The Reserve Bank of India has finally cleared the dust and permitted optionality clauses in equity shares and compulsorily and mandatorily convertible preference shares/debentures issued to a person resident outside India under the Foreign Direct Investment Scheme. An optionality clause will oblige the buy-back of securities from the foreign investor by Indian promoters/residents at the price prevailing/value determined at the time of exercise of the put option by such foreign investor, provided the put option is exercised without assuring any fixed return to the foreign investor.
Put options in favour of foreign investors will be valid and enforceable under the exchange control laws if:
- They are exercised after a minimum lock-in period of one year from the date of allotment of securities to foreign investors or any other lock-in period as may be specified under the FDI Policy, whichever is higher;
- The exit price should be as follows: (i) In case of listed company, at the market price determined on the floor of the recognized stock exchanges; (ii) In case of unlisted equity shares, at a price not exceeding that arrived on the basis of Return on Equity (RoE) as per latest audited balance sheet. RoE is defined as the profit after tax divided by the net worth (defined to include all free reserves and paid up capital); and (iii) In case of preference shares or debentures, at a price determined by a Chartered Accountant or a SEBI registered Merchant Banker.
While this move from RBI will help in regaining the confidence of foreign investors, the differentiation in valuation methodology for calculating exit price of equity shares and convertible securities requires some explanation from the regulator. Further, the ROE formula prescribed for calculating maximum exit price of foreign investors is not in line with standard market practice to value securities of a company. While the FDI Policy prescribes fair value/ DCF methodology, which is forward looking, for calculating the minimum floor price for FDI in Indian securities, the maximum exit price, through exercise of put options, is now capped at a valuation arrived at using ROE methodology, which is based on past performance of the company. This move may lead to lower returns for the foreign investors as they would be required to purchase Indian securities at a price taking into account the company’s future performance, but exit only at a price derived from performance of the company during the course of such foreign investment.