Investing Through Hybrid Instruments in Startups: New Kid on the Block for FDI

By Bhumesh Verma, Managing Partner at Corp Comm Legal & Soumya Shekhar, Associate

Start-ups and innovation are entwined and intrinsically linked to each other. New ideas breed start-ups. However, in the absence of adequate resources to translate these ideas into reality, many innovative ideas may be stifled.  Innovation is the engine on which most developed economies run and prosper.

The Indian government has been making numerous attempts at easing the business environment in India for start-ups. Recent initiatives such as simplifying the company registration process or introducing FDI in start-ups are some of the government’s ways of providing encouragement to innovation.

The latest proposal that the government has made in this regard is a proposal that the scope of foreign direct investment (FDI) instruments be expanded to include hybrid financial instruments within its ambit. Currently, FDI is allowed through equity shares, preference shares and debentures through external commercial borrowings.

Equity shares provide voting rights, preference shares typically earn one the right to get a fixed dividend and debentures get the investor interest on his loan. The most preferred and lucrative way of investment for a foreign investor is subscribing to / buying equity shares in a company. This gives him control over the company and the start-up founder resources to run his company. However, more often than not, the start-up founders end up losing control over their company in such a model of investment. The introduction of hybrid securities would address this issue and would enable the start-ups to raise funds without giving up control.

What are Hybrid Instruments?

Hybrid instruments reflect the features of more than one financial instruments. For instance, an instrument which contains the features of both an equity and debt would be a hybrid financial instrument. This may dilute the voting rights which the investor might have had if he had invested through an equity instrument and hence help the start-up founder retain control. At the same time, investors may be interested in such instruments as the exposure to risk is low. Some examples of hybrid instruments are optionally convertible debentures and partially convertible debentures. Hybrid instruments provide the following advantages over the conventional instruments:

  1. They give greater returns on capital
  2. Diversify risk
  3. Provide profits from both interest rates and equity share prices.

How would Hybrid Instruments help Startups?

The current method of raising funds (debt and equity) has left the start-ups high and dry. Raising money through debentures involves borrowing money from abroad and issuing debentures to investors in return. The high-interest rates involved does not make this route a very viable option. Raising money through issuing equity shares and diluting one’s shareholding leads to loss of control over the start-up.

An instrument which would help raise funds without being compelled to give up the control would be a boon for the start-up economy. Investors with low-risk appetite may wish to invest through hybrid instruments. Such instruments will also enable start-ups to diversify their risk as well and obtain adequate resources to put their ideas to practice at the same time. This could be the key for start-ups to raise funding while retaining control with themselves.

Conclusion

The introduction of hybrid instruments as an instrument of FDI in India would be a boon to innovations and entrepreneurship in the country. This would expand the scope of foreign investment in India and further propel economic development. The more successful a start-up becomes, the chances of an investor opting to invest through the equity route becomes more probable. In such circumstances, pushing for hybrid instruments may give start-ups more leverage. It would also help them in reducing their exposure to risk as they would not be putting all their eggs in one basket and would be in a better position to raise funding without losing control over their company.

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