Section 42 and the 200-Person Limit: How an Unlisted Company Accidentally Makes a Public Offer

A private limited company raising its first external round rarely thinks of itself as being anywhere near securities regulation. In practice it is one spreadsheet error away. Offer shares to more than the permitted number of people in a financial year and the offer is treated as a public offer — with the Companies Act's public issue provisions, the Securities Contracts (Regulation) Act and the SEBI Act all applying to something that was never intended as a public issue and has none of the apparatus of one.

This is the provision worth understanding before the first term sheet, not after.

What a private placement is

Section 42 of the Companies Act, 2013 governs the offer or invitation to subscribe to securities by private placement — an offer made to a selected group of persons identified by the board, through a private placement offer and application in Form PAS-4.

Two features define it. It goes to an identified group, chosen in advance by board resolution. And it may not be advertised: no public advertisements, no media, no marketing or distribution channels of any kind may be used to inform the public at large.

That second point is where modern practice collides with a 2013 statute. A LinkedIn post inviting interest in a round, a pitch circulated on an open investor WhatsApp group, a newsletter to a mailing list — each risks being characterised as an invitation to the public rather than an offer to identified persons, independently of how many people actually subscribe.

The limit

Under Section 42 read with Rule 14 of the Companies (Prospectus and Allotment of Securities) Rules, 2014, an offer or invitation may be made to not more than 200 persons in the aggregate in a financial year, counted per kind of security.

The mechanics of the count:

• it is per financial year, resetting on 1 April;
• it is per kind of security — equity shares, preference shares and debentures are counted separately, so 200 equity offerees and 200 debenture offerees in the same year is within the rule;
• it counts persons to whom the offer is made, not persons who subscribe;
• qualified institutional buyers are excluded from the count; and
• employees receiving securities under a scheme of employees' stock option under Section 62(1)(b) are excluded.

The QIB exclusion is why institutional rounds do not consume the allowance, and why a company expecting several angel rounds should watch the count far more carefully than one raising from a single fund.

The procedure, step by step

1. Board resolution identifying the persons to whom the offer will be made, and approving the offer.
2. Special resolution of the members, with an explanatory statement. For an offer of non-convertible debentures within the limits specified, a board resolution can suffice.
3. Valuation report from a registered valuer, supporting the price.
4. PAS-4 offer letter issued to the identified persons, serially numbered and addressed specifically to each — not a generic circular.
5. Record of offerees maintained in Form PAS-5, kept at the registered office.
6. Subscription money received by cheque, demand draft or other banking channel, from the subscriber's own bank account, and never in cash.
7. Separate bank account. Money received must be kept in a separate account with a scheduled bank and may not be utilised for any purpose other than allotment, or repayment where allotment fails, until the return of allotment is filed.
8. Allotment within sixty days of receipt of the money. If the company fails to allot within sixty days it must repay within fifteen days thereafter, and failing that the money carries interest at 12% per annum from the expiry of the sixtieth day.
9. PAS-3 return of allotment filed with the Registrar within fifteen days of allotment, with the complete list of allottees and their particulars.
10. Share certificates within two months of allotment, and the register of members updated.

The separate bank account rule in step 7 is the one most often breached in practice, and it is breached innocently: the money arrives, the company needs it, and it is spent before the PAS-3 goes in. That is a contravention of a specific statutory prohibition, and it is visible on the bank statement for as long as the statement exists.

What happens when the limit is crossed

Where the number of offerees exceeds the prescribed limit, the offer is treated as an offer to the public, and is governed accordingly — which engages the prospectus and public issue requirements of the Companies Act, the Securities Contracts (Regulation) Act and the SEBI Act, regardless of what the company intended or what the documents called it.

The practical consequences are severe and cumulative:

• the company has made a public issue without a prospectus, which it cannot retrospectively cure;
• Section 42 provides for refund of all money to subscribers within thirty days of an order, where the provisions are contravened;
• a penalty is attracted on the company, its promoters and its directors, which the section frames by reference to the amount involved subject to a statutory ceiling. The figures have been amended more than once, so check the current text rather than an older summary;
• the contravention is disclosable in due diligence, and it will be found. The commonest way companies discover a Section 42 problem is a lead investor's counsel finding it four years later, at which point it has to be disclosed, compounded and priced into the round.

There is a line of SEBI and appellate decisions on unlisted companies that raised from large numbers of investors and were held to have made public issues, with directions to refund with interest. Those cases involved far more than 200 investors — but the principle they apply is the one in this section, and the fact that nobody intended a public issue was not a defence in any of them.

Where companies actually trip

In the files we review, the problems cluster:

• the count is never maintained. PAS-5 is not kept, so nobody knows the running total, and in a year with three closes the answer is genuinely unknown;
• a broadcast replaces an offer. A deck circulated widely to "gauge interest" before the board has identified offerees;
• money arrives before the paperwork. A subscriber transfers funds on a handshake, weeks before the special resolution and PAS-4;
• the separate account is skipped, or the money is moved out of it before PAS-3;
• allotment drifts past sixty days while a late investor is waited for, with no refund and no interest provided;
• the valuation report is retrofitted to the price already agreed, which is a different exercise from valuing the company;
• convertible instruments are treated as nothing at all until conversion. A compulsorily convertible instrument is a security being offered now, and the offer is counted now.

Practical discipline

• Maintain PAS-5 as a live register, with a running count by kind of security and by financial year, owned by one named person.
• Identify offerees by board resolution before any document goes out, and issue PAS-4 individually.
• Keep the separate bank account untouched until PAS-3 is filed. Treat it as escrow.
• Diarise the sixty-day allotment deadline on the day the first rupee lands.
• Use a rights issue where the round is internal, and remember that QIBs do not count.
• Where a round will plainly involve a large number of small investors, stop and restructure it — through an AIF, a pooled vehicle, or a syndicate structure — rather than trying to fit it inside 200.