Venture Capital funds ("VCs") and Private Equity firms ("PEs") have undeniably played a pivotal role in the Start-up boom that has seized the Indian economy in the recent past. The Indian start-up ecosystem is the third largest in the world with over 94 unicorns1. However, the involvement of VCs in start-ups is accompanied by governance mechanisms that could lead to friction between the investor and investee with respect to the management of the enterprise. The problem becomes more acute in cases where entrepreneurs as well as the VCs, in their eagerness to 'strike the deal', end up overlooking the significance of legal documentation for the transaction. This article discusses the governance mechanisms employed by VCs/PEs regarding broad functioning of the investee company, and thereafter identifies some of the potential problems that can arise from such mechanisms2. This Article also endeavours to suggest approaches for overcoming or counterbalancing such potential issues.
Role of VCs in Start-Ups:
As key players in the upscaling of start-ups, VC involvement is not usually limited only to capital injection or seed capital funding. Rather, they play a more active and facilitative role as business enablers and developers. Thus, funding routes often envisage VC participation in profits as investor-shareholders3. They bring in financial and market expertise, business contacts and strategic partnerships, all of which aid in transforming speculative bootstrapped ventures into sustainable and profitable businesses. Due to the degree of their involvement, VCs tend to become interested in the governance and executive decision-making as to the activities of their investees. Especially so, because these matters would have a bearing on the value of their investment (returns), and their end goal of exiting with sizeable profits.
The Genesis of Investor Control Rights in Indian Private Equity and Venture Financing:
Historically, the ubiquitous presence of the family run businesses, and complex regulatory/compliance environment, had nudged PEs investing in private unlisted companies to opt for minority shareholding positions in Indian investees. To square off their minority interest, PEs had resorted to a practice of negotiating shareholders' agreements ("SHAs") and investment agreements ("IAs") with measures for governance and investment protection. The object of such mechanisms being to create a system for checking founder-opportunism and preserving value for investors. A similar trend is also visible in VC funding of start-ups. The nature of the investment itself being largely speculative and risky on account of factors such as market uncertainty, lack of sufficient data on performance and profitability (and the consequent inability to conduct a thorough diligence), information asymmetry on both sides; VCs prefer to steer clear of majority participation, and instead secure for themselves, the benefit of protective provisions.
An analysis of Governance Mechanisms, and their Enforceability:
The two most common mechanisms for governance are as follows:
- Board participation by
VCs/PEs: This is usually ensured by incorporating into the
SHAs/IAs, provisions for appointment of investor directors or
nominees to the boards of their investee. The number of
nominee/investor directors signals the extent of control the
investor enjoys over management of start-ups. Investors'
participation through board seats can be further enhanced by
inclusion of quorum conditions for participation by
Intriguingly, these investor/nominee directors embody a dual fiduciary capacity (both to the investee company as well as the investors of the funds) which may trigger concerns. Problem surfaces, when a nominee director of the investor, wearing this dual hat, participates in a decision-making process of the investee company, which may be conflicting with the views of the investor company or the founders or early-stage equity investors of the investee company.
- Special voting provisions: These are incorporated in the SHAs and IAs, either by means of veto powers or through affirmative voting rights in respect of certain reserved matters. These powers/rights enable their wielders/holders to block or disapprove transactions involving the investee company notwithstanding that they may be backed by majority shareholders. Thus, significant corporate actions of investees are usually subjected to a different threshold of approval, than what would ordinarily be required, had there been no such special voting rights.
Indian Courts have held that SHAs/IAs between shareholders would be enforceable so long as they do not exceed or contradict to the terms of the Article of Association ("AoA") of the concerned company4. Special voting provisions engrafted into AoA involving decision making (by investor-shareholders as well as of nominee directors) in exercise of 'affirmative voting rights' and categorization of 'reserved matters' have been affirmed by Indian courts in cases such as IL and FS Trust Co. Ltd v. Birla Perucchini Ltd.5 and Tata Consultancy Services Limited v. Cyrus Investments Private Limited and Others6. Courts are usually averse to interpreting the terms of an SHA / IA in a manner that would render the agreement unworkable by defeating the very purpose of the investment and its ultimate benefit to investors.
Thus, it is always better to have the SHA/IA properly vetted and negotiated between parties beforehand, rather to approach the courts to settle issues in case of a subsequent dispute.
The Sour Spot:
The incorporation of governance mechanisms in the SHAs and IAs per se cannot be termed 'illegal'. Although, at a management level, such participation may cause disgruntlement in the minds of founders/entrepreneurs as it may give investors the room for what may be termed as 'micro-management' by VCs. Affirmative voting rights of investor-shareholders or investor-directors often encapsulate matters such as strategic business decisions, transfer of vital assets, appointment, and removal of key managerial personnel etc., which may be sensitive to both VCs and founders. Divergence in ideologies, operating styles, methods, and aspirations also becomes an additional stumbling block to the VC-start-up / VC-founder alliance.
It is the operation of investment protection measures (such as anti-dilution clauses, pre-emptive rights of participation in subsequent rounds of financing, liquidation preference, exit option enforcement etc), which in conjunction with investor-centric governance measures, that can spark tensions between the entrepreneurs/founders and early equity holders on the one side and the investing VC or VC-backed board on the other side. These conflicts may manifest in diverse forms ranging from board room battles to full-blown lawsuits. In fact, the controlling rights of investors are amongst the most hotly negotiated terms of SHAs and IAs.
From the perspective of the entrepreneurs, it can become especially hard to reconcile the purpose of protective provisions in SHAs (i.e., checking founder opportunism) with the fact that their stake or role is inevitably diminished over time. Even amongst the top unicorns of India (e.g., Swiggy, Oyo, Flipkart, Delhivery, PharmEasy etc.,) the founders' stake is significantly low. The contractually sanctioned investor protection measures, invented for containing founder opportunism must be viewed in the light of the dilution of founders' stake and/or control. From this angle, it can be seen how entrepreneurs may feel as if they have been insidiously squeezed out of control and excluded from the business decisions concerning the very enterprise which was conceived through their ingenuity and labour. Perhaps, entrepreneurial freedom is the price of capitalization!
Founders and executives of start-ups can increasingly find their role reduced to that of employees, at the mercy of the VCs who could possibly cut them loose citing commercial reasons. In fact, the replacement of founder-CEOs with professional CEOs, in certain start-ups during the run up to a major fund-raise, has garnered media attention. On the other hand, hasty and "bold" decisions by the Promotors and inter se disputes amongst Promotors is a constant hinderance for a VC. Substantial amount of time of a VC is wasted in mediating inter se disputes between warring Promotors. All these factors may breed an environment of conflict, toxicity and oppression which may risk organizational health and sabotage the growth prospects of start-ups. The framework of the SHAs/IAs vesting ultimate decision-making with the VC may become a bone of contention between the VCs and founders/early-stage investors; from which disputes such as legal actions for oppression / mismanagement, corporate governance disputes and actions for declaratory or injunctive reliefs (qua outcomes of board meetings, asset transfers, strategic corporate actions) may arise.
Loosely worded exit clauses of SHA/IA end up creating a deadlock, where on one hand a VC wants an exit by selling its stake either to existing shareholders or to an outsider, and on other hand, the investee promotors are either averse to such outsider stepping in or are tangled inter se, trying to grab the controlling stake. These tussles usually lead to unwanted litigation, and VCs smooth exit is jeopardised by hastily sought injunctions.
Entrepreneurs as well as investors, both must be cautious not to underestimate the legal implications of SHAs/IAs, if the same ends up in court. They must refrain from signing up standardized legal documents without carrying out independent legal assessment, especially from a litigation exposure point of view. In their enthusiasm to get funding, the entrepreneurs should not take a hasty approach. Equally, the VCs should also not overlook the potential litigation scenarios, in their haste to get a cheaper deal in a potentially profitable enterprise. It is critical that both the sides enter investment relationships with their eyes wide open, after deliberating the effect and consequence of each of the terms of investment and duly appreciating the risk of potential conflicts/disputes that they may pose. VCs should also double check their exit mechanisms to ensure that when the time to exit is near, they are not hindered by existing shareholders. VCs should refrain from taking pro-investor SHA/IA terms lightly, simply because at the time of signing, these terms seemed to be VC centric. These seemingly pro-investor terms may lead to subsequent disputes on vital aspects of control, management, and governance, with founders alleging ouster, oppression et al. This can adversely impact not only their exit from a current start-up, but also their future fund-raising capacity and deal flow, as a litigious investor is not a good image for a VC.
To avoid and mitigate such concerns, it is advisable to not only have the SHA/IA terms vetted from transactional and business point of view by legal experts, but have it checked for litigation exposure as well. Running a "worse case scenario" simulation with litigation lawyers would better equip the investor as well as the investee before they sign on the dotted line.
2 Other than that, the VCs/PEs also avail of investment protection measures such as anti-dilution clauses, pre-emptive rights of participation in subsequent rounds of financing, liquidation preference, exit option enforcement etc, which are not analysed in this Article.
3 VCs select portfolio companies for investment, pump capital through successive rounds of investment, advise and monitor the investees' functioning (even replace management) and finally before the end of the fund's life, they exit the investment and return capital to their investors.
4 V. B. Rangaraj v. V. B, Gopalakrishnan and Ors. (1992) 1 SCC 160; World Phone India Pvt. Ltd. and Ors. V. WPI Group Inc., (2013) 178 Comp Cas (Del); doubted in Vodafone International Holdings BV v. Union of India and Anr. (2012) 6 SCC 613
5 2003 (3) Bom CR 334
6 (2021) 9 SCC 449
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.