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Investment is the lifeblood of any startup or company that requires funding in exchange for a stake in the shares/equity of that company. We don’t say it’s important without reason. A group of people with a brilliant, workable idea may lose their opportunity to seize the market due to lack of funds to start and run. Every startup has a purpose to fill or an idea to lead or change the world, in the current scenario where we see the government or influential, powerful citizens throw their money at something that has zero to no value, the startup circle has extended itself into an alternative source of investment. Allowing those who can, to capitalize on an idea, and possibly see profits in the future. In return, a startup in the need of this same money gets its share of benefits.

For a company to be considered a startup (a startup that wants to obtain benefits under the startup India initiative), it needs to obtain a startup stamp issued by the Inter-Ministerial Board Of Certification. Some of the conditions to be met are the firm under Notification 2 of the Government of India, Ministry of Commerce and Industry, Department of Industrial Policy and Promotion (“DIPP”), number G.S.R. 180(E), dated the 17th February, 2016, published in the Gazette of India, Extraordinary, part II, section 3, sub-section (i), dated the 18th February, 2016: be driven by intellectual property and/or technology , work towards commercialisation and innovation of novel products (which is extremely difficult to quantify and measure), be less than 5 years since incorporation and also, have a turnover of less than INR 25 Crore. A start-up can bring in an Investor and the investor would be exempt from paying tax if the investor is an Indian angel investor or if domestic funds (INR) are used for making an investment.

Funds raised by an unregistered startup (does not fulfill the conditions for being considered a startup under the initiative) by issuing equity will be taxed at over 30% of angel tax investment, for the amount of investment over and above the fair value of a startup. This was previously applicable to all startups, but the government has exempted all startups that have a startup stamp from paying tax on investment or funding acquired.

The Legal Requisites Of Bringing In An Investor

1. Registration, Incorporation, AOA and MOA

Though it is not a compulsion, it is advisable to register and incorporate a company in order to be able to accept funding. The list of investors/board members along with the articles of association and the memorandum of association provide legal documentation in the event of any dispute or liability that may arise during the course of business. If a new investor is accepted, changes need to be made in the respective official company documents including the name and duties (if any) of the new investor and his equity share in the company as well as documents held by government offices.

2. NDA – Pitch

A Non-disclosure Agreement (NDA) is essential to protect the interests of the company or startup in this case. A company would generally pitch their idea/product to several investors to get the best deal, and in a case where a deal may not work out (which is in most cases), an NDA is the safest bet to protect a company from information disclosed. During the pitch, important information, key metrics, business proposition/idea, innovation, content, software, etc that is shared with potential investors, needs to be secured against misuse or theft, knowingly or unknowingly. In essence, once the parties agree to a NDA, they are bound by the terms and conditions of the contract and must maintain confidentiality.

3. Source And Instrument Of Funding

Source of funding means from where to get your funding from. This could be an angel investor, institutional investor, venture capitalists (VC), loan sharks, bank loans, private loans, borrowing from friends and family, etc. It is important to identify at what stage the business is at and the source of funding the business requires. The instrument of funding is the way in which funding will be received by the company in terms of deposits, assets, technology, IP rights, etc. The guidelines for paying taxes are different, depending on the source and instrument used for funding.

4. Term Sheet

Once you have finalised on an investor or investment, it is sensible to make a template of what the final contract will be like and start working on it. A term sheet serves as a document that outlines the terms of investment. A term sheet is not a final agreement, unenforceable and non-binding, but serves as a letter of intent (an arrangement to enter into a future agreement) towards the preparation of the final agreement. Some of the contents of a term sheet are price per share, liquidation consideration, amount to be raised, voting rights, registration rights, valuation, etc. It is not like you don’t trust the investor, but is it worth it to lose out on an investor because of misunderstandings and disputes that could have otherwise been accounted for?

5. Valuation Of Shares By A Chartered Accountant

The shares need to be valued by a certified Chartered Accountant (CA) and the manner of valuation in order to ascertain the equity value of the company. Once the value is determined, the price for which a company will issue shares will be at par, at a discount or at a premium. For a startup, the entire investment amount will be exempt from tax and in other cases of unregistered startups and companies, vide Notification 1 dated June 14, 2016 (CBDT Notification) had made the required changes in Section 56(2)(viib) of the Income- Tax Act, 1961, the tax rate varies based on the profit or loss (if any) from capital gains.

6. IP, Assets And Balance Sheet

When bringing in an investor, it is important to secure the company assets and intellectual property rights. It should be mentioned to whom the IP and assets belong to, terms of its use, considerations for the investor (if any), etc. Upon dissolution and exit, a firm’s assets and IP rights will be distributed as agreed upon in the contract.

7. Compliance And Disclosure

After both parties agree to the terms of funding, it is important for either (generally the investor) or both parties to carry out due diligence, compliance and disclosure of all company related information. Generally, such information is made available to investors after investors agree to the NDA. The investor may also have access to a board seat and voting rights, based on the amount of equity and the clauses specified in the agreement. Omission of information, lack of information and inaccurate disclosure of information could make the investment fall through and the company may become liable to cover the damages suffered by the investor.

8. Final Agreement

A final agreement with the amount of investment in exchange for equity or shares needs to be drawn up  between the business and the investing party. This agreement certifies that the investor is a shareholder in the company and the transaction has been recorded in an official document. Once the agreement is executed, the payment is made from an escrow account to the company’s official bank account and the company can utilise the funds as proposed. The purpose of this agreement is to solidify the terms and conditions between the parties and reach a consensus on the tailor-made agreement. This agreement will be enforceable, binding and considered as the final agreement. The new ownership of equity needs to be mentioned in the company’s articles.

9. Remittance

If the funding is received from a foreign investor in foreign currency, then a Forward Remittance Inward Certificate (FRIC) is required by the company. The FRIC serves as an official document to record all transactions received by individuals/companies in India from outside the country. Non-Residential Indians (NRI) and Foreign Institutional Investors (FII) can invest in India through the Portfolio Investment Scheme (PIS).

The Foreign Exchange Management Act (FEMA) is an Act enacted by the Parliament of India relating to trade and payments relating to foreign exchange with respect to Foreign Policy.

The Securities Exchange Board Of India (SEBI) sets rules and guidelines for investments made and received by any individual or group of individuals to any company. The SEBI also enacted the Foreign Portfolio Investor Regulations, 2014 for regulating the process of foreign investment.

If funding is received from an Indian investor or an Indian company, then the investor can fund up to any amount as agreed upon with the company. An upper or lower limit does not exist yet and is at the discretion of the investor and the company.

10. Dissolution/Exit Strategy

There should always be a contingency plan in case of exigencies. No one intends for a business to shut down, but in the event that does happen, the liabilities and assets need to be distributed to creditors and shareholders/investors. A clause should mention what would happen in the event of a dissolution, merger, sale, etc. of the company. Each party should get their fair share and bear the burden of debt proportionally as mentioned in the agreement. Its is better to have this as a clause than to get entangled into a legal battle of time and resources, financial or otherwise.

Availing the help of a legal professional or legal services will ensure a smooth transition from wanting to invest, to becoming a shareholder. LegalDesk.com enables a company to bring in an investor by providing services in conjuction with registration and Legal agreements/contracts (Term sheet, Shareholders Agreement, Non-disclosure Agreement, Founders Agreement), as the case may be. So ensure you safeguard your company’s position before accepting investments in your company.