This article is written by Shreya Patil, pursuing a Diploma in Advanced Contract Drafting, Negotiation, and Dispute Resolution from Lawsikho.

Introduction

You might have an exceptional and innovative idea for your start-up but it might never happen if you lack the requisite capital. Hence, designing a plan to approach sources becomes extremely vital. The challenge to grow your company and landing the requisite capital comes with an equal amount of excitement and threat. 

Unless you possess supernatural powers, it is unlikely to hook an investor initially. Some might expect a detailed plan of your business and its strategies, while some even may ask for sureties. Hence, organizing your business documents and other essential documents to acquire investment opportunities is the first step to raise capital. Before understanding what essential documents/agreements are required to raise capital in your start-up, it is important to understand the structure of the legal entity for incorporation. 

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It is pertinent to note that giving away shares in your business as an exchange for investment is impossible unless the start-up is a private limited company. Hence, if you are operating as a sole trader, or you are intending to start, transferring all the property owned by the “business” into the company name. Start-ups most probably have start-up costs to secure either work-premises, purchase stock or equipment, hiring staff, or even pay for legal costs to make sure of the smooth running of the company. 

Financing your business can be executed in two categories: Either debt finance or equity finance. Borrowing money or some sort of value to exchange it for repaying the debts later with interest are debt finances. Loan notes or Bank loans are few common forms of debts that can be redeemed at a future date. Equity finances involve raising capital through the mode of selling the parts of the business to investors or shareholders.

Here is your guide to recognise and understand the most used documents in raising capital and investment agreement that you may need to utilize while raising capital for your start-up!

Investment agreement

A contract executed between founders of the start-up and potential investors who seek to purchase shares of the company is called an “Investment Agreement”. The investors can either be a new share-holder, an external investor, or even an existing share-holder. Not only does the agreement generally focus and outline the rights and responsibilities of the investors but also it applies restrictions with regards to exercising their powers.

Importance of an investment agreement

We are all aware of how the funding to a start-up is its lifeblood and extremely crucial for its working. The growth of a start-up is directly proportional to its survival where investment plays a major role. Although it is a lucrative opportunity to invest in a start-up, the fact that it also comes with its associated risks cannot be denied and that is the reason investors demand security for their investment which comes in the form of investment rights. However, often founders are reluctant towards giving away these rights as they fear losing power in their business. So, what can be done in such cases? That’s where a good investment agreement comes into the picture where the needs of the founder and the security for the investment are balanced out which brings down the chances of disputes. 

Hence, as the businesses must raise capital through investment from the investors and investment companies, this agreement helps to raise the capital by safeguarding the rights and responsibilities of the parties involved resulting in the acceleration of business growth. How could the owners of a company gain the trust of the investors? It can be done through an investment warranty where the statements made are explicitly true and accurate. 

Acquiring certain securities of the company in exchange for the investment is the purpose of this agreement. So, the securities are generally in the form of shares of the company. Few forms of the shares are: 

  1. Equity Shares- The riskiest form of investment for an investor are equity shares. However, incorporating certain essential rights to the investors such as ownership, voting rights, and dividends are some of the benefits which accelerate the growth of the company due to share appreciation. 
  2. Preference Shares- This type of share does not really bestow voting rights in the company on the shareholders. However, the payment of the dividends in priority to the preference shareholders over the equity shareholders is a benefit. 
  3. Hybrid Security- The most popular form of security these days are hybrid securities. Since they have both the features of equity/debt and preference shares. They are provided with initial security with a fixed amount of interest, equity shares and ownership rights, voting rights later. 

If you are an investor in a start-up, you are expected to know that each time there is a new investment, the shareholding percentage of your investment in the company reduces. Hence, ensuring the protection of your veto rights is a must for an investor. The investor possesses a veto right for the issue of fresh shares which essentially means that the company has to take the consent of the investor allowing them to take over the control of the capital structure of the company. 

Important clauses in an investment agreement that ensure the security of investors

Whenever there is a fresh issue of shares, the shareholding percentage of the previous investor who had invested reduces, which affects the interests of the investor especially when the subsequent investment is raised at a lower valuation. Hence, the investor ensures certain protection in the form of rights to his investment. 

  • Veto rights against the fresh issue of shares

Veto rights are granted to the investors in order to take control of the fresh issue of shares. This basically means that the company has to ask for the consent of the investor in order to decide the capital structure of the company. 

  • Pre-emption right

The pre-emption right enables the investors to subscribe to the fresh shares which protects as well as enables the investors to maintain their share-holding percentage. 

  • Anti-dilution right

Often companies issue fresh shares at a lower valuation in the funding round. In such cases, anti-dilution rights come to the rescue where the companies issue fresh shares to the investor. Though this might be a difficult road to go through with regards to the equity shares as Indian law restricts the free shares to be issued. 

Now that we have discussed the investor agreement, there are various kinds of agreements that accelerate the raising of capital in a start-up. They are as follows:  

  1. Shareholder’s agreement.
  2. Subscription agreement. 
  3. Share purchase agreement.

Shareholders agreement 

Shareholders are those who invest or have invested for a percentage ownership in a company in the form of shares. If you are a start-up, approaching shareholders to invest in your company can be a great way of raising capital. However, in order to protect your business, yourself, and your shareholders, drafting a shareholder’s agreement is extremely necessary. 

It is pertinent to understand that each agreement is crafted for the specific needs of each company and its shareholders without which one could suffer significant damage. An agreement that is concluded between the shareholders of the company at the time of the investment or before is known as the “shareholders agreement”. The rights and responsibilities which certainly protect the company, as well as the minority shareholders, are defined in this agreement. In case there already exists a Shareholders agreement, in place, the new investor can enter into a DEED of Adherence. 

Generally, when a group of people associated to form a company and take important decisions as to who shall be their contributors towards maximising the share capital of the company, an Article of Association is drafted which sets out terms and conditions of the company with respect to capital and shares, mode of share transfer, Director’s rights and duties, corporate meetings, proceedings of the board and other operational terms etc. 

The need for having a shareholder’s agreement

However, they may not have all the details with respect to the rights of the shareholders (minority or majority) and that’s where the importance of this agreement i.e., “shareholder’s agreement” pops up wherein investors in addition to the Articles of Association enter into such crucial agreement with the company. This agreement not only defines the relationship between the company and shareholders but may also define the relationship between the share-holders which state their rights and obligations with respect to the operation of the company.

With the shareholder’s agreement in force, the process of raising the capital and adhering to the legal requirements is executed seamlessly. Due to the similarity between the shareholder’s agreement and investment agreement, they are usually turned into one document. As your start-up matures, you may need to execute or modify your legal shareholder agreements but initially, before the company is created, it can negotiate and sign a seed-stage share-holder agreement that outlines contributions, obligations and the effort that the shareholder is expected to dedicate to the company. 

When drafting a shareholder’s agreement, we might have to consider the following: 

  1. The ownership of each shareholder in the start-up.
  2. The payment needs to be done by each shareholder to get their share.
  3. Rights of each shareholder under the corporate structure
  4. Protection of minority shareholders if any. 
  5. Restrictions to prevent shareholders from competing against the company. 
  6. Dividend policies. 
  7. Termination of shareholders per the interests of the company
  8. Rights of the Shareholders to abandon or acquire shares. 
  9. Rights of the shareholders to buy additional shares before a third party.
  10. Accounting policies of the company.
  11. Deadlock Resolution or dispute.   

Shareholder’s agreement is a great mechanism that saves the company from losses and protects its interest. The key provisions incorporated in a share-holders agreement create a balance between the shareholder’s interests and the company’s interests since the transfer of shares is generally not very difficult. It comprises such rules where the shares can’t be easily transferred without the written consent of the existing shareholders. The death of such shareholders is an exception since the shares of such shareholders are transferred to the family of or legal representatives. This is not the only restriction when it comes to the restriction to the transfer of shares. They are also described further. 

Right of first refusal

The right of the first refusal protects the company and the existing shareholders from selling any stocks to a competitor company or such parties with whom the company doesn’t really have friendly relations. Incorporating a clause in a shareholder’s agreement that in the event of share-selling by any shareholder, they have to show the right to match an offer received from the third party is of vital importance. 

Buy-out rights

When a shareholder is found to be incompetent due to certain major events, incorporating a buy-out rights clause where such shares of the particular share-holder can be bought by the existing shareholders safeguards the interests of the company. 

Importance of shareholder agreement for the shareholders 

There are two categories of Shareholders in a company depending on the ratio of the capital invested: 

1) Majority shareholders- Shareholders who collectively hold 51% of the share capital of the company. 

2) Minority shareholders- Shareholders who collectively hold less than 51% of the share capital of the company. 

We are all aware of how the decisions of a company are made, regardless of them being operational or managerial. There are often circumstances of shareholders not being in agreement with each other or circumstances where decisions of the majority shareholders jeopardise the minority shareholders. Under such circumstances, this Agreement plays a vital role since the rights and obligations of all the shareholders are incorporated in detail in order to eliminate injustice and move towards the goal of the progress of the company. 

In a fast-growing number of start-up-based countries like India, business is always going to be more complex and a goal-driven organisation is more crucial than ever. Such objectives can only be accomplished through quintessential and efficient internal and external management of the company where SHA plays a vital tool for the management of the company internally. 

Subscription agreement 

An investor’s application to join a limited partnership is a Subscription agreement which often is recognized as a two-way guarantee between a +new shareholder often known as a subscriber. When a company agrees to sell a certain number of shares at a specific price, it expects the subscriber to buy it at a predetermined price. Start-ups usually offer a subscription agreement in the early stages of investing. 

However, if your start-up company desires to protect its legal rights with more experienced parties, a well-written subscription agreement definitely helps your organization avoid future disputes. The utilization of the subscription agreement certainly depends on a few factors such as the needs of the company, industry, company size, etc. Despite such factors, there are key details regarding a previously agreed upon return on investment by new investors. 

Subscription agreements are varied depending on the company they pertain to and the reasons they are offered for. Often under such types of agreements, a predetermined rate of return of the initial investment by a new company is offered upon; which could also be corporate profits after the company reaches a financial milestone while growing business. A well-structured subscription agreement often includes the details of the transaction, the number of shares being sold and the price per share, and any legally binding confidentiality agreement and clauses. 

Advantages of a subscription agreement

  1. Limited partnerships without and personal liability. 
  2. Lump-sum investment. 
  3. Opportunity to invest early and witness the growth of the investment as the company scales. 

Disadvantages  of a subscription agreement

  1. No liquidity as once the investment of funds is done, there should be someone to buy out those shares. 
  2. Lack of transparency and oversight without the Securities and  Exchange Commission’s involvement. 
  3. Potential legal issues if expert advice is not used to examine the deal.

Working on the subscription agreement

  1. Executing your subscription agreement in writing.
  2. Ensuring your subscription agreement is in a simple yet effective format. 
  3. Identification of principals and investors of the agreement accurately.  
  4. Setting precise considerations and obligations in stone. 
  5. Determining the method of termination and settlement of disputes with the investors. 
  6. Retaining confidentiality of the affairs of the company and negotiation of contracts. 
  7. Preferably hiring a securities lawyer to draft a subscription agreement. 

Some start-up companies, in order to save a few bucks, get their contracts drafted online. However, it is pertinent to note that this may help to accomplish the basic objective but might affect and cost the company in the future. 

Share purchase agreement 

A formal and legal agreement between a purchaser of shares in the company and buyer with requisite terms and conditions is known as a share purchase agreement. When there is a purchase of a part of the company’s operating business, this type of transaction generally takes place where the buyer steps into the place of the seller. The share purchase agreement in India comprises information relating to the types of shares purchased, the number of shares purchased the share price, and the rights and liabilities of the company and the shareholder. 

Many start-up businesses don’t realize the importance of having this agreement drafted in the early stage. As the possibility of this agreement is mostly in the closely held companies, it regulates the sale and transfer of the company’s shares. 

  • The aim of this agreement is mutual agreement over the terms and conditions of the agreement if the seller agrees to sell the mentioned number of shares at a certain price. 
  • It’s an essential business practice since the absence of it might invite unwelcome consequences. 
  • This agreement gives a chance to carefully examine each clause in the document as it covers the wide-ranging aspect of the transaction. 

Hence, even though on one hand, we spectated as to how important a share purchase agreement is, is it equally important if your start-up has only one share-holder? Addressing this question directly, that private company with limited offerings are generally exempted from the Securities Act registration. Hence, it’s really not mandatory to own a share purchase agreement if your start-up consists of only one shareholder. 

Reasons to go for a share purchase agreement 

  1. It is a legally binding document, 
  2. It increases the possibility of Revenue through business, 
  3. It offers tax benefits, 

Contents of a share purchase agreement

The share purchase agreement contains all the terms and conditions that are finalized when selling the shares of the company. The following are listed in a share purchase agreement:

  1. Name of the company,
  2. Par value of shares,
  3. Name of the purchaser,
  4. Warranties and representations made by seller and purchaser,
  5. Employee benefits and bonuses,
  6. Number of shares that are to be sold,
  7. Details of the transaction,
  8. Indemnification agreement for unforeseen costs.

Before the finalization of the agreement, a letter of intent is formed where the buyer is obliged to perform due diligence to ensure that the purchase agreement and the letter of intent have the same terms. 

Business loan agreement

An extremely well-known and uncomplicated way to raise money for any business is through a business loan. Depending on the potential of your start-up, banks get only the interest instead of profit percentage or company share. This could be a viable option unlike sharing profit percentage or company shares with equity investors. However, regardless of the success of your start-up, one is made liable to pay the loan. The terms under which the loan is agreed upon are listed under the “loan agreement”. 

Not only an individual or a group of individuals who have gathered to initiate a business start-up can avail of a business loan, but it can also be availed by an existing business for expanding operations or any sort of development.

However, there are a few business loan eligibility and documents requirements for loan seekers. They are: 

  1. Minimum age of 21 and a maximum of 65,
  2. Indian Citizenship,
  3. Valid PAN and Aadhaar cards,
  4. Bank statement proofs of the past six months,
  5. Signature proof,
  6. Proof of ownership of business and robust business plan. 

The most important aspects taken into consideration for business loans are the business plan and a CIBIL score. A good credit score is generally proportional to the approval of the business loan application. Hence, having a solid business plan and a good score is very beneficial for any entrepreneur. 

Important contents of a loan agreement

A loan agreement contains the following information;

  1. Loan amount and duration: The clear specification of the loan amount given to the borrower for a certain period. 
  2. Interest clause: It states the rate of interest to be paid along with the principal by the borrower. If required, additional charges in the event of default along with the principal interest are also incorporated under this clause. 
  3. Repayment clause: The major element of a loan agreement is a repayment clause. It dictates how the clause specifies the method of repayment of the loan to be paid by the borrower to the lender. The loan sum payment can either be as a lump sum repayment or on a periodical basis. In the event of a periodical payment basis, it should specify the number of instalments due on the due date.
  4. Loan security: A loan can be secured or unsecured, however, in the case of start-ups, the possibilities of this clause may depend on the potentiality of the business and the sole discretion of the lender. Generally, in the case of a secured loan, some assets are pledged for collateral whereby may be recovered in the event of default. Hence, entrepreneurs should be of utmost caution while pledging any asset which directly doesn’t harm the start-up or raise any liability. 
  5. Prepayment clause: Early payment of loan i.e., payment before the due date. Prepayment of loan is generally granted allowance on the payment of penalty charges. The penalty is levied to protect the lender against the loss of interest payments.

Asset purchase agreement

Another important method of raising capital is through asset purchase where the start-up businesses may wish to finance themselves by selling some of their assets. An asset purchase may involve the purchase of some or all of the assets of the business which includes fixed assets such as buildings, machinery, or trading stock, and also intangible assets such as intellectual property rights or the goodwill of the business. An asset purchase agreement is used to document the purchase and outlines the terms and conditions relating to the sale and purchase of assets of a business start-up.   

Usually, instead of acquiring all of the shares, assets, and liabilities, a buyer very often prefers to take over certain assets. Possibilities of sale of the company itself are also possible in the asset purchase agreement and are termed as the acquisition of the company. However, an individual shareholder will be a seller in the share sales. 

It’s important to identify what exactly will be preferred to be bought while buying the assets of the business in an asset purchase agreement which may include: 

  1. Plant and machinery,
  2. Stock,
  3. Contracts,
  4. Premises,
  5. Good-will,
  6. Intellectual property. 

You might wonder, how  “goodwill” is termed as an asset in an ‘asset purchase agreement’. Let’s find out how: 

The brand reputation which is built concerning specific goods or services attracting the customers is the goodwill of the business. Where a business has established goodwill, the expectation of the customers to purchase something from the brand reputation is expected. Hence, the buyer will therefore seek assurances that there is protection from the seller affecting its goodwill. Inclusion of clauses such as non-compete clauses is required as restrictive covenants in goodwill asset purchase agreements.  

Venture capital agreements : term sheets

Equity financing used for small businesses and start-ups accelerates the high growth and increases the need for significant funding to sustain that growth and it is then that venture capital steps in into start-ups where the venture capitalists see potential. In return for the investment, venture capitalists often demand a seat at the board of the start-up. This type of resource often proves to be fruitful if the start-ups are engaging in a risky venture where bank loans and other types of loans won’t be qualified. Few of the most successful and influential businesses like Apple, Amazon, Facebook have received venture capital funding to evolve.

Venture capitals can either be individuals, companies, or any financing institutions that offer not only capital but strategic assistance, introduction to potential customers, partners, and employees. Start-ups generally offer proposals to a lot of venture capital firms.. Since most of the venture capitals focus on one geographical area, getting their attention is easier than approaching distant venture capitalists.

Once a start-up is successful in getting venture capital financing, they initially draft a “Term Sheet” and present it to the entrepreneur. 

  • It is an important document that signals the seriousness of the venture capitalists to invest, proceed with due diligence and prepare definitive legal investment documents. 
  • Despite the non-binding nature of the term sheet except for provisions like confidentiality, exclusivity, it is the most important document to negotiate with the investors. 
  • The term sheets cover all important facets of the financing. Example; valuation provided to the company, control issues, veto rights. 
  • The investors do not need to have control over the start-up, however; they can be an observer of the Board. 
  • An entrepreneur should perceive term sheets as the blueprint of the relationship between them and the investor.

Venture capital investors are also known as Angel investors who prepare term sheets that outline the terms by which an investor can make a financial investment in the company. It tends to consist of three sections: funding corporate governance and liquidation. 

What are known as debentures?

Debentures are movable property and are in the form of certificates that are issued by the start-ups or companies themselves as a “Certificate of indebtedness”. In case, the companies do not want to raise share capital, they issue debentures for a particular period and at a fixed rate of interest. 

According to the Companies Act 2013, “Debenture includes debenture stocks, bonds or any other instruments of a company evidencing a debt, whether constituting a charge on the assets of the Company or not”. The company has rights to issue bonds or debenture which is either secured or unsecured instruments acting to create a charge on the assets of the company. 

As per Section 71 of the Companies Act, 2013 issuing debentures into shares wholly or partly can be issued by the company at the time of redemption however such issuance of debentures to further convert into shares can be approved through the shareholders of the company by passing a special resolution.

Types of debentures

  • Redeemable debentures

These types of debentures are issued on the terms that the company is bound to repay either at a fixed date, upon demand, or after notice

  • Convertible debentures

The option given to the debenture holders in exchange for shares under certain conditions is known as convertible debentures. This also enables investors to upgrade their position from debenture holders to shareholders.

  • Secured and unsecured debentures

The security or insecurity of debentures is dependent on the mortgage or charge on the property of the company secured debentures are subject to terms and conditions as prescribed by the Companies rules 2014 and amendment thereof. 

Contents of debenture

  1. Name of the issuing company.
  2. Principal debt amount and interest payable by the company. 
  3. Debenture holder name, date, and the amount payable. 
  4. Brief description of terms and conditions in brief. 
  5. Nature of the debenture as to whether it is redeemable of a convertible debenture. 

Debentures are different from equity shares and do not constitute any voting rights; however, this is an extremely viable option if the start-up wants to generate capital without extending shareholders in the company. Hence, a format of the debenture certificate should be included if the company seeks to raise capital. 

Conclusion

Regardless of whether you are starting out or your business is in the growing stage, choosing the right legal structure for running your business is extremely necessary. Flexibility, complexity, liability, taxes, control, capital investment, licenses and permits are a few of the crucial factors to be considered while opting for your legal structure of the business. 

Capital investment by outside funding such as investment, capital venture, banks is only possible when you establish a corporation. They have an easier time obtaining such funding instead of sole proprietorships. Establishing a limited liability company may seem like a viable option; however, investors do not prefer investing in such a business due to tax implications and restrictions to invest in the LLC which might affect the raising of capital funding. Hence, if you are opening a corporation, the checklist of agreements provided in the article is a must for your startup corporation.   

References

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