The recent amendments in the valuation norms of unlisted shares introduced by the Reserve Bank of India may have an adverse effect on investments by foreign private equity and venture capital investors in India. Previously, the issue price of shares of an unlisted company transferred by way of sale by residents to non-residents was determined at book value in accordance with the guidelines issued by the Controller of Capital Issues. The recent changes introduced by the RBI propose to value such shares using a "Discounted Free Cash Flow" model.

1. Guest Column: New Pricing Model: Cause of Concern for Private Equity Investors in India
Author - Shantanu Surpure, Managing Attorney, Sand Hill Counsel, Mumbai, Assisted by Rashi Saraf,
Associate, Sand Hill Counsel
Introduction
The recent amendments in the valuation norms of unlisted shares introduced by the Reserve Bank of
India (“RBI”) may have an adverse effect on investments by foreign private equity and venture capital
investors in India.
Previously, the issue price of shares of an unlisted company transferred by way of sale by residents to
non-residents was determined at book value in accordance with the guidelines issued by the Controller
of Capital Issues (“CCI”). The recent changes introduced by the RBI propose to value such shares using a
“Discounted Free Cash Flow” (“DFCF”) model.
Guidelines issued by CCI
In India, the office of the CCI (SEBI’s precursor) determines the minimum price at which unlisted share
issuances are to be made. The pricing of shares of listed companies is determined in accordance with
the Securities Exchange Board of India (“SEBI”) guidelines.
Under the CCI Guidelines, the “Fair Value” (“FV”) of the company’s shares was computed by averaging
the values obtained by the “Net Asset Value” (“NAV” which is the traditional book value per share
computed on the basis of the latest published annual accounts) method and the “Profit Earnings
Capacity Value” method (“PECV”) under the share valuation process under the CCI guidelines. These
computations relied exclusively on recent audited accounts.
If the average of NAV and PECV, capitalized at a specified rate, fell short of market value by less than
20%, the average was regarded as a fair value. In other words, as much as 20% undervaluation was
considered acceptable. Since revaluation of fixed assets was not ordinarily permitted for NAV
computation, the average was usually an underestimate of the true value.
DFCF method
All unlisted companies are now directed by RBI to move from the existing book value method to the
market-based valuation method. Pursuant to the recent notification issued by RBI, the pricing of shares
of unlisted companies shall not be less than the fair valuation of shares conducted by a SEBI-registered
Category – I merchant banker or a chartered accountant as per the DFCF method.
This method is based on the future earnings. It uses future cash flow projections and discounts them to
arrive at a present value, which is used to evaluate the potential for investment. Therefore, the
valuation of the shares is likely to be higher than the valuation arrived at using the earlier book building
method.

2. Apart from introducing new pricing norms for shares of unlisted companies, investors in Indian
companies may also have to worry about paying additional taxes while making investments. As
proposed by the Central Board of Direct Taxes, an investor who buys shares at a value which is lesser
than the fair market value of shares will have to pay tax on the difference between the two. As a result,
foreign investors (liable to pay approx. 42 percent) and domestic entities (liable to pay approx. 33
percent) will be required to pay tax on purchase of shares at discounted rates in addition to paying
capital gains tax on exit.
Impact of the DFCF method
In addition to reducing the chances of a lower valuation which was possible under the CCI guidelines,
the new DFCF method will bring parent companies investing into their wholly owned subsidiary
companies under scrutiny.
The DFCF method may encourage foreign investors to register as a Foreign Venture Capital Investor
(“FVCI”) with SEBI to benefit from the exemption available to SEBI registered FVCIs from entry and exit
pricing regulations as per the RBI notification issued in December 2000.
However, registering as an FVCI is not without its negative aspects. FVCIs are granted permission to
register with SEBI only on the condition that they invest in the following nine sectors as identified by the
Finance Act, 2007 with regard to Section 10 (23FB) of the IT Act 1961:
i) Biotechnology
ii) Information technology relating to hardware and software development
iii) Nanotechnology
iv) Seed Research and Development
v) Research and Development of new chemical entities in the pharmaceutical sector
vi) Production of bio-fuels
vii) Building and operating a hotel and convention center with seating capacity of more than 3000
viii) Dairy or Poultry industry; and
ix) Developing, operating or maintaining any infrastructure facility
Conclusion:
It remains to be seen what the impact of the change in valuation methodology has on private equity
investors in India. It raises the minimum price of share issuances and therefore impacts the ability to
structure transactions.
About the Author
Shantanu Surpure is Managing Attorney of Sand Hill Counsel, a law firm with offices in Mumbai and
Silicon Valley. Shantanu holds law degrees from Oxford and Columbia and is licensed to practice law in
India, California, New York and England and Wales. Shantanu has a general corporate law practice with
a special focus on cross-border VC/PE and M&A transactions.