The start-up culture in India has picked up its pace as the country has become the third-largest start-up ecosystem in the world after US and China. With around 44 companies turning into a unicorn in 2021, India now houses 83 start-ups with this status.
However, people are still not confident enough to invest in these start-ups. A major reason is that retail investors don’t have the capacity to fund these companies. But, things are taking a turn now.
Tyke invest has introduced various investing instruments for retail investors so that they can be a part of the rising start-up culture. Two of these instruments are CSOP (Community Stock Option Pool) and CCD (Compulsory Convertible Debentures).
I will break down these two investing options completely so that you don’t remain unfamiliar with them. We will also compare both of these instruments to see which one can be the ideal choice for you.
What Is CSOP(Community Stock Option Pool)?
A community Stock Option Pool is an option under which anyone is capable of buying the equity shares of the company. It involves all the financial rights of the shareholder, but does not involve any voting rights and is not present on the cap table.
A CSOP is a contractual agreement between the company and the investor. It is not treated as a security under the companies act. It comes under the section of revenue and also involves direct and indirect taxes.
Similar to an ESOP (Employee Stock Option Pool), where a company offers equity shares to its employees, CSOP aims to retain the community of the company by giving them equity.
There are two types of CSOP:
1. Valuation Cap
The valuation cap of a CSOP means the maximum valuation that can be converted from an investment into equity shares.
For example, if you have invested Rs. 2,00,000 [2 lakhs] in a start-up at a valuation of Rs. 2,00,00,000 [2 crores], then you own 1% of the equity in the company.
Now, if the company goes into the next round of funding with a valuation of Rs 4,00,00,000 [4 crores], you’ll still hold 1% of the equity.
However, if the company decreases its valuation in the next round, let’s say Rs. 1,00,00,000 [1 crore], you will now have 2% of the company’s equity.
2. Discount Cap
Under the discount cap, an investor acquires the equity of the company at a reduced price.
For example, if you have invested Rs.2,00,000 in a start-up at a flat 30% discount cap, you’ll be priced at a discounted valuation when the start-up enters the next round of funding.
If the valuation of the company stands at Rs.2,00,00,000 [2 crores] during the funding round, then you’ll be priced at a 30% discount (0.70×2,00,00,000=1,40,00,000).
Eventually, you will now be owning 1.429%(2,00,00,000/1,40,00,000) instead of 1%(2,00,00,000/2,00,00,000) of the company.
What Is CCD (Compulsory Convertible Debentures)?
A Compulsory Convertible Debenture is a bond that should be converted into the form of equity shares at a specified date. It is a hybrid security, as it is not purely a stock or a bond.
A Debenture is either a medium or long-term debt security offered by a company to borrow funds at a determined rate of interest.
This does not cover any collateral, unlike corporate bonds, which are of investment grade. T his security is issued only on the credibility of the issuing company.
Generally, tyke offers four variants of CCDs. They are as follows:
1. CCDs At Fixed Valuation
Under this type of agreement, the debenture is fully converted into equity shares when the contract expires on a fixed valuation.
During the issuing time, the conversion ratio of the debenture is decided. When these debentures are converted into equity shares on the pre-determined date, these debenture holders automatically become the shareholders of the company.
The interest rate being paid on the debentures is only paid till they are converted into equity. Fully Convertible Debentures carry a lower interest rate than Non-convertible debentures.
When the companies don’t have sufficient track records or data, they prefer going for the CCDs at a fixed valuation. This process even increases the equity capital of the company. Thus, these types of instruments are popular among investors.
2. CCDs With Discount Cap
When a Compulsory Convertible Debenture is signed at a discount cap, it means that during the time of conversion, the investor will receive the equity of the company at a discounted price.
This happens mostly when a start-up is unable to determine its value and, thus, offers a CCD to the investor.
For example, if an investor offers a company Rs.1,00,000 at a discounted price of 20%, then in the next round, if the company raises funds at a valuation of Rs.1,00,00,000, then the debenture holder will receive his shares at a price of [Rs.1,00,00,000-20%] Rs. 80,00,000.
This means that instead of receiving 1% of the equity, the investor will have 1.25% of the equity on the date of conversion.
3. CCDs With Valuation Floor/Cap
An investor is liable to receive the equity at the maximum valuation of the company under the valuation cap. Through this, even if the valuation of the company decreases in the future, the investor will receive his share of equity on the maximum valuation.
You can even opt for CCDs with a valuation floor. Under this, the debenture holder is eligible to receive equity on the pre-determined valuation floor no matter how much the valuation of the start-up has gone down.
The valuation floor is meant to protect the investors from suffering extreme losses. It provides a safe and reliable exit on their investments. This option ensures that the share price of the next financing round is set at the present minimum value.
4. CCDs With Both Discount Cap & Valuation Cap
The investors even have the option of opting for the Compulsory Convertible Debenture with both valuation cap and discount cap. The features of both these caps come together on the table.
This means that the investor gets his equity shares in both the maximum valuation of the company and at a discounted price.
This type of investment is considered beneficial and less risky for the investors as they get both the advantages in their investment.
When a start-up becomes successful, the profits are hugely earned by the founders, investors, and employees. The community of the company who stood by their side throughout the journey gets nothing in return.
A community is the most integral part of any company. The only common factor in the 60% unicorns of the nation, irrespective of their domains, is its community. Retaining the core users of a company is a challenge, and CSOP deals with this problem very nicely.
CSOP aims to bring a dynamic change in the start-up industry by giving the community of the company a fair share of the profits, just like the investors. Offering equity of the company to the users not only boosts their morale but also thrives them to help the company grow further.
CSOP even helps in cutting a lot of costs on marketing for the start-ups, as the users getting the equity are self-motivated to grow the company to eventually earn good returns themselves.
A CCD is a type of debt that must be converted into equity on a specified date or when it is needed. So, we cannot consider it a debt exactly. As it is mandatory for the CCD to get converted, it can be termed a deferred equity instrument.
Start-ups prefer CCD as it has various advantages in equity and defers its issuance. From the point of view of an issuer, it has several tax advantages. It also possesses better pricing on equity, and is based on the company’s value in the future.
A PE investor also gets a guaranteed rate of interest with the potential of an increased value during the conversion, whereas direct equity does not promise any fixed returns. Now, with the fixed returns and the potential of an upside, a CCD is far more preferable than a preference share that has expensive service costs. This is because dividends are not taxable.
Rights Of A CSOP Holder
There are many rights that a CSOP holder gets and many that he does not. Let’s have a look at them briefly.
1. No Cap Table
CSOPs, as already discussed, are financial contracts that are in the form of revenue. This is why they are not present on the cap table.
2. No Voting Rights
Unlike the normal investors of the company, the CSOP holders don’t enjoy any voting rights in the company’s meetings. They can only participate if the matter involves their own investments.
3. Taxable Investments
These CSOP investments come under revenue for the start-ups, and thus they are taxable in the hands of the company. It can come under either direct tax or indirect tax.
4. Compulsory Call Option
If the company has reached the former valuation multiple(as we discussed in the above examples) at which the CSOP holders invested, all of the CSOP holders are required to accept the departure.
5. Investing Directly
There is no SPV (Special Purpose Vehicle) involved in carrying forward the investment. This means that the person can directly invest in the company by signing the CSOP agreement signed by the company’s founder and the investor.
6. Limited Information
There is a restriction on sharing the information and the financial data of the company with the CSOP investors. The investors get very limited information through the company, as it is already mentioned entirely in the agreement.
Rights Of A CCD Holder
A CCD holder is eligible to earn interests, but there are many things that he is not eligible to do while holding the debenture holder’s status. Let’s have a look at those rights:
1. No Voting Rights
The Debenture holders have no voting rights in the operations of the company, as they are not the shareholders of the company. This is also because a debenture is a hybrid security and not a bond or a stock.
2. No Cap Table
CCDs are not considered the share capital of the company until they get converted into equity. Thus, any participant with a CCD will not find a spot on the cap table.
3. Conversion Into Equity
The primary right of the debenture holder is that they get compulsorily converted into equity capital at a specified date with immediate effects.
A debenture is considered a capital gain income and is, thus, taxable by law. An investor must mention their debentures in their ITR and pay the mandatory income tax.
Benefits Of A CSOP Holder
There are multiple benefits involved for the CSOP holders. Let us have a look at them:
1. Easy Access To Growing Start-Ups
This option is specifically curated as a financial contract that is utilized by the growing companies that have already raised funds from the top VCs and institutions.
2. Low Risk
The risk involved is comparatively lower than the investors of the company, as the CSOP holders have an exit clause in the form of a cash buyout. This is made for users who are looking for quick liquid returns.
CSOP is a short and easy agreement that doesn’t involve many terms for negotiation. This makes the agreement quite hassle-free and quick.
Benefits Of A CCD Holder
There are many benefits for the CCD holder of a start-up. Here are a few of them:
1. Fixed Returns
One of the primary benefits of debenture holders is that they get fixed returns on their investments in the form of interests. This rate does not get affected by the highs and lows of the company.
2. No Concerns Regarding The Management
As the debentures are hybrid security and not equity capital, they do not interfere in the management of the company. They are just concerned with their returns.
3. Stable Income Source
This is an investment where you get a stable income from time to time. This is something rare in the investment sector, but this is the nature of the Debentures. They get paid a fixed rate of interest as specified during the agreement.
It is very much economical for the start-ups as the low-interest rate gives them an advantage in maintaining their finances without having to give away a lot of equity immediately.
5. Safe Investment
Unlike direct investment, CCDs are a safer investment option. With the fixed rate of return and foremost payment in the event of the company’s winding up, they offer very low risk. Thus, people who don’t like taking big risks can opt for a CCD.
Both CSOP and CCD investments are ideally present for the growing companies and the start-ups. Tyke offers these financial instruments through its platforms to all of its users. However, choosing any one of them as the ultimate winner is a varying topic that depends on the use and the capacity of the investor.
You may go for CSOP if you like taking a leap of faith and have full confidence in the company. Whereas, if you want to go to a safer side, then you may opt for CCD.
A CSOP has the potential to give enormous returns to the future if the company succeeds, as it provides direct equity in the company at a valuation cap. Talking about CCD, you get a stable source of income in the form of interests, which is a plus point for the people looking to make some money regularly.
Talking about the management, you are not eligible to vote in the company’s meetings or operations in both CSOP and CCD investments. However, as your CCD gets converted into equity shares in the future, you become a shareholder of the company and have the right to vote.
Overall, both of these instruments are very beneficial for the start-ups as it attracts the retail investors of the country to invest in them without taking any major equity in the company. With good returns and a smooth run of the company, it can be a win-win situation for the users investing either through a CSOP or CCD.
What do you think about these two investment options introduced by TykeInvest?
D o let me know your thoughts in the comment section below.