This article has been written by Kunal Dodeja, pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from LawSikho.
The current scenario
Start-ups in India often suffer from capital inadequacy when they are in their development stage. The Central Government has approved the ‘Startup India Seed Fund Scheme (SISFS)’ to provide financial assistance to startups for proof of concept, prototype development, product trials, market entry and commercialization. SISFS intends to provide financial assistance to startups via corpus of Rs. 945 Crore that will be disbursed through selected incubators across India in 2021-25. The seed fund under the SISFS will be disbursed to all eligible startups through eligible incubators across India.
Early-stage investments in startups help in the formulation of a business model and execution of business ideas whereas series funding rounds boost the business for expansion and activities resulting in an increase in revenues, creating a dedicated customer base and building strong teams for management of operations.
Stages of investment
Start-ups are initially backed by the promoters with their own capital and savings which is also known as bootstrapping or self-funding. This is usually done where the startup is at a primitive stage of its existence.
Friends and family
As the business is set up, startups need additional funds and move to early-stage funding to meet their financial needs. Early-stage funding generally consists of ‘friends and family round’ or ‘angel investments’. In friends and family around, the promoters approach their family, relatives, and friends for capital in exchange of shares (or through convertible instruments). Such investments are sought at a preliminary stage of the startups where promoters have done their bit by way of self-funding or bootstrapping but anticipate that additional funds would be required for the business to grow. Investments under friends and family round cater to the immediate cash needs of the startups. These rounds are less time consuming and are relatively less complex to raise funds as compared to obtaining finance from external sources like banks or financial institutions.
Post the friends and family around, comes angel round. Angel investment rounds consist of investments from individual high net worth investors, angel networks or organized angel investor funds or family offices. These investment rounds are slightly more sophisticated as compared to friends and family rounds and a formal process is followed including for the documentation, valuation of the company, business model, projections and compliances.
Institutional investors test the involvement of promoters in the business and initial funds raised through angel rounds gives confidence to institutional investors to invest. At times, companies prefer to directly opt for a seed round of funding instead of the traditional steps of bootstrapping and borrowing from friends and family.
Advanced stage funding is divided into different rounds like Series A, Series B, Series C and so on which target and aim for growth, acceleration, product development, increased market outreach thereby resulting in strong financials and credibility of the startups and higher investment returns for the investors. Investment in each series of an investment round is generally targeted towards a specific goal of the business. Series funding rounds are more complex in nature as compared to early-stage funding. Series funding rounds often take longer to close as compared to the early-stage funding rounds due to the complexity involved in terms of the number of investors, valuation, rights to be negotiated with all categories of investors, due diligence activities and legal compliances.
Rights of investors
Given the risk associated with very early-stage companies, early-stage investors seek more rights (and more shareholding) as compared to the total amount of money they invest in the company.
The promoters need to critically evaluate the rights which may dilute the control and operations of the business. Governance rights such as board seat or appointment of the observer or affirmative consent rights for management decisions should be provided with checks and balances to ensure that such rights do not create hindrances in the day to day management and critical decision-making process of the company.
Similarly, liquidation preference right is another right often demanded by investors which is best avoided by the promoters during early-stage investments. Even if the liquidation preference right is granted, the promoters must make the early-stage investors well aware that this right would fall away with future investments rounds in the company.
Early-stage investors may prefer to exit and gain a return on investment instead of staying invested with limited rights as superior rights are always given to institutional investors in advanced stage funding rounds.
Seed series investors bring in larger chunks of investments as compared to the early-stage investors and are more focused on the rate of return on investment. Seed series investors consist of a mix of angel investors and venture capital funds. The nature of securities issued to seed series investors can vary from equity shares, convertible preference shares, etc. Depending on the structure of the deal, issuance of compulsorily convertible debentures or convertible notes are options that can be considered by startups.
Many seed series investors demand board seats or a right to representation at the board level by appointment of board observers. While granting a board seat would essentially not result in shifting of control, the promoters may instead negotiate with the seed series investors and agree to provide reporting rights or information rights or board observation rights.
Affirmative veto (or consent) rights if agreed to be provided must be only applicable in case of major decisions which can have an impact on the overall business of the company. The promoters should negotiate the affirmative consent clause to make it clear, specific and applicable only in case of occurrence of activities listed in the said clause.
Seed investors usually seek pre-emption rights for future rounds of investments and consent requirements for future investment rounds. The promoters need to be mindful and ensure pre-emption rights, if agreed upon, should be restricted to the pro-rata shareholding of the investors in the company.
Lock-in for promoters is another expectation of investors and a way to test the involvement of promoters in the business and also indirectly ensure that the promoters do not leave the company while the investors are on board. While a period of 3 to 5 years lock-in is treated as reasonable, the promoters can negotiate to have certain exceptions to the lock-in period wherein sale of shares held by them is permitted even during the agreed lock-in period.
Investors further demand a right of first refusal paired with a tag-along right in case of any secondary sale of shares held by promoters. In such cases, the existing investors have a right of first refusal for the shares intended to be transferred/ sold by the promoters clubbed with a tag-along right where the investors get an opportunity to reserve their right to sell their proportionate shareholding to be acquired by a third party as a part of any transaction that the promoters undertake.
The liquidation preference clause is another most preferred right by the Investors. Investors generally demand liquidation preference rights in order to secure a specific percentage of return on the investment in the company upon occurrence of liquidation event which inter alia consists of winding up, merger, amalgamation or strategic acquisitions. Having a liquidation preference ensures that the investors get first preference over the distribution of assets of the company upon occurrence of a liquidation event.
Institutional investors consist of venture capital funds, private equity funds and financial institutions. It is often seen that the institutional investors demand all rights that are available with the existing investors in the company and to move a step ahead also demand for superior rights and additional rights.
The right to appoint a director on the board would usually rest with the lead investor in case of multiple investors and the other investors may be granted a right to collectively appoint an observer on the board.
In addition to the protection rights as demanded by seed investors including but not limited to lock-in for promoter’s shares, right of first refusal, right of first offer, tag along the right and so on, the investors also demand anti-dilution rights from promoters.
Anti-dilution right is usually demanded by investors to take care of a scenario where a company is allotting shares to a new investor at a price lower than the price paid by the existing.
Along with the right of first refusal and tag along the right, the institutional investors with a step ahead also demand drag-along rights on the shares held by other shareholders including the promoters. Drag along right gives the investors power to compel the other shareholders in the company to mandatorily sell the shares held by them to third party acquirers to whom the investors plan to sell their stake.
The mechanism for exit demanded by the investors varies from buyback of shares, third party sale, acquisition by promoters or initial public offering depending on the lifecycle and business cycle of the investee company and the proposed duration of investment made by the investors.
Each stage of investments caters to different needs of the startups and each new investment comes along with its own sets of rights, restrictions and other complexities. The most ideal funding opportunity for a Food and Beverage Startup would be the fusion of Angel Investors with Friends and Family Investors wherein the Friends and Family can pump in additional funds with minimalistic shareholding rights simply on the assurance of the Angel Investor being on the cap table with an expectation of good return on its investment, a win-win situation for all and which could also increase the probability of an Institutional Investor coming on board if need be.
Promoters should remember that while there could be market trends for reasonably acceptable rights and clauses in investment transactions, it ultimately depends on the bargaining power that the promoters have while negotiating with Investors.
This is exceptionally well-written by Kunal. Just three things:
- This is a writing assignment not weekly.
- Always include references.
- Mention case studies.
Students of Lawsikho courses regularly produce writing assignments and work on practical exercises as a part of their coursework and develop themselves in real-life practical skill.
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