This article is by Shivani Panda from Amity Law School, Delhi. Here she talks about start-ups and its effect on economic growth in India.
Start-ups are relatively new in India; trying to survive, sometimes successful, in the Indian ecosystem. With support from the government and increased global investors willing to invest in India, the idea of start-ups has appealed to the young innovators and creators of the country. However, the journey of a start-up is not as easy as it sounds, especially in the Indian economic climate due to significant drawbacks. A study conducted by IBM Institute for Business Value (IBV) and Oxford Economics found that 90% of Indian start-ups fail within the first five years due to the lack of innovation and unique business models.
In this article, the author would elucidate the legal and economic challenges faced by the founders and its effect on economic growth in India.
What led to the start-up boom in India
The start-ups in India have drastically evolved in the 21st Century and are now significant contributors to economic growth and development. There were a few start-ups in the 2000s, however, with weak economic policies, next to no mentoring and a few investors willing to invest, India was not ready to incorporate this idea in its ecosystem at that time. However, after 2014, start-ups began emerging primarily in Bangalore, but also managed to find foot-hold in Mumbai as well as in Delhi-NCR. The idea of self-employment appeals to the young minds of India, and the government initiatives like the Make In India campaign, aligned with their needs. This led to various changes in the policy and amendments of the acts, to support the young entrepreneurs that also increased the flow of investors in the Indian start-up ecosystem. Further, with the launch of telecom venture Jio by Reliance in 2016, offering cheap mobile data, the internet reached even to the remotest regions of India. Other reasons responsible for the growth of start-ups are:
- Large Indian Market: India’s diversity in culture, religion, and language has helped start-ups to create diversified products, according to the needs of a particular community. This becomes their Unique Selling Proposition, which in-turn entices investors to fund the start-up.
- Fast-moving business environment: In an uncertain and changing business ecosystem, the companies are under constant pressure to innovate to find a footing in the market. Sometimes, other companies invest or buy the start-ups to increase their own uniqueness.
According to the Startup India Portal, India has about 50,000 start-ups and is the 3rd largest ecosystem in the world. Start-ups are now emerging in tier-II and tier-III cities, such as Pune, Ahmedabad, and Kochi. Further, there is an increase in the investment flows from Chinese, Japanese, and Singapore based investors.
Legal basics every Indian start-up must know
Business type and founders agreement
Founders Agreement is a legal contract between the founders that lays down the rights, duties, and responsibilities, shares of equity, exit options, dispute resolution, and other basic but important terms required for smooth sailing of a business. The document is optional in most cases, however, it is generally recommended to draw up one, since it provides a structure to the business, demarcates responsibility of each party involved as well as attracts investors, which is pivotal for an infant company. The key components required in a founders’ agreement are following:
It is a basic and straight-forward, but an equally important part of the agreement as other elements. This includes the name of the founders and their roles in the company, name, and type of company, details of the registered office. It will also cover the length of validity, that is, for how long the company shall remain valid for and the process of dissolving the agreement. Further, the goals of the company, depending upon its type, shall be mentioned in the agreement.
Determining the distribution of equity requires discussion and deliberation among the co-founders, as they need to take into consideration various factors, such as money investment, experience and skills, existing intellectual property, and network in the industry. It is recommended that the co-founders should split 80-90% of their equity and save the rest for any unforeseen emergency.
Vesting is based on the principle that the founding members shall earn their equity ownership by contributing to value creation through sweat equity, or hard work against any intellectual property or know-how provided by them. It also helps them avoid getting taxed for capital gains, however, the company can purchase a percentage of the equity in case the co-founder exists or is ousted from the company. Thus, it works as a security for the company. Vesting of shares can be done in two ways:
Under this, the shares of the founder shall be vested in proportion to the time spent by the founder in the company. It generally lasts for four years and has a one-year “cliff”. This means that if a founder exists from the company before the completion of 4 years, they will not get their full share of the equity. However, the proportion of shares to be returned to the founder on existing keeps increasing, until it is 100% by the fourth year. Moreover, if the founder leaves the company before the completion of 12 months from incorporation, they will not get any share. This system is generally followed by companies in India.
This type of vesting is performance-based, that is, the vesting of shares takes place only when the mile-stone or goal set out in the agreement is completed. The founder can then leave the company if they want to, with their full equity.
Under this clause, the demarcation of decision-making power vested with each of the founders is laid down. Decisions generally range from investment, employment, termination, and salary arrangement. Thus, it is important to have a clear decision-making structure to avoid conflicts in the future.
Intellectual Property assignment
This clause of the agreement encompasses what comprises intellectual property in a business. Generally, in business the ideas and innovation developed by a founder become their personal intellectual property, however, while drafting this agreement, it is important to draft it in a way that the ownership of the intellectual property will remain with the business and not with an individual, even after they depart from the company. It shall be the company’s property once it is made during work.
Confidentiality and Non-Compete Clause
It is of paramount importance that the core team or the founders trust each other, and this clause enforces trust with each other. Under this, the partners shall refrain from sharing any confidential information with their competition or with anyone which might lead to conflict in the business. This agreement extends to any party involved who exited the company, meaning, they are prohibited from engaging with their previous company’s competition, start a similar business, break away suppliers, employees, or clients.
This clause shall encompass the mechanism of the salary and remuneration clause of the founders. The agreement may contain a general outline of the mechanism and a separate employment contract shall be entered into, providing detailed terms of employment of the co-founders, which will also cover the benefits given and restrictions that are to be adhered to by the founders.
The agreement shall lay down the termination clause of the agreement as well as the dispute resolution mechanism or framework of the company to settle down any conflict and disagreement among the parties.
Business registration and licenses
The key to a successful start-up is to obtain all the documents and licenses pertinent to run a business. Unavailability of license with the business will lead to expensive law-suits and settlements. The basic difference between business registration and business licenses is that the former is to be required for listing a business with the registrar, whereas the latter are the documents required for the functioning of a business. Startup India Registration is another kind of registration required if the company fulfils the following criteria necessary under the DIPP Notification:
- It has been incorporated as a registered Partnership, Limited Liability Company or Private Limited Company.
- It has not been more than seven years or ten years in the case of a BioTech Company, from the date of incorporation.
- Maximum annual turnover since the registration shall be Rs. 25 Crore.
- The firm shall be working towards innovation, development or improvement of product which will lead to wealth creation.
- Finally, it shall not have been formed by splitting or reconstructing an existing business.
Other registrations such as MSME registration, GST registration, or Udyog Aadhar registration are required, depending upon the type and scale of business. Moreover, the founders shall keep in mind that a few states or Union Territories, may require special permits to incorporate and run a business. Shop and Establishment License for Start-up registration is one of the common licenses generally required by all the businesses in India. Each state has its own shop and establishment or trade license, which is obtained under the state Shop and Establishment Act. It also provides for the rules to be followed by every business in each state. Import-Export Code registration is another kind of license required by all the importers to legally run their businesses.
Knowledge of accounting and taxation laws
Taxation and the company’s law keep changing according to the change in the economic climate of the country, thus, it is essential for a company to adapt to these amendments and reforms. The government, under the ‘Made in India’ campaign, promotes start-ups and provides tax exemptions and incentives to eligible start-ups. In 2019, it launched the Startup India Program, under which Eligible Start-ups, as explained above, are allowed tax exemptions, such as, the Start-Ups incorporated after April 1, 2016, will get 100% tax rebate on Net Profit for a consecutive period of 3 years in the block of 10 years. In 2019, it launched the Startup India Program under which the eligible start-ups are allowed tax exemptions. One of the most appreciated incentives provided under the program was to give 100% tax rebate to the start-ups incorporated after April 1, 2016, on net profit for a consecutive period of three years in the block of ten years. Further, the Angel Investors who were heavily taxed before are now exempted, as under Section 56 of the Income Tax Act, provided the paid-up share capital and share premium does not exceed Rs. 25 Crore.
Adhering to labour laws
Labour Laws fall under the concurrent list, wherein, both Union and the State Government can legislate it. It has evolved with the time and demands of the workers over the years and has diversified with one act to govern a particular matter. Broadly, it can be classified into laws relating to industrial relations, wages, work conditions, social security measures, and prohibitive labour laws. However, the laws which are for the protection of the labours in India can prove a bit restrictive for infant companies. Thus, the Department of Industrial Policy & Promotion (DIPP) issued an advisory in 2016 allowing self-certification with nine labour laws, and no inspection will be conducted for a period of 3 years. However, in 2017, following an amendment by ministry took place:
- The Ministry extended the self-certification compliance to five years from three years.
- No inspection under six labour laws (earlier it was 9) shall take in the first year of incorporation. They are:
i) Building and Other Constructions Workers’ (Regulation of Employment and conditions of Services) Act, 1996
ii) The Inter-State Migrant Workmen (Regulation of Employment and conditions of Services) Act, 1979
iii) The Payment of Gratuity Act, 1972
iv) The contact Labour (Regulation and Abolition) Act, 1970
v) The Employees’ Provident Funds and Miscellaneous Provisions Act, 1952
vi) The Employees’ State Insurances Act, 1948
The Start-ups are required to send self-certified returns under nine labour law acts, which includes the six mentioned above. The other three acts are:
i) The Industrial Disputes Act, 1947
ii) The Trade Unions Act, 1926
iii) The Industrial Employment (Standing Orders) Act, 1946
From the second year onwards, up to five years from the incorporation, the start-ups shall be taken up for inspection only when a credible complaint of a violation of the labour laws has been filed in writing, whose approval have been obtained from one level senior to the inspecting officer or from the Central Analysis and Intelligent Unit (CAIU).
Importance of efficient contract management
A contract can be understood as agreements which are made by the free consent of parties, for a lawful consideration object and are not expressly void. It is required in any business for the smooth functioning of the business. Thus, a start-up should take up a good contract discipline that would control costs and generate maximum value at low business risks, a failure of which might result in an expensive lawsuit. Contracts such as employment agreements, Non-Disclosure Agreements, Services Agreements, lease and rent agreements, etc. are among the crucial contracts required by a business.
Details about winding up of a business
Winding up of a company is required when the purpose for which the company is formed is over or it has become a defunct entity with low or zero assets and/or profit. When a company needs or decides to shut down, all the parties involved, such as the shareholders, employees, investors, or creditors, need to be informed in advance.
To wind-up a start-up, the fast track exit method is the most convenient one. The Ministry of Corporate Affairs (MCA), recently released the curtailed procedure of winding up a company through fast- track exit. This new method is not only beneficial for the companies but also for the National Company Law Tribunal, as the application regarding the winding up shall now be forwarded to the Central Government instead of NCLT. Following criteria are to be fulfilled by the companies to qualify fast track exit method:
- The company shall not have any asset or liability.
- The company shall not have commenced any business operation since incorporation or one year has been passed since the last business transaction.
Further, under the Start-up India Action Plan, the companies, upon application can be wound up within 90 days, wherein insolvency professionals shall be appointed for the start-up.
Why is Intellectual Property Rights (IPR) crucial for start-ups
Intellectual Property is a kind of intangible property, which is a creation of mind and is a result of creativity. There are various kinds of intellectual properties, like a trademark, copyright, patent, etc. These are the kind of intellectual properties that are generally identified and recognized in most of the countries. The IPR gives the owner exclusive rights to the intellectual property, for a certain time. With globalisation at its peak, IP can be a unique selling proposition (USP) of the product or service, which will be its differentiating identity.
In a start-up, Intellectual Property assumes even greater significance, which gives an advantage to that company in the market and creates a unique identity in the vast ocean of start-ups, which will in turn attract investors who will fund the company. Intellectual Property is an expensive affair, however, with a myriad of advantages attached to it, a start-up should definitely consider it. The IPR can yield the following advantages:
- Investors are likely to invest in a start-up that has patents in its name, due to its innovative and distinguished feature.
- Registering for a trademark or patent might give the start-ups an idea if there is another company with a similar patent in another part of the world and the start-up can stop working at it.
- Licensing or selling an IP can create additional revenue for the company.
- There are various national and international laws protecting Intellectual Property Rights.
In India, there are essentially three ways in which a start-up can protect its intellectual property, which is explained briefly in the following table:
Any kind of mark in the logo, shapes, slogans or holograms.
Exclusive use of marks and prevent others from using it without permission.
A new and unique invention or an idea.
Exclusive right over the invention, can license or sell it.
Books, lectures, art, music, etc.
Distribute copies of the work to the public, no unauthorised use of the work by others.
A lifetime of the creator and till 60 years after their demise.
Not required, unless the work was published before January 1, 1978, then renewal after every 28 years.
Need for strong employment contracts
An Employment contract is the backbone of a start-up and is one of the required clauses in the founders’ agreement as well. It shall outline the terms and conditions, emphasizing the duties of the employees and shall be executed at the time of engaging the employee. It is often seen that a standard Employees Contract is followed for all the positions, which should be avoided to steer clear of any ambiguity in the agreement. Certain conditions should ideally be modified, according to the requirement of the job. Following are the important clauses that are common in all kinds of employment agreement:
- As there should be an offer and acceptance to constitute a valid contract. Thus, the offer and acceptance of employment is a necessary clause in the agreement.
- Details of roles and responsibilities of an employee.
- Remuneration and salary, including any incentive in cash or kind which will be provided by the employer.
- Working hours and place of work for the employee.
- Leave and holidays.
- Non-compete and confidentiality clause to protect the intellectual property of the firm, as have been discussed above in detail.
- Code of conduct and dress code during office hours.
- Disciplinary procedure.
- Termination, suspension, and resignation of employees.
- Dispute Resolution.
- Death and benefits to legal heirs.
Indian start-ups: legal challenges and economic opportunities
The legal challenges to the start-ups are particularly unique due to its complex and ever-changing business policies. The failure to meet the legal requirements might lead to expensive land lengthy legal suits. The current legal structure has been discussed above, however, the previous legal structures have been even more complex and stringent, to protect the sensitive economy of India, post-independence. After the 1990s liberalisation and globalisation, India entered and successfully adapted to the foreign market. Moreover, there were various archaic and unsuccessful acts governing the companies in India, which were repealed to allow ease of doing business.
Some of the non-legal challenges which the company faces are the following:
- Finding the right team member to match the demand of the start-up.
- Lack of innovation and branding strategy.
- Supporting infrastructure.
- Lack of innovative marketing strategy.
Sick Industrial Companies Act, 1985 (SICA)
Sick Industrial Company, as defined under Sick Industrial Companies Act, 1985, is a company that existed for at least 5 years and had incurred accumulated losses equal to or exceeding its entire worth at the end of any financial year. The purpose of the Act was to revive and rehabilitate the sick industries by fully utilising the resources, and providing maximum protection of employment by using the funds of banks and other financial institutions. This step by the Government was imperative since the sickness of these companies were affecting the Indian economy due to which the Central and State government suffered a loss. However, the Act was not successful and was repealed and replaced with the Sick Industrial Companies (Special Provisions) Repeal Act, 2003.
Features of SICA 1985 & SICA 2002
- Two quasi-judicial bodies were established under SICA, namely Board for Industrial and Financial Reconstruction (BIFR) and Appellate Authority for Industrial and Financial Reconstruction (AAIFR). The BIFR was entrusted with the responsibility to identify and revive sick industries.
- It would make an inquiry when the Board of Directors would approach BIFR for determination of the sickness and revival of the company, for which it would appoint a special director, to safeguard its financial interests.
- If after the inquiry BIFR is satisfied that the company has become sick, it decides that, if the company is:
i) Practicable, then the Board will give it time to revive.
ii) Not practicable, then the company can be wound up or it may take any other decision it deems fit.
4. The other important feature which SICA 2002 had was that the Board had to make sure that the companies did not resort to sickness declaration to escape legal obligations.
5. AAFIR had the authority to hear the appeals from BIFR.
In 2016, SICA was fully repealed, in parts, as some of its provisions overlapped with the Companies Act, 2013. BFIR and AAIFR were dissolved and National Company Law Tribunal (NCLT) was enacted under the Companies Act to hear cases regarding sick industries, with other responsibilities. A new Act dealing with the bankruptcy of a company, Insolvency and Bankruptcy Code, 2016 (IBC) also came into force, cases under which are heard at NCLT.
Recovery of Debts Due to Banks and Financial Institutions Act, 1993 (RDDBFI)
Recovery of Debts Due to Banks and Financial Institutions Act, 1993 was renamed to Recovery of Debts and Bankruptcy Act, 1993, after its amendment in 2016. This Act deals with the recovery of Non- Performing Assets, which means the loans or advances that are in default or in arrears. They are generally shown as bad debt in the Balance Sheet, and the legal battle to acquire that property used to take years. Thus, to simplify the process, RDDBFI or RDB Act is enacted.
Features of RDB Act
- Two quasi-judicial acts are established under this Act, namely Debt Recovery Tribunal and Debt Recovery Appellate Tribunal. It was first established in Kolkata, and presently there are 33 tribunals functioning pan India.
- An application is to be filed by the financial institution or bank in support of its claim to the asset. The DRT can appoint a Recovery Officer if it grants a recovery certificate to take custody of the property.
- An appeal by the aggrieved party can be filed within 30 days in the DRAT.
- It is applicable to Banking Companies, SBI, Subsidiaries of SBI, Banks and Financial Institutions, Debenture Trustees, etc.
Further, in the case of Official Liquidator, U.P and Uttarakhand vs. Allahabad Bank and others it was held by the apex court that the RDB Act being a special law, would prevail over the Companies Act, 2013. The judgement not only protects the right of the banks and financial institutions for quick adjudication as under RDB Act, but also the interests of the workmen when the Company is winding up. Recently, the court in the case of Standard Chartered Bank vs. MSTC Limited provided clarity on the interplay between the provisions of RDB act and the Limitation Act, 1963. It had further refused to condone a delay of 28 days in filing a review application by the government borrower entity against a decree in favour of the bank.
The Indian market has an abundance of resources for a successful start-up and provides great opportunities to young Indians, which in turn generates income and employment in the economy. Support from government and private authorities and angel investors has drastically increased the success rate of start-ups post-2014. Mentoring and networking have also developed, with better infrastructure and start-up friendly ecosystems. However, Indian start-ups face significant challenges such as complex legal systems and stacking paperwork, unfriendly governmental authorities. Further, with the economic slowdown and COVID-19, the founders are getting increasingly anxious. Some economists are, however, of the view that economic slowdown may not have any impact on start-ups in India at all, as investments are done keeping in mind a five to seven-year cycle, thus not affecting the early-stage ecosystem. Thus, it will be interesting to see the changes that will gradually take place in the start-up ecosystem amid the lockdown and stunted economy.
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