#CCPSs – (Compulsory Convertible Preference Shares) are increasingly becoming preferred investment instruments for VCs, HNIs and PE investors to bridge the gap in a mismatch in valuation expectations between investors and promoters. The CCPS are anti-dilution instruments or hybrid instruments. Let us discuss in detail the characteristics of CCPSs.
𝑨𝒏𝒕𝒊-𝑫𝒊𝒍𝒖𝒕𝒊𝒐𝒏
CCPS benefited the promoters of the company to keep its equity stake intake when Company issue equity shares to new investors. The Promoters may convert their CCPS which was taken at the time of Lower valuation of shares when new investors bring the money at higher valuation thereby promoters can increase their stake without bringing money at a higher valuation.
𝑩𝒆𝒏𝒆𝒇𝒊𝒕𝒆𝒅 𝒕𝒐 𝑷𝑬 𝒊𝒏𝒗𝒆𝒔𝒕𝒐𝒓𝒔
CCPS are also benefited to PE Investors. The investors may link the time of conversion to the Company’s performance. This essentially means that the shares get converted only after the company achieves the promised growth. If the milestones are not achieved, then the PE firm reserves its right to increase the stake.
Secondly, Under the capital market regulator’s norms, any acquisition of 15% or more in a listed company triggers an open offer. Accordingly, a PE firm can take 14.9% direct equity and the rest in the form of securities that turn into equity within 18 months. This gives the firm the leeway to exit its investment in parts as typically a PE investment has a one-year lock-in period. In other words, before owning more equity and exceeding the 15% threshold limit, a PE firm can cash out at least a part of its existing stake and avoid making the mandatory open offer.
𝑩𝒆𝒏𝒆𝒇𝒊𝒕𝒆𝒅 𝒕𝒐 𝒔𝒕𝒂𝒓𝒕-𝒖𝒑𝒔
The CCPS helps the start-up Companies founders to control their stake at the funding stage of new investors without an infusion of new funds. CCPS are also anti-dilution securities and founders can manage their equity stake to keep control of the Company by holding a substantial stake in the Company.
𝑨𝒗𝒐𝒊𝒅 𝑽𝒂𝒍𝒖𝒂𝒕𝒊𝒐𝒏 𝑮𝒂𝒑
The CCPSs helps to avoid the valuation gap between founders and Investors. In theory, there are many methods to come up with the per-share value of equity.
In the secondary market, the most popular method is what is called ‘relative valuation’. Here, one uses multiples such as price-earnings, or EV/EBITDA, or price-to-sales (P/S) or price-to-book to arrive at a valuation. Here, you take a number like P/E from a set of comparable and apply that to the company you want to value.
This is not easy to apply to start-ups because a typical start-up may have no profit and loss (P&L) metric to show.
In other words, let alone net profit or EBITDA, it could be pre-revenue. Or even if the business is launched, it would be just one or two years old. Revenue may not be enough to even apply a price-to-sales (P/S) multiple.
The other popular valuation method is the so-called discounted cash flow or DCF method. The problem with this method is, there are too many assumptions involved. You need to do at least five years of forecast and use assumptions to arrive at the applicable cost of capital and terminal value. Other than in certain predictable businesses like utilities, in other cases, using DCF is no better than witchcraft. This brings us to what actually happens in the real world.
Therefore, one simple way to totally avoid a valuation discussion, particularly if there is a strong difference of opinion with the promoter, is to invest via convertible preference shares wherein the angel’s price is determined once the Series A investor (venture capital, who chips in as the first-time investor) comes in. You can convert to common shares at a discount to Series A. This method will typically need a cap and floor on valuations though.
FAQs
The CCPS helps the start-up Companies founders to control their stake at the funding stage of new investors without an infusion of new funds. CCPS are also anti-dilution securities and founders can manage their equity stake to keep control of the Company by holding a substantial stake in the Company.
Why do investors prefer CCPS? ›
Higher Returns: CCPS typically offer higher returns compared to other instruments such as bonds, as they offer a mix of fixed income and potential for capital appreciation. Convertibility: CCPS can be converted into equity shares at a predetermined price, giving investors exposure to the potential growth of a company.
Why do VC investors use preferred stock? ›
Most venture investors looking to fund startups will negotiate for preferred stock or shares so they can gain more privileges and rights. These can be particularly useful for mitigating risk and providing anti-dilution protections.
Why do startups issue CCPs? ›
CCPS, or Compulsorily Convertible Preference Shares, are a key element of startup financing. These shares carry certain terms—if an early investor has CCPS, he can have more rights than other investors who come in later at a higher valuation.
Which is better, CCPs or equity? ›
CCPS has precedence over common equity shareholders in two ways – before paying any dividends to equity shareholders, CCPS holders receive dividends, and if the company goes bankrupt and has to sell its assets, CCPS holders will receive a return on their capital on a priority basis when compared to the other ...
What is the importance of CCPS? ›
A CCP also allows for anonymous trading, resulting in benefits such as increased liquidity and reduced spreads (Ripatti, 2004). A CCP may further contribute to the transparency of a market as it provides for the centralized administration of long and short positions of clearing members.
What is the use of CCPS? ›
Central counterparty clearing houses (CCPs) perform two primary functions as the intermediary in a transaction: clearing and settlement. A CCP acts as a counterparty to both sellers and buyers, collecting money from each, which allows it to guarantee the terms of a trade.
What happens to preferred stock at IPO? ›
IPO. When a company holds its initial public offering (IPO), it is expected that all outstanding preferred stock will convert to common stock immediately before the IPO. This is because the underwriters (the investment banks) managing the company's IPO will require it.
Which is the most preferred type of company by investors? ›
Answer: The private limited legal structure is most commonly used for the incorporation of a company. It is preferred because this structure keeps the liability of the members limited to their share in the capital.
Do investors prefer common stock or preferred stock? ›
Common stock investments have a potentially larger reward, but also come with more risk because they're exposed to the market. Preferred stock investments are a safer investment with fixed-income dividends, but investors may miss out on a share's appreciation they would get with common stock.
Drawbacks. The Securities and Exchange Commission warns investors that convertible shares may depress the value of common shares by diluting them. 2 Another drawback is that convertible preferred shareholders, unlike common shareholders, rarely have voting rights.
Can CCPS be bought back? ›
Yes, it is possible. The procedure shall be the same as the one prescribed under Sections 68, 69, and 70 of the Companies Act 2013 and relevant rules.
What are the benefits of optionally convertible preferred stock? ›
Convertible preferred stock offers the investor the benefits of both preferred stock and common stock. Investors get the stability, liquidation priority, and higher dividends of preferred stock, but they also have the option to convert their shares into common stock later if they believe that the price will go up.
What are the pros and cons of convertible preferred stock? ›
The benefits of convertible preferred stock include flexibility, potential for capital appreciation, dividend payments, and priority in liquidation. However, convertible preferred stock also has several drawbacks, such as dilution of ownership, lower dividend rates, higher costs, and risk of conversion.
Which type of investor is not preferred by preference share capital? ›
Preference shares are not preferred by those investors who are willing to take a risk and are interested in higher returns; Preference capital dilutes the claims of equity shareholders over assets of the company. The dividend paid is not deductible from profits as an expense.
Can CCPs be secured? ›
For companies, CCPS is a financial tool that serves as a bridge between debt and equity financing. It allows them to secure capital while maintaining control.
What are the advantages of holding preference shares? ›
Benefits Of Preference Shares
The primary advantage for shareholders is that the preference shares have a fixed dividend. This payout is typically done prior to any dividends being paid to common shareholders. If the company turns a profit, the dividends are paid on some types of preference shares.
Why are compulsorily convertible preference shares? ›
Overall, CCPS can be a valuable tool for risk mitigation by combining the benefits of debt and equity while addressing the specific needs of both investors and businesses. From an investor's viewpoint, Compulsorily Convertible Preference Shares (CCPS) offer a mix of benefits and considerations.
Which benefits do convertible preferred stockholders hold? ›
Convertible preferred stock offers the investor the benefits of both preferred stock and common stock. Investors get the stability, liquidation priority, and higher dividends of preferred stock, but they also have the option to convert their shares into common stock later if they believe that the price will go up.
