Beyond The Term Sheet: Navigating The Legal Minefield Of Startup Funding

Author: Aman Kumar Singh

I. Introduction: The Term Sheet is Just the Beginning

For all intents and purposes, signing a term sheet is often confused with the end of a transaction in the Indian startup community - the world's third-largest in terms of recognised startups. Actually, the term sheet is just a non-binding ‘statement of intent’. The legal framework that influences the relationship between a startup and its investors is finalized during the weeks and months to come and is far more important and far more intricate than the terms of the investment.

Indian startup funding is governed by a complex matrix of laws and regulations such as the Companies Act, 2013; Foreign Exchange Management Act, 1999 (FEMA) and its regulations; Securities and Exchange Board of India (SEBI) regulations; the Income Tax Act, 1961; and others. Errors at any point have the potential to result in regulatory liability for the founders, as well as a loss of control that was never intended, and/or commercial disadvantage for the founders in future rounds.

In this blog, I'll review the most important legal matters that come into play once a term sheet is signed, and look at some of the more common overlooked or misunderstood matters amongst early-stage founders. It is not a comprehensive list, but an analytical discussion of the pressure points in a funding transaction that precede the post term sheet stage.

II. The Definitive Transaction Documents: Beyond Headlines

1. The Shareholders' Agreement and its Architecture

The principal transactional document that follows a term sheet, when it is agreed upon, is called the Shareholders' Agreement (SHA) and is usually accompanied by a Share Subscription Agreement (SSA). These documents convert the business intent of the term-sheet into ever-lodging contracts. In particular, the SHA controls the continuing relationship between founders, the startup company and its investors and often continues beyond the life of the investment.

Their founders often find themselves only in the middle of a conflict, when legal implications of several commitments in a SHA become evident. One such area is the representation and warranty provisions. The SSA usually demands very broad statements regarding the company's finances, the accuracy of its IP disclosures, there being no material litigation, and adherence to applicable law by the company and its founders. Breach of these representations may result in an obligation of the indemnity-possibly personal to the founders.

Another important element is Conditions Precedent (CPs). Investors make it part of their investment agreement to require CPs such as filing with regulatory committee, obtaining board and shareholder resolutions, existing shareholding structure modification, outstanding tax demands clearance and/or conversion of existing loans. These CPs are to be completed within agreed deadlines. If not, the transaction remains in jeopardy and the investor can back out of it without saying "sorry!If so, the investor will have a green light to walk away, without a "sorry!" to be said.

2. The Pitfalls of Convertible Instruments

In fact, Convertible notes and Compulsory Convertible Debentures (CCDs) have seen a huge popularity in early-stage funding in India where investors delay the valuation discussion to a later stage of the investment process when their expectations are likely to have grown more concrete. The legal consequences of these instruments, however, are extremely complex.

The foreign investment in Indian companies shall be made subject to the provisions of pricing guidelines framed by the Reserve Bank of India under the Foreign Investment in Indian Companies Rules, 2019. CCDs are reported as equity when reporting foreign investment. The countdown price of a CCD should be based on the internationally accepted pricing methodology at the moment when the CCD is issued. In cases where it is renegotiated later, if it is reduced, like it often happens when the startup does not meet its milestones, the changed terms may not adhere to FEMA's pricing formalities - which may need to be approved by the RBI. The start-up and foreign investor don’t realize the ploy at first, but only at a later moment.

In the same way, convertible notes issued to foreign investors are allowed exclusively to the startups recognized under the DPIIT recognition framework¹ and are subject to minimum investment requirement of Rs. at present. 25 lakh per investor. The company may find that its convertible notes, which are outstanding, no longer fall within the prescribed parameters following the loss of recognition by DPIIT; which could happen in a situation where the company's turnover reduces or the company is not incorporated for the prescribed period, resulting in contravention by FEMA and hefty penalties.

III. Investor Protections: Understanding What You Have Actually Agreed To

1. Anti-Dilution Rights and Their Mechanics

One of the most important provisions of a SHA is anti-dilution rights given to the investors. These rights safeguard an investor's financial stake in a company if it goes on to raise money at a valuation below the investor's valuation upon exit - a ‘down round'. There are two main types of anti-dilution protections: weighted average, and full ratchet.

When the investor's conversion price is reduced under a full ratchet, the price is adjusted to a new, lower price regardless of the size of the down-round or the number of shares issued. Founders and other non-protected shareholders are decimated. The weighted average mechanism, on the other hand, adjusts the conversion price in a manner that takes into consideration the current number of shares outstanding, along with the amount of shares that will be issued at the lower price, in order to achieve a more proportional adjustment². In India, the weighted average option is more common and agreements for such provisions are very normal but the founders do not fully understand ripple effects of dilutive options in a downside side case and merely agree with such terms.

This should perhaps be emphasized: Usually the company must provide additional shares to the protected investor at nominal price, or modify its existing instrument's conversion ratio. Both of these can depress the net shareholder value of the founders and other shareholders. If the weighted average anti-dilution clause is general in nature in the SHA, the general dilution of a large number of investors can be significant.

2. Drag-Along, Tag-Along, and the Question of Liquidity

In the case of a drag-along clause, it is a question of a majority shareholder (usually one of the investors, and above a threshold percentage) forcing a minority shareholder to sell at the conditions imposed. The rationale for drag-along rights is also simple: if an acquirer can acquire 100% of a company's stocks, why should it be bound by the will of a minority shrewdly awake to the transaction? But, the use of drag-along rights can have legal nuances.

In contrast to the Companies Acts of 2013, the transfers of shares resulting from such a “drag along” provision are fully expressible through a compulsory transfer. In the past, the issue with respect to the enforceability has been considered by the courts in reference to the enforceability against minority shareholders who are not party to the SHA. In Messer Holdings Ltd. v Shyam Madanmohan Ruia³ and Others, the Bombay High Court confronts the issue of enforceability of provisions of a SHA in light of diverse obligations under the Company Act. In general it has be treated as if a SHA provision is a contractual performance capable of contractual enforcement between the parties; on the other hand it obviously cannot be said to be a matter of specific performance in the absence of a statutory clause to assist that enforcement.

In contrast, Tag-along rights are minority shareholder rights. They give minority rights to be involved in any sale by a major shareholder on the same terms and price. Although on the surface a protection for the secondary transaction, a tag-along provision that is not well drafted can cause practical issues in any subsequent transaction, such as how the tag-along notice will be provided, what means will be used for valuating the company in the event of any disputes, or how a partial sale will be treated.

IV. Regulatory Compliance: The FEMA and SEBI Dimensions

1. FEMA Compliance in Foreign-Funded Rounds

If the startup receives foreign funds - not only are the majority of startups that raise funds in higher rounds, namely, Series A, A+, B, and beyond, covered by FEMA but also most of them are unexpectedly complex regarding its procedures. As per Foreign Exchange Management (Non-debt Instruments) Rules, 201⁴, and as per reporting framework suggested by the RBI, any company accepting foreign investment is mandated to submit report of Foreign Currency-Gross Provisional Return (FC-GPR) to RBI within 30 days of receiving allotment. If they don't file in this time period, it's a compounding application with monetary penalty and lots of paperwork.

The more substantial requirement relates to the pricing of equity shares issued on allotment to forex investors which has to be based on the SEBI valuation guidelines which specifies the requirement for allotment of equity shares by an unlisted company is in compliance with the valuation principles as certified by a Merchant Banker registered with SEBI and holding a Category 1 Registration Certificate (RC) and/or a Chartered Accountant in accordance with any pricing methodology accepted internationally. Startups can get these kinds of certificates, but the protocol followed in their procedures is often not detailed with the rigour it should be for a regulatory investigation. This mismatch is an issue while going through M&A due diligence or when the RBI puts a question to the incentives provided⁵.

The downstream investment criteria also apply to startups having foreign investment and itself investing in other investee companies (which is becoming a common occurrence amongst startup groups in India). The definition of "foreign-owned and controlled company" (FOCC): If the Company obtains more than 50 per cent foreign equity higher, the Indian Company becomes a FOCC Company with more than 50 per cent foreign equity holding and its downstream investments are required to be in compliance with the FDI policy as if it had received FDI. It is a requirement that many startup founders find themselves at when they are creating a subsidiary or making a strategic investment.

2. Preferential Allotment and SEBI Regulations for Listed Entities

For startups that have progressed to the listed stage or are in the process of listing on the SME platform or the main board, investor-related equity issuances become subject to SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018. Preferential allotment to investors must comply with detailed conditions: the issue price cannot be below a SEBI-prescribed floor calculated on the basis of a 26-week or 2-week high, whichever is higher; the allottee must not have sold any shares of the company in the preceding six months; and the allotted shares are subject to a lock-in period⁶. Non-compliance renders the allotment void and may trigger SEBI enforcement proceedings.

V. Governance and Control: What Founders Often Surrender

1. Board Representation and Reserved Matters

One of the overlooked aspects of post term sheet-related discussions is corporate governance. Typically investors (strategic or institutional investors) discuss with the company and secure a seat on the Board of Directors for a nominee investor. If the right is combined with a list of ‘reserved matters’ and ‘affirmative vote matters’ (matters that must be decided by the investor director or by a certain portion of investors), it can effectively give investors a veto power over decisions which the founders would consider routine.

Reserved matters are typically those involving authorising the annual business plans, spending capital expenditure over a certain level, appointing and removing key managerial personnel, launching litigation in excess of a certain monetary limit and changes in capital structure of Indian SHAs. The width of reserved matters can have a profound impact on how agile a startup can actually be, in practice. Under the Companies Act, a director, a nominee director, has fiduciary duties to the company and not only to the shareholder who nominated the director for appointment. But investors' directors often act in their own appointor's interest, carry the risk of conflict and the Act unfortunately does not sufficiently eliminate that.

2. The Founders' Lock-In and Restrictive Covenants

The Indian start-up cap table is grounded in Silicon Valley principles, and that includes founders accepting a "vesting schedule" for their company stock.Vesting schedule - an idea that grew popular in Silicon Valley and has become commonplace for Indian venture deals - is virtually universal in a start-up cap table as well. Vesting effectively means that every time a founder accepts shares, let's say 10 per cent of the company for example, those shares will effectively be 'unvested' until such time as the founder remains in the company beyond the specified vesting cliff date, at which point these shares are truly vested, and can no longer be forfeited or bought back by the company at a nominal price. In India, the typical cliffed four-year vesting period is the common rule of thumb.

Under Indian law, there has always been an ambiguity on enforceability of founder vesting clause. According to Section 58(2)⁷ of the Companies Act 2013, any restriction on the way in which the shares of a private company may be transferred (as provided in the articles) shall have the effect of binding. Generally, the SHA will only allow the articles to be modified to include vesting provisions.

 In several cases, the Bombay High Court in India has looked at how the provisions of the SHA interact with the provisions of the company law and considered the issue of a transfer of shares. However, a clear judicial précis in India for founder vesting has yet to be found.

Beyond vesting, founders have to follow non-compete and non-solicitation covenants. Section 27⁸ of the Indian Contract Act 1872, broadly holds that an agreement in restraint of trade is void, but exceptions are drawn for reasonable restraint that is warranted on legitimate business concerns. In the case of Niranjan Shankar Golikari v. Century Spinning and Manufacturing Co. Ltd⁹, a non-compete agreement has to be strictly tailored with the duration of such a restriction and the geographical area restricted limited to a certain area. The wording of "broadly drafted" covenants (which are typical in most SHAs) have a great chance of being held to be void.

VI. Tax Considerations That Cannot Be Deferred

Another area in which legal problems crop up regularly, if not comprehensively, is with tax implications of capital raising ventures (startups). Specifically three provisions in Income Tax Act, 1961, are relevant.

First, in terms of Section 56(2) (viib)¹⁰ - more commonly known as 'Angel Tax' - if a closely held company issues shares for an amount in excess of their fair market value ('yield above the fair value'), the excess price paid will form part of the company's income from other sources. A framework to address the issue of angel tax exemptions for start-ups was recently introduced under a notification system by DPIIT, but eligibility and procedural requirements are subject to compliance of the start-ups. Prior rounds may be subject to this provision to a startup that either has not been recognised by DPIIT or by categories of investors under the exemption.

Second, tax authorities now have the option of invoking Section 68 of the Income Tax Act to treat the receipt of the unexplained share capital and share premium by the company as unexplained cash credit (UCC) in particular where the source of the investment and the investors likely source of contention have not been sufficiently established. Supreme Court in PCIT v. NRA Iron & Steel Pvt. Ltd¹¹. upheld that mere production of document by the company by assessing officer would not be the sufficient evidence to conclude that the investors would be the same persons. Any startup that takes an investment from an angel investor or a small investor needs to be well documented with proper identification of investors and origin of funds.

Third, the founders of such a company in which shares have been transferred in connection with a restructuring (including by way of a conversion of a private limited company to a public company, or by way of a merger of a holding company) may have some capital gains consequences, in some cases despite no de facto monetary consideration having been exchanged. Throughout transactions, structuring is paramount and the guidance of an experienced tax professional is of critical importance.

VII. Conclusion: Building Legal Literacy into the Funding Process

The Indian startup ecosystem has truly built itself up in the past ten years and the legal framework governing founder - investor relationships has lagged behind in pace with deal-making. Term sheets are signed on weekends; definitive agreements are frequently read through in a compressed period of time; and founders, especially those who have been entrepreneurs first time, rarely have the legal expertise to question any provisions which will define the nature of the companies they have founded for many years to come.

The legal questions in this blog, including whether the FEMA methods comply with federal law, how anti-dilution provisions work and how drag-along provisions fit into a merger, whether restrictive covenants are enforceable, as well as the tax implications of funding transactions – are not theoretical issues. They are on-the-spot business threats that have led to rule violations, clash-of-interests conflicts on board and even cancelled mergers and/or acquisitions. The founder should proceed to the post-term-sheet stage with the same level of seriousness as the commercial negotiation phase that has gone before it - with a sense of "business is business", not "admin is admin".

The question may also be raised if it is necessary to simplify regulations. FEMA's reporting requirements framework places an undue compliance cost on smaller companies that don't have finance and legal personnel. A less punitive framework that offers measure of relief from filing requirements for startup businesses, where investment does not exceed a specific limit recognised by DPIIT will help ease some of the turbulence in the market while ensuring proper controls. Likewise, there is not a lot of clarity in the existing law of what happens when it comes to enforcing SHA provisions, such as the founder vesting and drag-along rights, which would clarify the uncertainty around such provisions now.

In the absence of such reforms, founders and their advisors are left with the legal obligations to understand what’s out beyond the term sheet, and to make sure that the framework of a funding transaction is prepared to take on the strain.

Footnotes

^{1 DPIIT, 'Startup India: Annual Report 2023-24', Department for Promotion of Industry and Internal Trade, Ministry of Commerce and Industry, Government of India, available at https://www.startupindia.gov.in/.}

^{2 Swathi Girimaji & Bhanusri Subramanian, Enforcing Anti-Dilution Rights Brings Unforeseen Consequences, LAW.ASIA (Asia Bus. L.J.) (Oct. 10, 2024), available at https://law.asia/anti-dilution-rights-india/}

^{3 2010 SCL BOM 104 293}

^{4 Foreign Exchange Management (Non-debt Instruments) Rules, 2019, Ministry of Finance, Government of India, published in the Gazette of India (Extraordinary), October 17, 2019.}

^{5 Reserve Bank of India, 'Reporting under Foreign Exchange Management Act, 1999' — Master Direction on Reporting under FEMA (as updated), RBI/FED/2017-18/60.}

^{6 Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2018, Gazette of India, Extraordinary, Part III, § 4, No. SEBI/LAD-NRO/GN/2018/30 (Sept. 11, 2018), as amended by Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) (Amendment) Regulations, 2024, No. SEBI/LAD-NRO/GN/2024/___ (effective May 17, 2024), ch. V regs. 155–176, available at https://www.sebi.gov.in/}

^{7 § 58(2) of the Companies Act, 2013.}

^{8 The Indian Contract Act, 1872, § 27}

^{9 (1967) 2 SCR 378.}

^{10 CBDT Notification No. 13/2019 and subsequent amendments providing exemption to DPIIT-recognised startups.}

^{11 2019 SCC ONLINE SC 311.}

REFERENCES

1. SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018, Chapter V (Preferential Issue), available at https://www.sebi.gov.in/
2. 2. Anirudh Krishnan, 'Corporate Law in India' (3rd edn, Oxford University Press, 2020).
3. 3. Vaish Associates, 'A Legal Guide to Startup Funding in India', available at https://www.vaishlaw.com/.
4. 4. Nishith Desai Associates, 'Venture Capital and Private Equity in India: A Legal and Tax Guide' https://nishithdesai.com/

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.