Key promoter considerations: foreign investment in Indian startups

Foreign investments in startups, also known as “easy capital” for startups, come at a cost. As they say: there’s always a catch! The new-gen Indian entrepreneurs are taking a pro-active approach in making their business models attractive to these foreign investors, but in the final-bargain may end up: (a) giving certain critical rights in their businesses; and (b) taking on onerous obligations.

   
Key Promoter Considerations- Foreign Investment In Indian Startups

In recent years, Indian Startups have attracted unprecedented foreign investments from several jurisdictions. Apart from the liberalised regime, the credit goes to the brilliant and innovative ideas of young Indian entrepreneurs. The enhanced risk-appetite of Indian promoters, promising business models and excellent initial traction has attracted the majority of these investments. It appears to be a win-win situation, the promoter gets the capital boost for the startups, and the investor receives an excellent avenue for financial gains in future.

The cherry on the cake is the liberalised regulatory environment for foreign investments in Indian startups. More than half of the recent unicorn companies in India have substantial foreign investments. The capital pools available to be invested in Indian startups would deepen in the near term as well as in the long run. On the other hand, the Indian investors and banks are not very keen on investing/financing the Indian startups as these business models have a high-risk, aggressive approach, and generally low on tangible assets.

A startup is an entrepreneurial venture that aims to meet a marketplace need, want or problem by developing a viable business model around products, services, processes or platforms. The Government of India has come up with the Startup India Scheme, which provides various benefits, such as certain tax exemptions, rebate in patent applications, and investment through AIFs and other schemes of the Government of India. FVCIs can contribute to the entire capital of startups, irrespective of the sector in which it is engaged, under the automatic route. In addition to this, startups can also issue convertible notes to NRs, subject to certain conditions.

“Every silver lining has a cloud.”

Foreign investments in startups, also known as “easy capital” for startups, come at a cost. As they say: there’s always a catch! The new-gen Indian entrepreneurs are taking a pro-active approach in making their business models attractive to these foreign investors, but in the final-bargain may end up: (a) giving certain critical rights in their businesses; and (b) taking on onerous obligations.

Though the recent amendments in the FDI regime have resulted in a setback to Indian startups in attracting Chinese investments, other jurisdictions have scaled up their investment strategies. They have become more aggressive in down-streaming their investments in Indian startups.

With the easy money waiting to be deployed, the Indian promoters have to be more cautious regarding the terms on which it is available. They need to assess the opportunity vs cost model, for such fundings.

“Not to get too greedy and not get too scared.”

We discuss specific broad issues that Indian promoters need to be cautious about while negotiating a foreign investment transaction to safeguard their interests. Indian promoters seeking foreign investments for their startup have to strike a right balance on certain critical aspects.

Minority vs Control Deals

In recent times, we have seen a tectonic shift in foreign investor’s strategy in India. From minority interests, the focus is changing to control deals now. This has been triggered by the interplay of several factors such as elevated level of dry powder, startups looking for easy money and the recent trend of some Indian promoters looking to sell the idea and working under the foreign management with performance-linked incentives.

Through control deals, foreign investors get absolute power to: (a) monitor and manage their portfolio companies, (b) decision-making, (c) implement strategies. Their idea is to scale up and expand so that they can exit for financial gains. They don’t invest for the long term and in no way can be treated as a strategic investor. Therefore, Indian promoters need to be mindful of certain factors before they agree to foreign control deals.

Indian promoters intending to raise capital should be clear on the expectation and the reason for raising funds. Giving up a substantial stake at the initial stage of the startup may not be the right move unless the Indian promoter is looking to exit in the near future.

Valuation Game

The stake corresponding to the investment amount is directly linked to the valuation of the company. Therefore, the extent of funding must be aligned with the valuation of the company. If a large amount of capital is raised from foreign investments and the valuation of the company is not very high, the Indian promoters run the risk of getting diluted to sub-control level. It may happen over time if convertibles are issued instead of direct equity to the foreign investor. While this may work for some promoters, others should be commercially aware of what instruments are being given to foreign investors and what will be the shareholding pattern of the startup on a fully diluted basis.

Minority Protection Paving Path To Operation Control

Foreign investors would typically through veto rights, take negative control of the startup, which may lead to the Indian promoters losing their operational flexibility in the functioning of the startup. Apart from the critical aspects like future funding of the startup, the foreign investor will also control the other essential business elements, like formulating strategies, business plans, approving budgets, hiring and firing decisions vis-à-vis KMPs.

A balanced approach should be negotiated and agreed about the broad powers of the foreign investor investors (in their role as minority shareholders) and the operational freedom of the Indian promoters. Even in controlled deals, the Indian promoters should have operational flexibility if there are any performance-linked obligations on them or their incentives are based on certain performance-linked milestones. In fact, in control-deals, the Indian promoters should negotiate specific performance-linked incentives, based on certain agreed milestones.

Ideally, in both minority and controlled deals, it is crucial for the Indian promoters also to seek affirmative voting rights on certain fundamental and critical matters, which also affects the promoters continuing interest in the startup. This is important even in minority deals, as in future, depending on the agreed terms, the promoter’s shareholding may get diluted as the foreign investor will have deeper pockets.

In a minority-deal, it is a no-brainier that the Indian promoters will be controlling the startup and will be the “occupier” or “officer in default/charge”. However, in control-deals, the Indian promoters should negotiate on some time frame so that the promoters and/or their nominee directors are not included as “occupier” or “officer in default/charge”, for compliance with applicable laws. This also depends on other terms, like the responsibilities & rights of the Indian promoters, and the kind of engagement they will have with the startup.

Also, suitable D&O insurance policies should be obtained, and the startup should even agree to indemnify the nominee directors of the Indian promoters. Unlike the earlier company law, the 2013 Act has no restriction on companies indemnifying the directors.

No disproportionate obligations on future sales by The investor

For a secondary sale by the foreign investor, all the representations, warranties and indemnities to the third-party purchaser should be only provided by the selling foreign investors. The Indian promoters and/or the startup company should not be obligated to undertake such disproportionate obligations.

Exit Rights

In a minority deal, the Indian promoters should be mindful of the obligations which they are taking to provide an exit to the foreign investors. Generally, the consequences of not providing the desired exit to the foreign investor may lead to the exercise of draconian rights, like drag along the right or put option. In control-deals, the Indian promoters should also negotiate certain exit rights, including the right to participate in the exit along with the foreign investor.

Other Important Considerations

Certain shareholding of the Indian promoters should be freely transferable to create liquidity or for funding exigencies. There should be a restriction on the sale securities by the foreign investor to a competitor of the startup. The duties of the Indian promoters, non-compete and non-solicit restrictions and termination provisions (with cause/without cause) in the employment agreements of the Indian promoters should be well negotiated.

Conclusion

The issues highlighted above are not exhaustive, and there are several other points which the Indian promoters should be mindful. Most importantly, utmost care should be taken by the Indian promoters to ensure that the financial investment by the foreign investor results in effective synergy between the parties, provides the required capital to the startup at a good and fair valuation, and provides the Indian promoters the required protection so that they can focus on growing on the startup rather than wasting energy on operational issues and fighting a battle in the initial years of the startup. Proper legal representation is a must to achieve this balance.

Stay Hungry and Bootstrap!

The opinions expressed in this article are those of the author. They do not necessarily purport to reflect the opinion of the organisation to which he is associated.

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