Raising Your First Priced Round: The Private Placement Procedure Under Section 42

Term sheet signed, valuation agreed. Before the money can legally arrive, the company-law procedure has to be followed. Every priced round in a private company (equity, preference shares, debentures, or CCPS, which are compulsorily convertible preference shares) is a private placement under section 42 of the Companies Act, 2013 and rule 14 of the Companies (Prospectus and Allotment of Securities) Rules, 2014. Skip a step and the consequences range from daily penalties to the round being treated as a public offer. This is the procedure, in order.

The frame: identified persons, no renunciation, no publicity

A company may make a private placement of securities, subject to section 42 (s.42(1), Companies Act 2013). "Private placement" means an offer or invitation to a select group of persons, other than by public offer, through a private placement offer-cum-application that satisfies the section's conditions (Explanation I to s.42, Companies Act 2013).

The placement may go only to persons identified by the Board ("identified persons"). Their number must not exceed fifty or such higher number as is prescribed, in a financial year, excluding qualified institutional buyers (large regulated investors) and employees offered securities under an ESOP scheme (an employee stock option plan) (s.42(2), Companies Act 2013). The company issues the private placement offer and application to identified persons whose names and addresses it has recorded, and the offer and application carry no right of renunciation, meaning the investor cannot hand the offer to someone else (s.42(3) and its proviso, Companies Act 2013). An investor cannot pass an allocation to someone else.

There is also a publicity ban. No public advertisements, and no media, marketing or distribution channels or agents may be used to inform the public at large about the issue (s.42(7), Companies Act 2013). A placement marketed like a public fundraise stops being a placement.

The headcount ceiling has real consequences. If a company makes an offer, invites subscription, allots, or even agrees to allot securities to more than the prescribed number of persons, the issue is deemed an offer to the public. This applies whether or not payment has been received and whether or not the company intends to list (Explanation III to s.42, Companies Act 2013). Separately, a private placement not made in compliance with s.42(2) is deemed a public offer, with the Companies Act, the Securities Contracts (Regulation) Act, 1956 and the SEBI Act, 1992 applying (s.42(11), Companies Act 2013). Count every offeree, not only those who subscribe.

Special resolution first, with the price justified

A company must not make a private placement offer unless the proposal has been previously approved by its shareholders by a special resolution, for each of the offers or invitations (rule 14(1), PAS Rules 2014, as substituted in 2018). The explanatory statement to the shareholders' notice must disclose, among other things (first proviso to rule 14(1), PAS Rules 2014):

• the particulars of the offer, including the date of the Board resolution;
• the kind of securities offered and the price at which they are offered;
• the basis or justification for the price, including any premium;
• the name and address of the valuer who performed the valuation;
• the amount the company intends to raise;
• the material terms, proposed time schedule, purposes or objects, and the promoters' or directors' contribution.

The price justification is therefore a documented shareholder-level fact before any PAS-4 goes out. Two narrow variations exist: for non-convertible debentures, a single special resolution once in a year can cover all such offers in the year where the amount exceeds the section 180(1)(c) borrowing limit (third proviso to rule 14(1), PAS Rules 2014); and an annual resolution is also allowed for offers to qualified institutional buyers (proviso inserted by the 2020 amendment to rule 14(1)). Neither is relevant to a first equity round.

Offers to a body corporate incorporated in, or a national of, a country that shares a land border with India need Government approval under the Foreign Exchange Management (Non-debt Instruments) Rules, 2019, attached to the offer letter (proviso inserted by the 2022 amendment to rule 14(1), PAS Rules 2014). Check investor nationality before circulating anything.

The numbers: two hundred persons, per kind of security

The rules prescribe the higher number the Act leaves open: an offer or invitation must not be made to more than two hundred persons in aggregate in a financial year. Offers to qualified institutional buyers, or to employees under an ESOP scheme under section 62(1)(b), are not counted (rule 14(2) and proviso, PAS Rules 2014). The limit is reckoned individually for each kind of security: equity share, preference share or debenture (Explanation to rule 14(2), PAS Rules 2014).

Subscription money must come from the bank account of the person subscribing, and the company keeps a record of the account from which each payment was received. For joint holders, payment comes from the account of the first-named holder (rule 14(5) and proviso, PAS Rules 2014). Founder-funded "round-tripping" through another person's account fails this test on its face.

PAS-4 out, money into a separate account, allot within sixty days

The offer travels as a private placement offer-cum-application letter in Form PAS-4. It is serially numbered, addressed specifically to the person to whom the offer is made, and sent in writing or electronically within thirty days of recording that person's name. Only the addressed person may apply on it; any other application is invalid (rule 14(3) and proviso, PAS Rules 2014). The company maintains a complete record of private placement offers in Form PAS-5 (rule 14(4), PAS Rules 2014).

Application money has its own rules:

• Each identified person applies in the private placement offer and application, with subscription money paid by cheque, demand draft or other banking channel and not by cash (s.42(4), Companies Act 2013).
• Money received on application is kept in a separate bank account in a scheduled bank and used only for adjustment against allotment or for repaying money where the company cannot allot (proviso to s.42(6), Companies Act 2013).
• The company must not use the money until allotment is made and the return of allotment is filed with the Registrar (proviso to s.42(4), Companies Act 2013).
• The company must allot within sixty days of receiving the application money. If it cannot, it must repay within fifteen days from the expiry of the sixty days, and on further delay it owes interest at twelve per cent per annum from the expiry of the sixtieth day (s.42(6), Companies Act 2013).
• No fresh offer or invitation under the section may be made until allotments on the earlier offer are completed or that offer is withdrawn or abandoned by the company (s.42(5), Companies Act 2013). Overlapping rounds need sequencing.

PAS-3 and the penalty clock

After allotment, the company files the return of allotment with the Registrar within fifteen days of the allotment, with a complete list of allottees (s.42(8), Companies Act 2013). Rule 14(6) uses the same window: Form PAS-3 within fifteen days of allotment, with the prescribed fee, listing for each holder the full name, address, PAN and email ID, class of security, date of allotment, number of securities held, nominal value and amount paid, plus particulars of any non-cash consideration (rule 14(6), PAS Rules 2014).

If the company defaults in filing the return in time, the company, its promoters and directors are liable to a penalty of one thousand rupees for each day of default, up to twenty-five lakh rupees (s.42(9), Companies Act 2013).

A wider penalty applies if the company makes an offer or accepts money in contravention of section 42. The penalty may extend to the amount raised or two crore rupees, whichever is lower, and the company must refund all money with interest to subscribers within thirty days of the order (s.42(10), Companies Act 2013).

Step-by-step: the round sequence

• Board identifies investors and records their names and addresses, within the Act's fifty-or-prescribed ceiling and the two-hundred-person rule (s.42(2)-(3), Companies Act 2013; rule 14(2), PAS Rules 2014).
• Shareholders pass a special resolution for the offer, with the price basis and valuer disclosed in the explanatory statement (rule 14(1), PAS Rules 2014).
• Send PAS-4 with serially numbered application forms, within thirty days of recording each name; only the addressee may apply (rule 14(3), PAS Rules 2014).
• Maintain the PAS-5 record of the offers (rule 14(4), PAS Rules 2014).
• Collect money by banking channel into a separate scheduled-bank account, from each subscriber's own account; no cash and no use before allotment and return filing (s.42(4), proviso to s.42(6), Companies Act 2013; rule 14(5), PAS Rules 2014).
• Allot within sixty days; refund within fifteen days of the sixty days expiring, with twelve per cent interest on further delay (s.42(6), Companies Act 2013).
• File Form PAS-3 within fifteen days of allotment; one thousand rupees a day on default, capped at twenty-five lakh rupees (s.42(8)-(9), Companies Act 2013; rule 14(6), PAS Rules 2014).

What to do now

• Next step: Board records the identified investors' names and addresses (s.42(3), Companies Act 2013), then calls the general meeting for the special resolution with the price justification in the explanatory statement (rule 14(1), PAS Rules 2014).
• Deadlines: send PAS-4 within thirty days of recording each name (rule 14(3), PAS Rules 2014); allot within sixty days of receiving application money (s.42(6), Companies Act 2013); file PAS-3 within fifteen days of allotment (s.42(8), Companies Act 2013; rule 14(6), PAS Rules 2014).
• Consequences: a late return draws one thousand rupees per day up to twenty-five lakh rupees (s.42(9), Companies Act 2013); an offer to more than the prescribed number of persons is deemed a public offer (Explanation III to s.42, Companies Act 2013); a non-compliant offer or acceptance of money can draw a penalty up to the lower of the amount raised and two crore rupees (s.42(10), Companies Act 2013).

Have a CA review your facts before you act or file.

FAQ

Can we add an investor after PAS-4s go out?
Only within the ceilings and the sequence. The offer goes to Board-identified persons whose names and addresses are recorded (s.42(2)-(3), Companies Act 2013), capped per financial year (rule 14(2), PAS Rules 2014), and no fresh offer may be made until earlier allotments are completed or the earlier offer is withdrawn or abandoned (s.42(5), Companies Act 2013). A new investor needs a fresh, separately approved offer.

Can an investor renounce in favour of their fund?
No. The offer and application carry no right of renunciation (proviso to s.42(3), Companies Act 2013), and no person other than the addressee may apply on the form (proviso to rule 14(3), PAS Rules 2014).

Can we use the round money to pay salaries before allotment?
No. The money sits in a separate scheduled-bank account for adjustment against allotment or repayment only (proviso to s.42(6), Companies Act 2013), and it cannot be used until allotment is made and the return of allotment is filed (proviso to s.42(4), Companies Act 2013).

What if too many investors are offered?
If the offer goes to more than the prescribed number of persons, the issue is deemed an offer to the public, whether or not the company intends to list (Explanation III to s.42, Companies Act 2013). Fix the count before circulating anything.

Do ESOP holders count toward the headcount?
No. Employees offered securities under an ESOP scheme under section 62(1)(b) are excluded from the section 42(2) count and from the rule 14(2) two-hundred-person count (s.42(2), Companies Act 2013; proviso to rule 14(2), PAS Rules 2014).

Can one special resolution cover two tranches six months apart?
Not for equity or preference shares. Approval is for each of the offers or invitations (rule 14(1), PAS Rules 2014), and a fresh offer must wait for earlier allotments to complete or the earlier offer to be withdrawn or abandoned (s.42(5), Companies Act 2013). The standing approvals the rule allows are for non-convertible debentures (once in a year above the section 180(1)(c) limit) and for qualified institutional buyers (rule 14(1) provisos).

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See Also

• Family and Friends Money in Your Startup: When a Loan Becomes a Deposit
• Allotting Shares After a Public Offer? Minimum Subscription, Listing Permission and Refunds Under Sections 39–40
• Debentures Under Section 71: Conversion, DRR, Trustees and Holder Remedies