With India's strong ties with Silicon Valley and its maturing tech and startup ecosystem, outside investments in Indian companies are becoming increasingly common. However, the Indian economic and legal regime has some unique characteristics. Here are a few things you should consider before investing:
Foreign Direct Investment – Industries/Sectors and Limits
Are you investing/operating in a sector where foreign investment is permitted?
India is an economy with exchange controls, meaning any transaction involving foreign investment into India or outbound investment outside of India is regulated. At present, foreign investment into India is permitted via the Automatic Route (i.e., without prior approval from the Reserve Bank of India (RBI)) in most industries or sectors. However certain sectors remain totally prohibited (atomic energy, the lottery business, real estate, gambling, tobacco). Others have restrictions such as a cap on the amount of investment (e.g.: insurance, financial services, print media, telecom) or local sourcing requirements (e.g.: e-commerce, retail).
Which country does the investment originate from?
In April 2020, the RBI imposed further restrictions on investments originating in certain countries that share a land border with India, i.e. Pakistan, Nepal, Bangladesh and, importantly, China. Where the beneficial owner of any investment is situated in, or a citizen of, any such country, prior approval of the government is required for such investment. As of the time of this writing, there is significant uncertainty around how this new rule will be applied in practice and further clarifications from the government are expected.
One additional consequence of the exchange control environment in India is the pricing guidelines. In secondary transactions involving one foreign investor and one domestic Indian counterparty, certain fair value requirements are applicable, which favor the Indian counterparty. For example, a purchase of shares by a foreign investor from a domestic Indian counterparty needs to be at a price above a statutory fair value. And, conversely, a sale of shares by a foreign investor to a domestic Indian counterparty must not be above the statutory fair value. The fair value will need to be computed and certified by a chartered accountant or a registered merchant banker. Similarly, there are restrictions on deferred consideration, earnouts and indemnification escrows (including the escrow period).
Are you going to be a director on the board of an Indian company?
There is no requirement to be resident in India to be a director. However, all directors need to obtain a Director Identification Number (DIN) from the Ministry of Corporate Affairs and will be subject to fiduciary duties, whether they reside in India or elsewhere. Directors of Indian companies are subject to a duty of care and duty of loyalty (similar to Delaware corporations), and additional statutory liabilities attach to specified conduct, which can come with harsh penalties for the individual director responsible for such conduct. This article provides additional detail on the liabilities of directors of Indian companies.
Who owns the IP?
Making sure that the IP is validly assigned and owned by the company can be a critical factor in protecting the value of the enterprise – especially in the case of a business whose value is based significantly on its patents and other intangible assets. The default rule in India is that patents are owned by the employee/contractor unless validly assigned. Valid assignments should be done via a deed with stamp duty paid and the assignment registered with the patent registry. In addition, assignments of IP or inventions created in the future may not be valid under Indian law, necessitating periodic assignments of IP (as a good practice).
Obtain tax advice early – several fundamental aspects of tax imposition in India change frequently. Investments into India traditionally involved routing the investment via Mauritius or other tax-efficient jurisdictions with double tax avoidance agreements which can mitigate capital gains taxes. However, the tax benefit of that structure has been effectively closed. Even without the tax benefits, there are still some ancillary dispute resolution/investment protection benefits of routing an equity investment through certain specific jurisdictions that have a bilateral investment treaty with India.
In addition, beware of the "Indirect Transfer Tax", which may apply in a transaction that occurs completely outside of India. If a foreign holding company holds shares in an Indian company, transferring the shares in the foreign holding company could attract capital gains tax in India if "substantial value" of the shares sold is derived from the underlying Indian shares.
Timing and Expectations
Be prepared that certain aspects of an investment into India can be time-consuming. Every inbound investment into India requires routine compliance filings with the Reserve Bank of India (most often by the company issuing shares), even if no exchange control "approval" is required for the transaction. As a result, although the main transaction documents can often be negotiated and signed fairly quickly, the formalities for "closing" – such as becoming the record owner of shares, obtaining share certificates, being appointed to the board of directors or obtaining tax identification information – can take longer.
Key documents for an equity investment into India
Share Subscription Agreement
This is the main transaction document dealing with the purchase of shares by the investor and the issuance of shares by the company – similar to a Stock Purchase Agreement in a US-style venture capital investment.
This document governs the post-closing relationship among the shareholders and the rights of investors, addressing terms such as liquidation preference, pre-emptive rights, voting rights, board rights, etc. This document contains provisions that would be included in the Investor Rights Agreement, the Voting Agreement and the ROFR/Co-Sale Agreement, as well as in certain sections of the Certificate of Incorporation, in a US-style venture capital investment.
Articles of Association
This is the main statutory document, akin in some respects to a Delaware Certificate of Incorporation, and will typically contain all the provisions that are negotiated in the Shareholders Agreement so as to preserve the rights of the shareholders under law.
Register of Members
This is the statutory register under Indian law which records the name of each shareholder and the number of shareholders. In addition to share certificates, the register of members serves as the proof under law of share ownership and an extract of the register of members will typically be shared as part of any closing process.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.