Legal Aspects of funding and investments per the Indian laws.

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Owing to technological and industrial advancements, the start-up ecosystem in India has evolved to become one of the best in the world. But with changing times, it is imperative that we know the critical aspects of funding and investment in the case of start-ups. Generally, for start-ups, funds are an ever-posing challenge due to a tumultuous market position and a fear of failure. After the incorporation of a start-up, it can be either financed through equity or debt financing.

Equity Financing

In this type of financing, start-ups are usually funded by angel investors and/or venture capitalists or private equity investors

i. By a Venture Capitalist

An investment made by the Venture Capitalist/ Private equity investor can be termed as the first large investment received by a start-up. The investor and the start-up enter into a non-binding offer on the basis of a preliminary valuation of the start-up following the process of due diligence, as demanded by the investors. In continuance, this investment involves the execution of the following documents of transactions between the investor and the start-up:

a. Term Sheet / Letter of Intent /Memorandum of understanding:

It translates to a basic commercial understanding between the start-up and the investor, further providing the terms of due diligence to be produced in the agreements.

b. Share Subscription Agreement/ Debenture Subscription Agreement:

It addresses the issuance of shares in the share capital or debentures at a subscription amount determined based on the valuation of the start-up, condition precedent to completion of transaction or conditions subsequent to be completed within the agreed time frame after the completion date, and sets of representation, warranties, and indemnification extracted through due-diligence or otherwise, etc.

c. Shareholders’ Agreement: It essentially provides the following components.

▪ Nomination/representation rights on the board of investees;

▪ Information and reporting rights and disclosure obligation of investee to the investors;

▪ Redemption rights on debenture or preference shares;

▪ Pre-emption rights, Right of First Refusal or Right of First Offer, Tag Along with Right, Drag Along with Rights, Lock-in-period for the investor or promoter’s holding, put and call options, affirmative vote rights on certain reserved matters, anti-dilution provisions;

▪ Exit options to investors after the lock-in period, etc.

ii. By an Angel investor

These investors are generally industry professionals who enthusiastically fund a start-up venture in return for an equity stake. According to the SEBI (Alternative Investment Funds) Regulations, 2012 after being amended in 2013, the restrictions imposed on the investment of angel funds in an Indian company are:

a. An investee company has to be within 3 years of its incorporation, not listed on the floor of a stock exchange and should have a turnover of less than INR 250 million, and not be promoted by or related to an industrial group (with group turnover exceeding INR 3 billion).

b. The deal size is required to be between INR 5 million and INR 50 million. Separately, it is required that an investment shall be held for a period of at least 3 years.

Debt Financing

i. Loans

Loans provided by the Banks and Non-Banking Finance Companies (NBFCs) assist in financing the purchase of inventory and equipment in addition to securing operating capital. The start-up is required to pay interest on the loan received, at regular intervals without fail. Such Banks and NBFCs mandate collateral and inspect the track record of the company. The procedure of obtaining a loan through this way involves:

a. Application for loan sanction by borrowers;

b. Issue of sanction letter by the Bank;

c. Agreement of Loan;

d. Security/collateral documentation, such as (i) Deed of Mortgage; (ii) Deed of Hypothecation; (iii) Deed of guarantee; (iv) Share pledge agreement; (v) Memorandum of Entry; etc.

ii. External Commercial Borrowings

External Commercial Borrowings (ECBs) provided by non-resident lenders in the form of buyers’ credit or suppliers’ credit or securitized instruments also act as a source of financing for a start-up. ECBs are prevented from being lent or invested in the capital market in addition to acquiring a company in India.

iii. Credit Guarantee Trust for Micro and Small Enterprises scheme (CGTMSE) loans

The present scheme is launched by the Ministry of Micro, Small & Medium Enterprises (MSME), Government of India, in a move to support the entrepreneurs and provide them with loans up to Rs. 1 crore without any collateral or surety. Any new and existing MSME is eligible for obtaining the loan from all the scheduled commercial banks and specified regional rural banks. This includes organizations of National Small Industries Corporation (NSIC), The North Eastern Development Finance Corporation Ltd (NEDFi), and Small Industries Development Bank of India (SIDBI), which have all ratified an agreement with the Credit Guarantee Trust.

Crowd Funding

Crowd Funding is considered a revolutionary way of obtaining seed funding by way of securing funds in small amounts from a large group of people (crowd), commonly through the internet. A start-up can obtain money by showcasing the utility and distinctiveness of its idea and attracting the attention of the people. Forums such as Wishberry and Catapoolt provide the start-up with a platform to produce its idea and project. In 2014, the Securities and Exchange Board of India (SEBI) released ‘Consultation Paper on Crowdfunding in India’ enumerating the framework of Crowdfunding to encourage the start-ups to opt for seed funding in small sums from a broad base of investors. However, no regulations were issued to govern this process.

Incubators

Incubators assist the entrepreneur in developing a business idea or designing a prototype by furnishing resources and services in exchange for an equity stake generally from 2 to 10%. They are government-aided institutes like the IIMs or the IITs, technical institutes, or the private ones held by industry experts or companies. The period of incubation can normally range from 2-to 3 years, during which, management training, administrative support, adequate space, and help with legal compliances are provided.

Startup India Seed Fund Scheme (SISFS)

The present scheme launched by the Department of Promotion of Industry and Internal Trade (DPIIT), took effect on April 1, 2021. It endows the start-ups with financial assistance, for the proof of concept, prototype development, product trials, market-entry, and commercialization, which was released with an outlay of Rs. 945 crores. A start-up is required to be incorporated not more than two years ago at the time of application, for it to be eligible under the scheme. Furthermore, start-ups should not have received more than Rs. 10 lakhs of financial support through any other Central or State Government Scheme. A committee is set up to oversee the implementation and management of the SISFS. Upon selection of the eligible incubators by the committee, grants of up to Rs. 5 crores (milestone-based payments) are provided. As a grant for validation of proof of concept, prototype development, or product trials, the incubators are empowered to disburse up to Rs. 20 lakhs and are further empowered to disburse Rs. 50 lakhs of investment for market entry, commercialization, or scaling up through convertible debentures or debt or debt-linked instruments.

SOURCES

  • http://www.nishithdesai.com/fileadmin/user_upload/pdfs/Research_Papers/Startups-and-Venture-Capital-Investments.pdf
  • https://www.mondaq.com/india/securities/456322/a-legal-business-guide-for-startups
  • https://www.natlawreview.com/article/startup-india-seed-fund-scheme-switching-startup-game
  • https://dipp.gov.in/sites/default/files/Guidelines-FundScheme-Startup-29January2021.pdf



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