FDI startup

In this article, Brijesh Bhatt who is currently pursuing M.A. IN BUSINESS LAWS, from NUJS, Kolkata, discusses structuring advice to software startup who wants to receive FDI.

Structuring advice to software startup who wants to receive Foreign Direct Investment

Let us first understand what types of major legal business structures are available in India and what are their advantages and disadvantages:

Sole Proprietorship

Sole Proprietorship is the simplest and easiest form of business structure. This form of business is owned and operated by the same person i.e. the person running the business and the person owning it are the same. The owner and business in this form has same liability. Also, income from business is considered as income of its owner and it is taxed at the same rate at which tax is applicable on Individuals. Thus, for tax purpose also owner and business are considered as one. Due to its simplicity, a large number of small business adopts this form of business structuring such as shopkeepers, consultants, small traders, etc.

 Following are the advantage of Sole Proprietorship

  • Owner remains in complete control of his business
  • Income from such business is at disposal of its owner and he can use the income in any manner he deems fit.
  • Sole Proprietorship can be wound up quickly.

Following are the disadvantages of Sole Proprietorship

  • This type of business structure has limited access to funds. Funds can be borrowed for the business basis personal capacity of the owner and his ability to repay the debts.
  • Owner of the business has unlimited liabilities.
  • This type of business does not attract talent. Talented people avoid working with Sole Proprietorship firms.
  • It has no succession, business ceases after the death of owner.

Partnership [1]

Partnership is the form of business where two or more persons agree to share the profits of business carried on by all or any of them acting on behalf of all of them. Sharing of profit is an essence of partnership. It is not necessary that all the partners carry out business of partnership firm, any of the partners can carry out business on behalf of the partnership firm. In India partnership is governed by The Indian Partnership Act, 1932.

Partnership is formed by minimum two persons, there is an agreement between the partners to share profits from business and also the losses incurred by the partnership firm during the course of its business. Partnership agreement can be written or oral.

Following are the advantages of a Partnership

  • Partnership firm is easier to form, registration of partnership deed is optional, hence forming partnerships takes lesser time.
  • Partnership firm has more capital availability in comparison of sole proprietorship as there are more than one partner and they can contribute more capital. Further, they can get enhanced credit as they can apply for loan jointly and their loan limit will be considered jointly. Banks/NBFCs also considers partnership safer than proprietorship for the purpose of lending.
  • More talent pool is available to partnership firm in comparison to proprietorship firm as two persons or more are the partners/owners in the partnership firm. Different persons can contribute different skills set and ideas.
  • Like sole proprietorship firm, partnership firm is also flexible it is easier to form and can be wound up quickly.
  • Sharing of loss, losses can be shared amongst the partners.

Following are the disadvantages of Partnership

  • Like sole proprietorship, in partnership firm, partners also have unlimited liability. Their personal assets can be attached for default of firm or any illegal act of any of the partners. In partnership firm, all the partners are jointly and severally liable.
  • Since all the partners are the owners there are the chances of conflict as there may be difference in the functioning style of each partners. There may also be conflict amongst the partners on policy decisions which may turn out to be harmful to the firm.
  • Each partner is considered as the agent of the firm, hence any partner by his act or omission can bind firm and other partners. Due to this binding effect if a partner takes any incorrect decision it may ruin entire firm and/or its partners.
  • There is no continuity of business the firm may be dissolved if any partner resigns or dies.

Limited Liability Partnership (LLP)

LLP is the form of business structure which provides the ease of doing business like partnership and offers limited liability like limited liability company. LLP can be described as partnership firm with benefits of the company. LLP is governed by the Limited Liability Partnership Act, 2008 and the main features of LLP as per this Act, are as under:

  • LLP will be a body corporate, distinct from its partners. Any two or more persons desiring to do lawful business for profit can form LLP, by getting LLP registered with registrar of LLP.
  • Relationship between the partners of LLP, inter-se or LLP with its partners will be governed by LLP agreement. Partners are free to choose the terms and conditions of LLP agreement.
  • LLP shall have minimum two patterners and minimum two individuals as designated patterner. Out of two designated partner one must be resident of India. Rights and obligations of designated partners are prescribed in the Act.
  • LLP is required to maintain statement of account as regards its true value and assets, and solvency report and is also required to report them to the registrar of LLP.
  • LLP may be wound up either voluntarily or as per the orders of Company Law Tribunal.
  • The Indian Partnership Act 1932, shall not be applicable to the LLP.

     Following are the advantages of LLP

  • Liability of each partner is limited to its contribution. LLP is liable upto its assets. Also other partners are not liable for unlawful and unauthorized acts of other partners.
  • LLP offers greater flexibility partners can decide on number of partners and their contribution on LLP business. Further there is no mandatory requirement for all the partners to attend meetings.

  Following are disadvantages of LLP

  • Many states in India do not permit business entity by way of LLP.
  • LLP cannot bring Initial Public Offer (IPO) and list on the platform of stock exchange. In the event owner of LLP desire list it they have to get the LLP converted it into the company.
  • LLP has less credibility than corporation in perception of public at large considers LLP at par with the partnership firm.

Company [2]

Company incorporated under The Companies Act, 2013 is a separate legal entity. Company can do business in its name, and company can sue in its name.

Following are the main advantages of a Company

  • Duly incorporated company has perpetual succession. This means even after the death of its member’s company continues to carry out its business and hold its assets and discharge it labilities. Even after change of its directors or management the company continues.
  • Ownership of the company is being held by its owner in the form of shares. Shares are movable assets hence the ownership of the company can be transferred easily as per terms of its articles of association.
  • The company can hold property and other assets in its name and these property and assets will not be treated as the property or assets of its members. Company can open and operate bank account in its own name.
  • The company can raise capital easily in comparison of partnership or proprietorship. Lending Institutions prefer company over other forms of business.
  • The company is juristic person, hence as juristic person the company has the capacity to sue. Similarly, the company can be sued by the third parities.
  • The company is governed by the Companies Act, 2013 which ensures better governance and smooth functioning of the company.

Following are the disadvantages of a company

  • In comparison to proprietorship, partnership, LLP the company is costly to incorporate. Moreover, the day to day functioning and meeting compliance is also a costly affair. Thus, this form of business requires more capital.
  • Since the company is regulated by the Companies Act, 2013, it requires to undertake more compliance such as filing of returns, conduct of board meetings, preservation and submission of the records.
  • In this form of the business as the directors are different from the shareholder or the owners of the company, there may be lack of control by the owners.
  • The winding up of the company’s business is tedious and time consuming task. It is difficult in comparison of the other forms of the businesses.

For understanding the suitable form of company, let us also understand what are the different types of company which can be incorporated under the Indian Companies Act, 2013:

Private Limited Company

  • There are minimum two or more members are required to incorporate private limited company. There cannot be more than two hundred members in the private limited company. Similarly, the private limited company requires minimum two directors and the number of the director cannot be more than 20. Private Limited company requires minimum paid up capital of One Lakh Rupees.

Small Company

  • It is the company other than public limited company whose paid up capital does not exceed Fifty Lakh Rupees, or such other amount as may be specified by the Government, but not exceeding Five Core Rupees or whose annual turnover does not exceed Two Crore Rupees.
  • However, any holding or subsidiary company or section 8 company will not be treated as small company. Thus, only private limited company can be small company. There are various compliance exemptions provided to the small company under the Companies Act, 2013 such as holding only two board meetings, returns can be signed by Company Secretary or single director.

One Person Company (OPC)

  • OPC can be incorporated by one member only. At the time of incorporating in the memorandum of association, the member is required to disclose the name of one person who would act as member in the event of his death so that the perpetual succession of the OPC continues. OPC can have one director. There are various exemptions provided to OPC similar to small companies.

Dormant Company

  • As per the Companies Act, 2013, the company which is registered for doing business in future or the company which holds intellectual property or assets in its name and has no significant entries in its books of accounts can be classified as doormat company.

Foreign Direct Investment (FDI)

  • FDI generally refers to investment made by non-resident Indian business or individual in business in India. This investment can be made by owning business or acquiring controlling stake. FDI investment has lasting interest than mere an investment by an investor. A company receiving FDI not only gets access to capital but also gets access to technology and management style of investee company/group.

Now, relevant Foreign Direct Investment (FDI) rules prevailing in India,

Ministry of Commerce & Industry Department of Industrial Policy & Promotion, Government of India from time to time prescribes FDI policy, with the objective of attracting and promoting FDI in order to supplement domestic capital, technology and skills, for accelerated economic growth. FDI, as distinguished from portfolio investment, has the connotation of establishing a ‘lasting interest’ in an enterprise that is resident in an economy other than that of the investor[3].

Eligible Investee Entities for FDI in India[4] – Entity wise eligibility details are as under:

Incorporated Company

As per FDI policy Indian Companies can issue capital against FDI. Thus it is amply clear that at an entity level FDI in incorporated company is permissible and no restriction on receiving FDI by the company.

Partnership Firm/Proprietary Concern [5]:

FDI in these entities are allowed subject to following conditions and permission,

  • A Non-Resident Indian (NRI) or a Person of Indian Origin (PIO) resident outside India can invest in the capital of a firm or a proprietary concern in India on non-repatriation basis subject to the following conditions;
  1. Amount is invested by inward remittance or out of NRE/FCNR(B)/NRO account maintained with Authorized Dealers/authorised banks.
  2. The firm or proprietary concern is not engaged in any agricultural/plantation or real estate business or print media sector.
  3. Amount invested shall not be eligible for repatriation outside India.

Investments with repatriation option: NRIs/PIO may seek prior permission of Reserve Bank for investment in sole proprietorship concerns/partnership firms with repatriation option. The application will be decided in consultation with the Government of India.

Investment by non-residents other than NRIs/PIO: A person resident outside India other than NRIs/PIO may make an application and seek prior approval of Reserve Bank for making investment in the capital of a firm or a proprietorship concern or any association of persons in India. The application will be decided in consultation with the Government of India. (iv) Restrictions: An NRI or PIO is not allowed to invest in a firm or proprietorship concern engaged in any agricultural/plantation activity or real estate business or print media.

In view of the above provisions, it is clear that FDI in Partnership and/or Proprietorship FDI is by and large not allowed.

Trust [6]

FDI is trust is not allowed, except Securities and Exchange Board of India registered Venture Capital Fund or investment vehicle.

LLP [7]

FDI in LLPs is permitted subject to the following conditions:

  1. FDI is permitted under the automatic route in LLPs operating in sectors/activities where 100% FDI is allowed, through the automatic route and there are no FDI-linked performance conditions.
  2. An Indian company or an LLP, having foreign investment, is also permitted to make downstream investment in another company or LLP in sectors in which 100% FDI is allowed under the automatic route and there are no FDI-linked performance conditions.
  3. FDI in LLP is subject to the compliance of the conditions of LLP Act, 2008.

Entry Route for FDI [8]

Investments can be made by non-residents in the equity shares/fully, compulsorily and mandatorily convertible debentures/fully, compulsorily and mandatorily convertible preference shares of an Indian company, through the Automatic Route or the Government Route. Under the Automatic Route, the non-resident investor or the Indian company does not require any approval from Government of India for the investment. Under the Government Route, prior approval of the Government of India is required. Proposals for foreign investment under Government route, are considered by FIPB.

Route of FDI on software

Let us examine whether FDI on software comes under Automatic Rout or Approval Route. Let us first consider prohibited sectors, following are the prohibited sectors for FDI [9]

  1. Lottery Business including Government/private lottery, online lotteries, etc.
  2. Gambling and Betting including casinos etc.
  3. Chit funds
  4. Nidhi company
  5. Trading in Transferable Development Rights (TDRs)
  6. Real Estate Business or Construction of Farm Houses.
  7. Manufacturing of cigars, cheroots, cigarillos and cigarettes, of tobacco or of tobacco substitutes
  8. Activities/sectors not open to private sector investment e.g.(I) Atomic Energy and (II) Railway operations (other than permitted activities mentioned in the guidelines).

Foreign technology collaboration in any form including licensing for franchise, trademark, brand name, management contract is also prohibited for Lottery Business and Gambling and Betting activities.

Now let us examine the sectors in which FDI is under approval route and/or FDI has sectoral cap[10]

Agriculture, Plantation Sector,  Mining of metal and non-metal ores, Mining – Coal & Lignite, Manufacturing, Broadcasting Carriage Services ( Teleports, DTH, Cable Networks, Mobile TV, HITS), Broadcasting Content Service – Up-linking of Non-‘News & Current Affairs’ TV Channels/ Down-linking of TV Channels, Airports – Greenfield, Airports – Brownfield, Air Transport Service – Non-Scheduled, Air Transport Service – Helicopter Services/Seaplane Services, Ground Handling Services, Maintenance and Repair organizations; flying, training institutes; and technical training institutions, Construction Development, Industrial Parks -new and existing, Trading – Wholesale, Trading – B2B E-commerce,  Duty Free Shops, Railway Infrastructure, Asset Reconstruction Companies, Credit Information Companies,  White Label ATM Operations, Non-Banking Finance Companies,  Pharma – Greenfield, Petroleum & Natural Gas – Exploration, activities of oil and natural gas fields, Petroleum refining by PSUs,  Infrastructure Company in the Securities Market, Commodity Exchanges, Insurance,  Pension, Power Exchanges.

  • In case of government/approval route for taking FDI Foreign Investment Promotion Board (FIPB), Department of Economic Affairs (DEA), Ministry of Finance or Department of Policy and Promotion is required.
  • Thus, from the above it is clear that software does not fall under any of the list, hence software service can get FDI under automatic route.
  • Now let us consider various legal business structuring options which software business can consider at its implication on FDI:

Proprietorship/Partnership

If the software business considers structuring itself as proprietorship/partnership, then in such event the business will not attract talented manpower for developing software, nor it will be easy for them to arrange capital for infrastructure facility for software development. Even, in cases where the partnership/proprietorship manages manpower and capital there are very high chances that they will not get FDI, as first and foremost no overseas investor will invest in business model which is uncertain and there is no perpetual succession and the investor will not be assured of lever of compliances followed by the partnership/proprietorship firm. Further, FDI rules do not allow FDI in such form of business directly, and the permission is subject to various restrictions as detailed above which makes it virtually impossible to get FDI in partnership/proprietorship.

LLP

In this form of business structuring software business will be in fare better position as regards manpower, capital and perpetual succession, moreover LLP can attract FDI form non-residents. However, as per prevailing FDI policy, LLP can get FDI subject to conditions contained in FDI policy.

Private Limited Company

In the event software business structures as Private Limited Company it can get suitably qualified manpower as talent is more attracted to the company in comparison. Further the company get access to adequate capital for its initial business set up, after which it can get in touch with non-resident FDI investors for FDI in their company basis their performance. It is also pertinent to mention here that prevailing FDI policy of India has not placed any restriction on FDI by company which falls under automatic FDI route.

Conclusion as to structuring advice

In view of the above discussions as regards major types of business entities and rules governing FDI in India, it is advisable for software business who desires to receive FDI should incorporate a private limited company under the Companies Act, 2013. FDI by private limited company has to come across least number of laws and regulations for receiving FDI.

[1] Source: The Indian Partnership Act, 1932

[2] Source the Companies Act 2013

[3] Section 1.1 of Consolidated FDI Policy Circular of 2016

[4] Section 3.2 of Consolidated FDI Policy Circular of 2016

[5] Section 3.2.2 of Consolidated FDI Policy Circular of 2016

[6] Section 3.2.3 of Consolidated FDI Policy Circular of 2016

[7] Section 3.2.4 of Consolidated FDI Policy Circular of 2016

[8] Section 3.4.1 of Consolidated FDI Policy Circular of 2016

[9] Section 5.1 of Consolidated FDI Policy Circular of 2016

[10] Section 5.2 of Consolidated FDI Policy Circular of 2016

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