Demystifying Unlisted Shares: Everything You Need to Know

Did you know that 95% of the companies in India are privately held? Even when companies become public limited, the vast majority of them are not listed on stock exchanges i.e., they are unlisted. How do we tap into the potential of these companies?  

Companies can be broadly classified as either private limited or public limited, based on their ownership structure and whether their shares are traded on a stock exchange. Initially, companies start their journey as private limited companies and seek investments from shareholders to create value in their business. As they progress and attain a certain threshold of shareholders, they need to transition into public limited companies. This allows them to continue growing and create value, leading them to eventually list on a stock exchange through an IPO (Initial Public Offering). In this article, we will explore the distinctions between private and public limited companies, the key parameters that define their status, and shed light on the concept of unlisted shares while debunking related myths. It is important to note that there are other legal structures available for company formation, such as sole proprietorship or partnership. However, for the scope of this article, we will focus solely on Private & Public Limited companies.  
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Active Companies Limited by Shares as on 31 March, 2022 based on 8^th Annual Report on Working & Administration of Companies Act, 2013 by MCA.

Number of Shareholders / Investors

Start-ups require funding to initiate their operations. Initially, founders may rely on personal savings or contributions from family and friends. However, to facilitate business growth, it becomes essential to assemble a competent team to manage and expand the venture. To address the financial requirements of the company, founders seek investments from various sources, including angel investors, venture capitalists, or crowdfunding platforms. In exchange for funding, these investors become shareholders and receive a share in the company, anticipating future value creation. The classification of a company as private or public limited is determined by the number of shareholders involved. If the number of shareholders is less than 200, the company is considered private limited, whereas reaching this threshold makes the company public limited. Private companies have restrictions on transfer of shares, whereas public limited companies do not have these restrictions.  
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What are Unlisted Securities or Unlisted Shares?

If the shares of a company are NOT listed on a public Stock Exchange, these shares are termed as "unlisted" shares. While the shares of a private limited company are also unlisted, there are restrictions on free transfer of shares as governed by the shareholders’ agreement and articles of the company. (we will cover that in a separate article). For this article, when we refer to unlisted shares, we are referring to the unlisted shares of public limited companies. Also known as Pre-IPO shares, or Off-market shares. These could be shares of young, innovative and high-growth companies (such as Ola, Oyo, Of Business), or established companies (such as NSE, Serum Institute of India, etc). Shares of all these companies can be traded freely, in fact the shares of some of these companies are traded quite frequently in what is informally termed as the “grey market”.  

While the term "grey market" might usually have a negative connotation and suggests something illegal. But the truth is trading in unlisted shares is NOT illegal in India. And this grey market is simply a network of brokers, dealers, and some online platforms who perform the Off-The-Market transactions of buying and selling unlisted shares for themselves and their clients. However, word of caution that these grey markets are not tightly regulated by the SEBI (Securities and Exchange Board of India) and are lot less transparent and carry far more risk. So why would one want to invest in unlisted shares, you ask?
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Recommended Reading: Qonversations on ESOP Liquidity: ESOP Surrender vs. ESOP Buyback

Benefits and Risks of Unlisted shares.

There are several advantages to investing in unlisted shares. First, they can offer the potential for higher returns than listed shares. This is because unlisted shares are less liquid and less actively traded, which means that their price may not fully reflect their underlying value. This can create opportunities for value investing and long-term capital growth. Second, unlisted shares can offer investors the chance to get involved in early-stage companies that have the potential to grow rapidly. This can be a very rewarding experience, but it is important to do your research carefully before investing in any unlisted company.

However, there are also some risks associated with investing in unlisted shares. First, there is the risk that the company may not be successful, and its shares have the potential loss of capital. Second, there is the risk that the company may be unable to raise the necessary capital to grow, which could also lead to the shares losing value.

Finally, it is important to note that unlisted shares are not as liquid as listed shares. This means that it may be difficult to sell your shares if you need to do so quickly.

How to buy Unlisted Shares?

These are the steps involved in buying unlisted shares.

1. Discovery - The process begins with identifying potential sellers on online platforms and through brokers. Conducting thorough due diligence is crucial during this phase. This involves comprehensive research on the target company, its financials, promoters, growth prospects, business risks, and valuation. Evaluating the current financial performance and future growth potential of the company is essential. Understanding the competitive advantages and market position of the company is also part of the assessment. Additionally, verifying the authenticity, legality, and intentions of the seller is essential. Gathering details about the stake being sold, including the seller's percentage of ownership, the price per share, and the valuation method used, is a key aspect of the discovery process.

2. Sign a Deal Terms Agreement or a Share Purchase Agreement (SPA) - The second step is to finalize the transaction by signing a Deal Terms sheet or a Share Purchase Agreement (SPA). After identifying the appropriate company and willing seller, the agreement becomes a crucial document in the buying process. It is a binding contract between the investor seeking to purchase shares in a private or public unlisted company and the existing shareholder(s). Depending on the size of the investment the agreement varies between a simple Deal Terms sheet to a SPA. For smaller investments investors sign off a Deal Terms Sheet, which outlines the terms and conditions of the sale. The sellers put the onus of the due diligence on the investor. While this is the accepted norm with smaller investments, in bigger trades where the size of the investment is large a SPA is signed.  
   
   The SPA serves as a legally enforceable agreement that outlines the terms and conditions of the share sale. Furthermore, the document covers warranties and representations provided by the seller, ensuring that the information about its shares is accurate and reliable. This section safeguards the buyer's interests by minimizing potential risks and uncertainties associated with the purchase. The SPA encompasses other essential transactional details, such as payment terms, dispute resolution mechanisms, confidentiality clauses, and any additional covenants or agreements between the parties. Within the SPA, several key components are detailed to ensure clarity and protection for both parties. These include specifying the exact number of shares to be transferred, along with the agreed-upon price per share. The completion procedure, outlining the steps required to finalize the transaction, is also included. Conditions precedent, which are specific requirements or events that must occur before the agreement becomes effective, are addressed in the SPA. By signing the SPA, both the buyer and the seller confirm their commitment to the terms stipulated in the agreement, providing a legally sound framework for the share purchase. It is crucial for both parties to thoroughly review and understand the SPA before signing, seeking legal counsel, if necessary, to ensure a smooth and transparent transaction process. Watch out for this space for a more detailed explanation of SPA and its key components.    

3. Transfer of Shares - After signing the Share Purchase Agreement (SPA) and verifying the seller's ownership of shares in her DEMAT account, the buyer proceeds to make the payment through bank transfers, cheques, or an escrow mechanism. Upon receipt of the payment, the seller initiates the transfer of shares through an Off-Market Transfer. This process ensures a direct transfer of shares between parties outside the stock exchange. The buyer should receive the shares in their DEMAT account within 24 hours of completing the payment. This smooth and efficient procedure ensures a secure and timely exchange of shares between the parties involved.

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Also Read: Navigating the Funding Winter: Unlocking Liquidity through Secondaries

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