Shares
Before issuing preference shares, an unlisted company must ensure compliance with Section 55 of the Companies Act, 2013.
Authorization in Articles of Association
Before issuance of preference shares, we must check the Articles of Association (AOA) and AOA must authorize the issuance of preference shares. If AOA does not permit then first we should alter the AOA, then issue the preference shares.
Approval of Shareholders
The issue of preference shares requires approval of shareholders through a special resolution passed in a general meeting.
The explanatory statement attached to the notice must contain detailed disclosures.
Disclosures Required in Explanatory Statement
The explanatory statement should include:
Size of the issue.
Nature of shares.
Object of issue.
Price of issue.
Basis of valuation.
Terms of redemption.
Terms of dividend.
Manner of issue.
Expected dilution impact.
Conversion terms, if applicable.
These disclosures ensure transparency and informed decision-making by shareholders.
Tenure of Preference Shares
As per Section 55, preference shares must be redeemed within twenty years from the date of issue. Therefore, a company cannot issue preference shares with an indefinite tenure.
Exception for Infrastructure Projects
Companies engaged in infrastructure projects may issue preference shares for a period exceeding twenty years subject to:
Redemption of a specified percentage annually.
Compliance with prescribed conditions.
This relaxation is intended to facilitate long-term financing requirements of infrastructure projects.
Modes of Issuing Preference Shares
An unlisted company may issue preference shares through:
1. Private Placement
Most commonly used method. The company issues share to identified persons through a private placement offer letter.
2. Preferential Allotment
Shares are allotted to selected investors after obtaining shareholder approval.
Valuation Requirement
Valuation plays a critical role in the issuance of preference shares. For unlisted companies, valuation should be conducted by a Registered Valuer.
The valuation report generally considers:
Net Asset Value Method
Discounted Cash Flow Method
Earnings Capitalization Method
Comparable Company Analysis
The valuation report helps justify the issue price and protects the interests of stakeholders.
Step-by-Step Procedure for Issuance of Preference Shares
Step 1: Check Articles of Association
Verify whether the Articles authorize issuance of preference shares. If not, alter the Articles by passing a special resolution.
Step 2: Obtain Valuation Report
Engage a Registered Valuer to determine the fair value of preference shares. The valuation report should be available before shareholder approval.
Step 3: Convene Board Meeting
Issue notice of Board Meeting.
The Board should approve:
Issue of preference shares.
Draft notice of general meeting.
Valuation report.
Terms of issue.
Private placement offer, if applicable.
Board Resolution should also authorize officers to undertake compliance filings.
Step 4: Convene General Meeting
Pass Special Resolution under Section 55 and Section 42 (if private placement is involved).
The resolution must approve:
Number of shares.
Issue price.
Dividend rate.
Redemption period.
Conversion terms.
Investor details.
Step 5: Filing of MGT-14
The company must file Form MGT-14 with the Registrar of Companies within 30 days of passing the special resolution.
Attachments generally include:
Certified copy of resolution.
Notice of meeting.
Explanatory statement.
Step 6: Issue Private Placement Offer Letter
Where preference shares are issued through private placement, Form PAS-4 must be issued to identified persons.
Step 7: Receipt of Subscription Money
Application money must be received through:
Banking channels.
Cheque.
Demand draft.
Electronic transfer.
Cash receipt is prohibited. Funds must be received in a separate bank account.
Step 8: Hold Board Meeting for Allotment
The Board approves allotment after receipt of subscription money. A Board Resolution for allotment must be passed
Step 9: File Return of Allotment
Form PAS-3 must be filed within 15 days from allotment.
Attachments include:
List of allottees.
Board Resolution.
Valuation report where applicable.
Step 10: Issue Share Certificates
Share certificates must be issued within two months from allotment.
Certificates should comply with the Companies Act and applicable rules.
Step 11: Update Statutory Registers
Necessary entries must be made in:
Register of Members.
Register of Share Capital.
Register of Share Transfers.
Beneficial Ownership records, if applicable.
Redemption of Preference Shares
Preference shares can be redeemed:
Out of profits available for dividend.
Out of proceeds of fresh issue of shares.
The company cannot redeem preference shares unless they are fully paid-up.
Creation of Capital Redemption Reserve
Where redemption occurs out of distributable profits, an amount equal to the nominal value of shares redeemed must be transferred to the Capital Redemption Reserve (CRR). The CRR helps maintain the capital base of the company.
Consequences of non-redemption
Failure to redeem preference shares may lead to legal consequences.
With consent of preference shareholders holding at least three-fourths in value, the company may approach the National Company Law Tribunal (NCLT) for extension of redemption period or modification of terms.
Voting Rights of Preference Shareholders
Generally, preference shareholders vote only on matters affecting their rights. However, they obtain voting rights on all resolutions if dividends remain unpaid for two years or more. This provision safeguards investor interests.
Voting Rights of Preference Shareholders
Generally, preference shareholders vote only on matters affecting their rights.
However, they obtain voting rights on all resolutions if dividends remain unpaid for two years or more.
This provision safeguards investor interests.
Sectoral caps.
Entry routes.
Pricing guidelines.
Reporting requirements.
Filing of Form FC-GPR.
Compliance with Foreign Exchange Management (Non-Debt Instruments) Rules.
Companies receiving foreign investment should consult FEMA professionals before issuance.
Tax Considerations
The issuance of preference shares may have tax implications.
Important aspects include:
For the Company
Compliance with fair valuation norms.
Avoidance of provisions relating to issue of shares at unjustified premium.
For Investors
Dividend taxation.
Capital gains taxation upon transfer.
Taxability of redemption proceeds.
Tax advice should be obtained considering the specific transaction structure.
Common Mistakes Made by Companies
Many companies face compliance issues due to:
Absence of Valuation Report
Issuing shares without proper valuation may attract regulatory scrutiny.
Improper Private Placement Process
Non-compliance with Section 42 can result in severe penalties.
Delayed ROC Filings
Failure to file MGT-14 or PAS-3 within prescribed timelines may lead to additional fees and penalties.
Non-Issuance of Share Certificates
Delay in issuance may attract penal consequences.
Incorrect Terms of Redemption
Redemption terms inconsistent with Section 55 can render the issue non-compliant.
Advantages of Preference Shares
Preference shares provide several benefits to companies:
No dilution of management control.
Flexible capital structure.
Attractive instrument for investors.
Lower compliance burden compared to debt instruments.
Fixed dividend commitments.
Useful for strategic investments.
Advantages for Investors
Investors benefit through:
Priority dividend rights.
Preference during liquidation.
Stable returns.
Potential conversion rights.
Reduced investment risk compared to equity shares.
Conclusion
Preference shares have emerged as one of the most effective instruments for raising capital in unlisted companies. They offer a balanced approach between equity and debt financing by providing investors with preferential rights while enabling promoters to retain managerial control. However, the issuance process involves strict compliance with the Companies Act, 2013, valuation norms, private placement regulations, and FEMA requirements where foreign investors are involved.
Companies planning to issue preference shares should ensure proper structuring of terms, obtain a valuation report from a Registered Valuer, secure necessary approvals, complete ROC filings within prescribed timelines, and maintain statutory records meticulously. A legally compliant issuance not only protects the company from regulatory penalties but also enhances investor confidence and corporate governance standards.
Professional guidance from Company Secretaries, Chartered Accountants, and legal professionals can significantly reduce compliance risks and facilitate a smooth fundraising process through preference shares.
Author: Prahalad Kumar , in case of any queries please contact/write back to us via email to chhavi@khuranaandkhurana.com or at Khurana & Khurana, Advocates and IP Attorney.
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