Diligence-Ready Approach for Start-ups: Key Considerations
This article is meant for start-up founders that have raised funds and are in the process of gearing up for further fund-raising to give an insight on how to adopt a diligence-ready approach.
Did you ever encounter a challenge while running your start-up? Did you wish you had planned better to negotiate your deals? Or, understand certain legal aspects and not just let your lawyers/corporate consultants battle it out? While attracting funding to make a product-market fit and ensure business expansion is a top priority for start-up founders, understanding the intricate aspects of strategy and legal ramifications is equally essential. In doing so, founders can protect themselves and their company and be on a level playing field while negotiating with investors and third parties such as vendors and suppliers.
In this article, as a start-up founder, you will understand the key considerations to keep in mind while running your business and the legal & tax implications of domestic and cross-border transactions.
Key Considerations: Blending Strategy and Legality
As a founder of an early-stage company, your desire to grow and expand your business is reflected in your innovative ideas and entrepreneurial drive. However, to successfully reach that goal, there needs to be a solid strategic and legal foundation established for your company. Whether it be a dilution of control, protecting your intellectual property or entering into cross-border transactions, you need to ensure you protect your interests while, at the same time, adhering to the law. Let’s understand those key considerations below:
- Methods of Anti-Dilution: In India two most used forms of anti-dilution protection are i. Full Ratchet and ii. Broad-based Weighted Average. From an investor’s point of view, full-ratchet protection is more favourable as the existing investors’ shareholding is adjusted based on the reduced price per share offered as part of the down round. However, for the founders, broad-based weighted average protection is more favourable as it applies a price based on the weighted average price all the investors have paid so far. Thus, the founders should always remember that this provision is always negotiable. They can prevent future investors from negotiating away anti-dilution protections of earlier investors, thereby avoiding disputes among investors.
- Legal Implications of Anti-Dilution Provisions: It is also pertinent to note that in India, the execution of anti-dilution protection is complex, considering the existing laws. For instance, shares issued to foreign investors must comply with the pricing guidelines as prescribed under the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (“ND Rules”), which state that the price at which shares of an unlisted/private Indian company is issued to a non-resident, must not be less than the fair market value of such shares as determined by any internationally accepted pricing methodology duly certified by a Chartered Accountant or a Category I Merchant Banker registered with the Securities and Exchange Board of India (“SEBI”) or a practising Cost Accountant. Consequently, issuance of shares ‘free of cost’ or at any cost below the fair market value to a non-resident under anti-dilution protection would be a challenge.Moreover, the ND Rules require that the price/conversion formula of any convertible instrument must be determined upfront at the time of issuance, and such price must not be lower than the fair market value of the equity shares determined at the time of issuance of the convertible instrument. It becomes pertinent for the founders to remember that where any changes to the conversion formula are contemplated to achieve anti-dilution protection, the conversion price should never fall below the fair value of equity shares at the time of issuance. Thus, founders should not only negotiate anti-dilution provisions in a way where it’s a win-win for them and the investors but also keep in mind the legalities of the provision. b) Employee Stock Option Pool: Although ESOPs are an excellent method to onboard and retain talented employees and incentivize them, it may be difficult for you, founders of early-stage companies, to determine how much ESOP to give at what stage. For instance, a large ESOP pool dilutes promoters’ ownership in the company, which may pose challenges while raising funds subsequently. Therefore, it becomes vital to understand how to structure your ESOP pool correctly. As per Qapita, 10-15% ESOP pool size is deemed suitable per market standard, but keep in mind that you can have a smaller or bigger pool depending on your hiring needs. C) Advisor Equity: Start-ups and early-stage companies often compensate advisors by giving a percentage of equity in their company since they may not have the required finances to provide cash compensation. Moreover, companies cannot issue ESOPs or sweat equity shares to consultants and advisors who are not employees or directors of the company. Doing so will result in a violation of the law. In such cases, it becomes crucial for companies to evaluate different methods to compensate advisors, keeping in mind tax implications and the percentage of ownership dilution. It is advisable for founders to enter into a formal agreement with the advisors and set out essential terms such as the role of the advisor, vesting schedule, compensation (based on milestones) and time commitments.
2. Intellectual Property Protection
Intellectual property (IP) is a precious asset for any start-up and early-stage company. As technology adoption is widespread, it becomes all the more critical for a company to secure its IP rights. For instance, if a start-up does not obtain a patent for its invention, industry giants can easily copy or use their invention to stay ahead in the market. Third parties such as suppliers, partners and customers may also exploit your IP rights if clear ownership and confidentiality provisions are not clarified in the contracts with such parties. Early-stage companies should ensure that they adequately protect their IP rights from the initial stages to avoid fatal mistakes and costly litigations at later stages. They should develop an IP strategy that matches and supports their business plan. Start-ups and early-stage companies should take the following steps to be diligent-ready in protecting their IP rights:
- Ensure that patent applications shall be filed at the earliest opportunities while the invention is still “new”, and ensure the application is drafted appropriately to ensure the scope of protection is broadly defined.
- If start-ups fail to keep potential IP assets confidential till they have applied for IP protection, there is a looming threat of them becoming unviable. Therefore, they should prioritise preparing and implementing confidentiality agreements with third parties, including suppliers, partners, and potential customers. By doing so, they can protect their IP even if disclosing their assets becomes necessary for conducting business with such third parties.
- There could also be situations where employees, third-party suppliers, and contractors may contribute or be responsible for innovations. As start-ups may eventually work across borders, laws may differ, wherein the law may not automatically assign ownership to the employer. Thus, it becomes important for companies to include clauses that deal with IP ownership in their employment agreements. For similar reasons, where a third-party contractor has done any inventive or creative work, the agreement between the third party and start-up should ‘assign’ to the start-up all work that is necessary for the success of its business. Such clear clarification of IP ownership will help protect all its assets.
- In contrast to the above, if the start-up is in the position of an external contractor, it is essential to clarify what rights devolve on whom and what restrictions are placed on the use of IP. Start-ups and early-stage companies must therefore ensure that such issues are negotiated beforehand to avoid potential litigation and ensure that it has a “clean title” to the IP it creates.
The upsides to having adequate IP protection is also attract funding and increase the valuation of the company. Interestingly, a study undertaken by CIRC revealed that 43% of Indian tech start-ups received investment funds after applying for IPR protection or after registration.
3. Cross-Border Investments and Transactions
For start-ups and early-stage companies to be diligent, they should comply with the relevant foreign exchange laws. All transactions which involve foreign exchange are governed by Foreign Exchange Management Act, 1999 and subordinate legislations, and RBI acts as an administrative authority. Inward investments in Indian companies can be through Foreign Direct Investment (FDI). The Department for Promotion of Industry and Internal Trade (DPIIT) issued the FDI policy wherein Indian start-ups can raise funds by issuing equity, equity-linked instruments, debt instruments and convertible notes.
Moreover, in start-ups recognized by DPIIT (“Eligible Start-Ups”), Foreign Venture Capital Investors (FVCI) do not require any approval from RBI and can invest in equity or equity-linked instrument or debt instrument issued by an Indian ‘start-up’, irrespective of the sector in which the start-up is engaged. Here, the founders need to know that the investments through the FVCI route are not subject to any such pricing norms, making the investment and exit easier to structure. As good news for the founders, India’s FDI inflow in 2022 was $58.8 billion compared to 2014, where it was only $24.3 billion, resulting in a growth of 142% in 8 years. Thus, complying with the route of FDI (automatic or approval), the sectoral cap on investment and other rules is highly beneficial for start-ups.
As far as raising debt from foreign sources is concerned, External Commercial Borrowings (ECB) guidelines provided by RBI permit recognized start-ups to raise borrowings under the automatic route. The minimum maturity period for ECB is 3 years, and the amount of ECB that can be borrowed is limited to up to USD 3 million per financial year. Start-ups can borrow in the form of loans, non-convertible, optionally convertible or partially convertible preference shares in both Indian and foreign currency. These borrowings can be from any entity that is a member of FATF and IOSCO. Start-ups can benefit from availing loans at relatively lower interest rates and can have a diversified investor base. However, they should keep in mind the restrictions provided in ECB guidelines and ensure to hedge their foreign currency exposure.
4. Employment Contracts
Building an A-Team for a start-up is crucial to ensure its continued success. Although it may seem insignificant for early-stage companies with a limited workforce, it will go a long way in clarifying the working relationship, preventing future misunderstandings and outlining the primary rights and obligations of the employer and employee.
5. Non-Solicitation Clauses and Contracts
Confidential information, such as marketing strategies, manufacturing methods, technical know-how, and client lists, are likely the most valuable assets that a start-up or an early-stage company may own. Protecting such information is, therefore, critical to success. To ensure that employees of such companies do not misuse trade secrets and other essential confidential information, a non-solicitation clause may be added to their employment agreement, or a separate contract may be entered into. A non-solicitation clause or contract restricts employees from soliciting or poaching business clients for personal benefit. As a start-up founder, it becomes essential for you to ensure that a non-solicitation clause or agreement will incorporate all the necessary terms and conditions to protect your valuable information. The following points should be kept in mind while enforcing such contracts:
- Ensure that the scope of the clause or agreement is appropriately defined, and it should not be too broad or too narrow and should cover all the possible ways that a current or former employee can use to hamper the growth of the business.
- Ensure that the agreement’s term is reasonable to protect its enforceability and avoid legal hassles.
- Ensure that there shall be no scope for loopholes. For example, solicitation can mean different things and include several things. It can involve poaching clients, inducing employees to leave the company or moonlighting, or even using confidential information for their benefit. The most important part is to make a tight-knit non-solicitation clause by defining what you mean by solicitation.
6. Supplier Contracts
As a start-up founder, a supplier contract is one of the most common contracts you’d likely encounter. Start-up founders need to ensure that their supplier contracts have explicit and unambiguous terms, mainly related to the price, quantity of goods, payment deadlines, and warranties given by the start-up. The contract must have a confidentiality provision to ensure that the vendor does not misuse any vital information and IP. In addition, Due regard shall be given to the “indemnification clause” wherein the start-up should not be responsible for the vendor’s negligence or provide a clause wherein each party will be accountable for their negligent acts.
7. Tax implications for Start-Ups
a) Income Tax Implications
- TDS and Withholding tax: When employees exercise ESOPs, start-ups are obligated to deduct tax at source by treating it as a part of salary perquisite. Furthermore, as compensation to advisors, companies can issue shares for cash or consideration other than cash. Considering the income tax implications, such shares should be issued at fair market value. Here the founders should note that the companies will be responsible for TDS on the compensation value.
- Tax Audit: While tax audit is mandatory for businesses with turnover exceeding Rs 1 crore, eligible start-ups to receive tax incentives should mandatorily get their accounts audited by a Chartered Accountant.
- Transfer Pricing: For start-ups with operations in two or more countries, transfer pricing provisions would come into play, which seeks to price transactions between group companies or related parties. Here, the transactions are prices assuming that the entities of the same group are totally independent (Arm’s Length Principle). Non-compliance with the transfer pricing concept can result in penalties and severe consequences for start-ups, such as curbing incoming investments and confronting tax authorities.
b) GST Implications: Although businesses with an annual turnover of less than Rs 20/40 lakhs are exempted from GST registration, e-commerce and ed-tech companies must comply with GST compliances. Start-ups must adhere to tax rates ranging from 0% to 28%, depending on the goods and services sold. On the flip side, they can claim a tax credit for purchases. Founders of start-ups must refrain from keeping tax compliances on the back burner as it may negatively impact their profitability and growth.
The bottom line is it would be helpful to you, founders of start-ups and early-stage companies to stay vigilant and prepare yourselves from strategic, legal and taxation angles from the get-go than fall into unavoidable legal mishaps at a later stage. It also enables you to negotiate favourable terms with various parties you may encounter in your corporate life cycle.
In case you’re looking for assistance in preparation of Term sheet, drafting of agreements and corporate secretarial compliance support for issuance and allotment of any shares/securities, then please get in touch with us.