Opportunities and Challenges for AIFs in

India’s first IFSC, GIFT City, Gujarat.

Introduction to IFSC and GIFT City

India has been witnessing a high growth in the investment funds domain, ranging from fund-
raising activity to active investments by funds, and also an adaptive and dynamic regulatory
environment conducive to the witnessed growth. The formation of most of these funds however
have been concentrated to the well-known financial hubs such as Hong Kong, Mauritius,
Singapore, etc. The success of theses financial hubs is generally attributed to the regulatory, tax
and other business-conducive financial service centres. The International Financial Service
Centre (IFSC), is India’s attempt to create an avenue into financial globalisation.

An IFSC allows overseas financial institutions and overseas branches/subsidiaries of Indian

financial institutions to operate within India and cater to customers outside the jurisdictions of
India. This is achieved only when the IFSC provide favourable regulatory regimes and business
environment to investors and financial institutions.

Provisions for the setting up and regulations of an IFSC were thus introduced in the Special
Economic Zone Act, 2005, and in 2015, Gujarat International Finance Tec-City (GIFT City)
came into being to facilitate such financial services within the geographical territory of India,
which would otherwise have been carried on abroad or through offshore branches/subsidiaries of
Indian financial institutions.

As an IFSC, GIFT City is regulated under specific regulations and guidelines by India’s major
financial sector regulators, i.e. the Reserve Bank of India (RBI), the Securities Exchange Board
of India (SEBI), and the Insurance Regulatory and Development Authority of India (IRDA). This is
because of the major identified thrust areas for IFSCs in India, which would need regulation as
follows:

 Banking and Forex: to be regulated by the RBI

 Capital Markets: to be regulated by SEBI
 Insurance: to be regulated by IRDA

Why consider AIFs in GIFT City?

GIFT City as a facilitator of international business has already set a firm initial footing in the
above identified thrusts areas with more than 150 units licensed by the financial regulators
already operating in GIFT City. The banking units at GIFT City are working well with transactions
of more than USD 16 Billion having taken place. In the insurance sectors, the IRDA has licensed
entities engaged in insurance business. And for the Capital markets, both National Stock
Exchange (NSE) and Bombay Stock Exchange (BSE) are operating out of GIFT City, and
several SEBI licensed companies are offering IFSC products from GIFT City.

REPORT THIS AD

Setting up of Alternative Investment Funds (AIFs) in GIFT City, being the species of private
pooled funds recognized in India, becomes another important step in commencing the third stage
of proliferation of financial and capital market activities.

It is to be noted that the authorities at GIFT City and the SEBI are fully aware that India has a big
market for India-focused offshore feeder funds which are set-up outside India. Keeping in mind
the premise offered by IFSC as fully capital account convertible, i.e. providing full exemption from
FEMA norms for transactions from and to the IFSC, emerges as an important alternative to
offshore feeder funds. For all transactional and regulatory aspects, an AIF operating from GIFT
City, is an offshore AIF.

Thus, to assess the viability of setting up AIFs in GIFT City as opposed to an offshore fund will
require an analysis on Regulatory (fund formation, registration, tax considerations, etc.) as well
as Operational (ease of conducting business, etc.).

Regulatory Regime for AIFs in GIFT City

Soon after the introduction of GIFT City, SEBI promulgated its SEBI (International Financial
Services Centres) Guidelines, 2015 (SEBI Guidelines) on March 27, 2015. The SEBI Guidelines
permits only ‘recognized entities’ registered with SEBI or registered/recognized with foreign
regulators, to set-up units in IFSC, in this regards AIFs operating in IFSCs are treated as
recognized financial institutions.

Further operational and regulatory clarifications for stakeholders waiting to set up AIFs in GIFT
City, the circular titled ‘Operating Guidelines for Alternative Investment Funds in International
Financial Services Centres’ dated 26 November, 2018 (AIFs in IFSC Guidelines) by SEBI,
provided much needed clarity on several aspects with respects to setting up and operation of
AIFs in GIFT City.

1. Continued applicability of the SEBI (AIF) Regulations, 2012 – the AIFs in IFSC
Guidelines work under the broad ambit of the SEBI (AIF) Regulations, 2012 (the AIF
Regulations). Thus, all provisions of the AIF Regulations and the circulars issued
thereunder, will also apply to AIFs set-up in GIFT City, and also to the investment
managers, sponsors, and investors. This would include periodic reporting, event-based
reporting, adherence to disclosure norms to SEBI.
2. AIFs in IFSC are considered offshore entities – RBI, in its Foreign Exchange
Management (International Financial Services Centres) Regulations, 2015 dated 02
March, 2015 has stated that any financial institution or branch of a financial institution set
up in the IFSC and permitted/recognised as such by a regulatory authority shall be
treated as a person resident outside India. Therefore, under FEMA, the transactions with
Indian residents or making investments in Indian securities would require compliance
with FEMA norms.
3. No separate registration process – The conditions as applicable to domestic AIFs for
registration with SEBI, will continue to apply to AIFs in GIFT City as well.
4. Operating Currency – AIFs operating in IFSCs can accept money only in foreign
currency.
5. Eligible Investors – A person resident outside India, NRIs, Indian institutional investor
permitted under FEMA invest funds offshore, Indian resident having net worth of at-least
USD 1 Million during the preceding financial year (subject to limits under Limited
Remittance Scheme of RBI). It would be beneficial if the guidelines clarify, whether
investment by Indian residents into the AIF set up in GIFT City, which further invests into
Indian companies, is considered as round-tripping.
6. Investible Securities – AIFs in GIFT City can only invest in securities that are; listed in
IFSC; issued by companies incorporated in IFSCs; or issued by companies incorporated
in India or companies belonging to a foreign jurisdiction.
7. Investment Route – Earlier, such AIFs in IFSCs could only invest in India through the FPI
route. Now, such AIFs may invest in India through the FDI or Foreign Venture Capital
Investor (FVCI) route as well.

REPORT THIS AD

Following is an encapsulation of other conditions applicable to AIFs operating in IFSCs:

Minimum Corpus of AIF at least USD 3 Million.

Minimum investment value by any at least USD 150,000 [for employees/directors of AIFs, minimum value of investment is

one investor USD 40,000].

at least 2.5% of the corpus or USD 750,000, whichever is lower (such interest cannot be

Continuing interest of the through waiver of management fees). For Cat-III AIFs, the continuing interest shall be at-

Manager/Sponsor least 5% of the corpus or USD 1.5 Million, whichever is lower.

Sponsor/Manager of an existing may act as Sponsor/Manager of AIF operating in IFSC only by setting up a branch in the

AIF in India IFSC or incorporating a company or LLP in the IFSC.

Sponsor/Manager of Cat-I and II AIFs are required to appoint a custodian registered with

Appointment of Custodian for SEBI for safekeeping of securities, if the corpus of the AIF is more than USD 70 Million.

Securities
Appointment of custodian is mandatory for all Cat-III AIFs operating in IFSCs.

Application Fee : USD 1,500

Registration fee for Cat-I AIF (other than

Angel Funds) : USD 7,500

Registration fee for Cat-II AIF : USD 15,000

Registration fee for Cat-III AIF : USD 22,500

Registration fee for Angel Funds : USD 3,000

Application and Registration fees Scheme Fee for AIFs : USD 1,500

Following are the special conditions as applicable to Angel Funds operating in IFSCs:

Minimum Corpus USD 750,000

(a) Individual investor to have net tangible assets of at least USD 300,000

(excluding value of principle residence).

Criteria for becoming an ‘angel investor’

(b) body corporate to have net worth of at least USD 1.5 Million.

Minimum investment value for ‘angel Investment from an angel investor should not be less than USD 40,000 (up to a

investor’ maximum period of 5 years)

 Angel funds to invest in Venture Capital Undertakings (VCUs) as defined in Reg.

19(F)(1)(a) of the SEBI (AIF) Regulations, 2012. Also;

– Turnover of venture capital undertaking (VCU, is the company which receives

the investment by the AIF) must be less than USD 3.75 Million

Investible entities – VCU must not be promoted/sponsored/related to industrial group with group
turnover more than USD 45 Million

Minimum investment by Angel fund in VCU – USD 40,000. Maximum

investment – USD 1.5 Million

Investment caps on Angel Funds

2.5% of the corpus of fund or USD 80,000 whichever is lower (such interest

Continuing interest of Manager/Sponsor cannot be through waiver of management fees)

REPORT THIS AD

Key Takeaways from the Regulatory Perspective

Key Opportunities:

 The regulatory provisions applicable to AIFs in IFSCs do offer a viable alternative to

offshore feeder funds, and can act as a feeder fund for an Indian AIF.
 Other offshore funds investing in India which traditionally operate out of other countries
like Mauritius, Singapore, etc. may deliberate on the option.
 Indian overseas fund managers looking to set up funds for investing outside India, may
find it easier to raise capital from overseas investors and Indian investors simultaneously.
Indian offshore fund managers can also use AIFs in GIFT City as feeder fund to invest
funds offshore.
 Costs for setting up the fund appear to be much lower in comparison to setting up an
offshore fund.
 As a deemed overseas fund, conditions on overseas investments by AIF prescribed by
SEBI in October 2015 such as overall investment limit (USD 750 million), specific SEBI
approvals, and other conditions shall not apply.

Key Challenges:

 There is lack of clarity with respect to AIFs in IFSCs being able to invest in securities
listed on overseas stock exchange.
 Although, investment under FDI, FVCI or FPI route is allowed for AIFs in IFSCs, it has
not been specified whether such AIFs would require separate licenses to invest as FPIs
or FVCIs. Ideally, as a recognised AIF, they must be granted FPI/FVCI status as well.
 New Investment managers of AIF in IFSCs must necessarily be incorporated in the IFSC,
this might add to the cost of setting up the fund. Ideally, if the IFSC truly aims to attract
global funds, management by offshore managers should also be allowed.
 With respect to Angel Funds, it appears that angel funds in IFSCs can only invest in
Indian entities.

Key Development: Proposed Unified Authority for regulating all financial services in
IFSCs in India
Cognizant that the dynamic nature of the business conducted in IFSC requires immense inter-
regulatory co-ordination, the Central Government has acted on the need for having a unified
financial regulator for IFSCs in India to provide world class regulatory environment to financial
market participants. Thus, the International Financial Services Centres Authority Bill, 2019
(the Bill) was introduced in the Rajya Sabha on 12 February 2019 by the Finance Minister
providing for the establishment of an authority to develop and regulate the financial services
market in the IFSCs. This is an important development, as the presence of a unified and
dedicated International Financial Services Centres Authority (the Authority) is proposed to play
a significant role towards the IFSCs ultimate goal of ease of doing business.

REPORT THIS AD

Under the Bill, all powers relating to regulation of financial products, services, and institutions in
IFSCs, which were previously exercised by the respective regulators will be exercised by the
Authority. As per the Government’s rationale, the Authority will be responsible for providing
world-class regulatory environment to market participants from an ease of doing business
perspective.

Tax and Operational Considerations for AIFs in GIFT City

Under Sections 10(23FBA) and 115UB of the Income Tax Act, 1961 (the IT Act), Category I and
II AIFs are accorded tax pass-through status with respect to AIF’s income other than business
income, thereby tax being chargeable in the hands of the investors. These provisions are
extended to AIFs in IFSCs as well, as they continue to be tax residents in India despite being
non-residents under FEMA.

There are several beneficial provisions available for IFSC units, however, since they are not AIF
specific, which leads to ambiguities regarding the availability of such incentives to AIFs in IFSCs.
Nevertheless, the beneficial provisions for IFSC units under the IT Act are as follows:

1. Tax holiday under Section 80LA – Any unit set-up in an IFSC shall not be taxed in
relation to income from business as follows in two blocks. First block of 5 years in which
100% of the income beginning with the year in which the permission or registration was
obtained is exempt from income tax, and; Second block of 5 years in which 50% of
income is exempt for the next 5 consecutive years.
2. Lower rates of Minimum Alternate Tax (MAT) and Alternate Minimum Tax (AMT) – MAT
and AMT in case of a unit located in an IFSC and deriving its income solely in convertible
foreign exchange shall be charged at a lower rate of 9% as opposed to the general
18.5%.
3. Exemption from Dividend Distribution Tax (DDT) – A unit located in an IFSC and deriving
its income solely in convertible foreign exchange, being a company, is exempted from
paying DDT at the time of distributing dividend.
4. Gains from certain securities transferred by non-residents not considered as capital
gains– Any transfer of derivatives, global depository receipts, or rupee denominated
bonds of Indian companies by a non-resident on a stock-exchange in an IFSC is exempt
from tax on capital gains.
5. Exemption from Securities Transaction Tax (STT) – A transaction undertaken on
recognised stock exchange in an IFSC shall be exempt from STT.
6. Exemption from Goods and Services Tax (GST) – All supplies made to and made by
units in SEZs are exempt from GST applicability.

Apart from the tax considerations, units in IFSCs also being subject to the Special Economic
Zones Act, 2005 as SEZ Units might face other problems. This argument stems from the fact that
the SEZs were originally conceived as special designated zones for manufacture and export-
oriented industries, and thus SEZ Units are subject to certain conditions which might prove
difficult for non-export-oriented business to satisfy. For example, in the recent Special Economic
Zones (2nd Amendment) Rules, 2019 dated 07 March, 2019, Rule 53 of the Special Economic
Zones Rules, 2006 was substituted to mandate a positive net foreign exchange earning by SEZ
Units calculated cumulatively for a period of five years from the commencement of production.
IFSC units specialize in financial services and products, might find it very difficult to meet the net
foreign exchange earning criteria set by the government.

REPORT THIS AD

Key Opportunities

 The tax holiday is a big benefit for investment managers established in the IFSC,
management fee and other income will be exempt.
 Other exemptions with respect to MAT and AMT for non-market players, and DDT and
STT exemptions make GIFT City an attractive destination.

Key Challenges

 There is dearth of clarity in taxation of income of AIFs in IFSCs on many fronts, such as
will the tax holiday be available to AIFs in IFSCs with no business income, whether
investors in AIFs will be required to obtain PAN and file tax returns in India in case of tax
pass-through being available, etc.
 There is a need to harmonize the provisions as applicable to SEZ Units with respect to
IFSC Units requiring necessary carve outs and exemptions to be created.
 Unless a unified regulator is in place, the problem of multiplicity and overlapping of
authority will continue to diminish the growth of AIFs in IFSCs as viable alternatives to
offshore funds.

Observations:

There certainly are numerous benefits for setting up an AIF in GIFT City. With the proposed
unified regulator, ease of doing business, it holds many promises.

However, it is to be noted that many grey areas especially with respect to taxation of AIFs in
IFSCs need to be clarified and resolved to understand the true effects of such provisions on AIFs
as mentioned above. The determining criteria would be clarity to the tax incentives available for
AIFs in IFSCs. How well does GIFT City perform, will determine the success of AIFs in IFSCs,
too.

Advisors in Start-ups and Early

Stage Companies
India is witnessing a high growth in the number of start-ups in the country and is also amongst
the top start-up ecosystems in the world. The government has provided a few benefits to startups
as well, through the Startup India Action Plan.

However, only a few of these start-ups actually succeed. It is a treacherous path with a lot of
unknowns. An advisor or an advisory board in a start-up might help the early stage companies to
atleast know some of those unknowns. Financial investors certainly add value, sometimes
domain expertise even. The comfort of speaking with an advisor where they bring in the expert
views, advice and sheer experience onto the table is very valuable. As the saying goes,
‘Experience is the best teacher’.

Who are these Advisors and what role do they play?

An advisor is a person who brings in his unique skill sets and expert opinion on the business of
the company, operational or otherwise. They are the people ‘who have been there and done
that’. They can play a major role, especially if the founders and the team are new to the industry
and do not have much experience. There are celebrity advisors even, who by being called as an
advisor adds value to the startup.

Advisors can play different roles, for example, advisors who bring in their expertise in a particular
domain or area; help with their networks and can introduce potential clients, employees or
investors; or scaling up teams; expansion to new geo. It is not just having the advisors but also
heeding to their advice. Therefore, advisors need to be chosen very wisely, so that their advice
can be relied and executed upon.

How to choose the right Advisor?

Hiring an advisor who does not add much value or provides incorrect advice to the company may
turn out to be counter-productive or disastrous. The advisors bringing in complementary skills or
“deeper” skills which the founding team has a gap would be great. Identify the areas where the
founders lack expertise or sufficient industry knowledge, where they face difficulties or have
faced difficulties in the past or any area where they would require expert advice. Once there is
clarity on where and why advisors are required, do some research and talk to people who can
introduce you to some advisors. Discussing the same with the existing investors (if any) might
also be a good idea as they might be able to connect the founders with the relevant people. And
since the investors have invested in the company, they would ensure that the advisor will be
someone who can add value to the company.

Ensure that they are people with the relevant expertise and knowledge, proven track record,
good communication skills, networking skills, etc. Advisors should be individuals who would
invest their time for the growth of the company and who can provide support to the founders
where there is lack of expertise or knowledge.

Engaging with the advisor

An advisor may be compensated in cash, equity etc. Many a time, the advisor is interested in just
giving back to the eco-system. One should evaluate if the advisor has time to provide support to
the startup, whether the advisor is associated with other companies which the startup may have
conflict / competition. Maintaining a good rapport, having regular discussions and candid
conversations, updating the advisor on a regular basis about the business and other relevant
aspects of the business can go a long way. The most important factor is to ensure that there is
trust between the parties.

Some startups look for a small investment by the advisors into the company, as a test to ensure
that the advisor believes in the idea, startup, founders etc.

Compensation for Advisors

Let us now evaluate some of the ways to compensate advisors for the value-add they bring to
the company.

Start-ups, more often than not, compensate advisors by giving a percentage of equity in the
company since they may not have the finances to give cash compensation (unless well-funded).
New shares can be issued to the advisors or shares can be transferred from the founders. Such
issuance or transfer should ideally happen at the face value of the shares since it is a
compensation for the services rendered by the advisors and the advisors would not want to pay
the full price of the shares. As the same is being issued/transferred at face value instead of the
fair market value, tax implications need to be evaluated since any issuance/transfer of shares
below the fair market value will fall under the ambit of the Income Tax Act, 1961. Also, the
percentage holding of the founders needs to be taken into account so that their shareholding
percentage does not get diluted to a large extent considering that there will be future
investments, where the shareholding will get diluted further. Another aspect to be considered is
that, an issuance of shares will dilute the shareholding of all shareholders (including investors if
any) whereas the transfer of shares from founders will dilute only the founders’ shareholding.

Another way of compensating the advisors is by issuing shares to them by way of consideration
other than cash under section 62 (1) (c) of the Companies Act, 2013 (“Act”) read with rule 13 of
Companies (Shares Capital and Debenture) Rules, 2014. The private placement process under
section 42 of the Act will have to be followed for this purpose. The advisors have to raise invoice
for the services rendered which will be commensurate with the fair market value of the advisory
shares. Company will be responsible for TDS which will be a cash out on the Company. Further,
the entire amount shall be taxed in the hands of the Investor as income from other sources, at
the applicable tax slab.

Yet another option could be granting phantom stock options (“PSOs”) to the advisors. These are
options which are settled by way of cash settlement. It a performance-based incentive plan
through which the advisors will be entitled to receive cash payments after a specific period of
time or upon reaching a specific target. A separate agreement can be entered into for capturing
the details. This is directly linked to the value of the company’s share price. For example, the
advisors could have promise of ‘x’ number of shares at ‘y’ price at grant. At exercise, the
appreciation in the value of the share price, is handed out as cash incentive. Tax will be
applicable at the time of payout. However, unlike employee stock options, which is recognized
under the Act, PSOs by private limited companies does not fall under the ambit of the Act and
therefore, will be in the nature of contractual right. Please see our previous post on Phantom
Stock Options to know more about this.

It has to be noted that advisors are not eligible for employee stock options (ESOPs) as ESOPs
can be given only to employees and directors subject to the restrictions under the Act and
relevant Rules.

Advisory shares to Non-Residents:

It becomes a little more complex when the advisor is a non-resident since the shares
issued/transferred to a non-resident needs to be in compliance with the pricing guidelines as
provided in Foreign Exchange Management (Transfer or Issue of Security by a Person Resident
Outside India) Regulations, 2017 (“FDI Regulations“). As per the pricing guidelines, capital
instruments which are issued or transferred to a non-resident has to be priced as per any
internationally accepted pricing methodology for valuation on an arm’s length basis duly certified
by a chartered accountant or a SEBI registered merchant banker, in case of an unlisted
company. Considering these rules, granting of advisory shares to a non-resident can be a very
tricky situation. PSOs may be a better option in this case.

Formal Agreement with Advisors

The engagement with the advisors should be fruitful for the company and help in its growth. It is
advisable to enter into a formal agreement with the advisors which captures all important terms
regarding the engagement which will be beneficial for both the company and the advisors. This
will help in keeping track of the contribution of the advisors and also if in future, any differences
arise between the company/founders and the advisors, it will always help to have a formal
agreement. The exact role of the advisor and deliverables, vesting schedule, time commitments,
compensation, non-compete, confidentiality, exit related provisions, etc. should be captured in
such agreements. Specific milestones may also be included in these agreements. Once the
milestones are satisfactorily completed, compensation as agreed can be given.

Once the advisors become shareholders in the company, depending on the shareholders’
agreement (if any), the advisor might need to enter into a deed of adherence, so that the rights of
the shares are captured.

Mooting the utility of Representations &

Warranties Insurance Policies in exit deals for
a PE and VC Investor
M&As and Investment transactions have been growing rapidly in India and there is no doubt that
in such transactions allocating the risk of a breach is extremely important. In the recent past, we
are witnessing detailed indemnification clauses including the “loss” related clauses covering
grossing up of tax and grossing up of shareholding.

In the secondary sale of shares, venture capital investors are reluctant to provide representations
beyond their title in the shares that they hold. Traditionally, such investors will be hesitant in
providing any indemnity to potential acquirers because the traditional method of indemnification
involves the carry forward of payment rule, wherein the VC investor may be required to indemnify
the party beyond a certain time frame as well. Moreover, VC investors have a limited fund life
and hence prefer not to have indemnity obligations beyond the life of a fund.

The most common way in which a buyer protects itself is by incorporating provisions of indemnity
in the contract which requires the seller to indemnify the buyer for any breach of representation
or warranty. Traditionally, indemnification is the most common method of safeguarding one’s
interest in a transaction but there were many limitations to this approach, like risks for seller
wherein he is not able to receive the remainder of the purchase price, risks for buyer wherein the
buyer fears that the fund held back would be insufficient to cover all indemnity claims.

Traditionally used methods to secure the promises of indemnification are:

1. A holdback of purchase price

2. Escrow account for indemnification
3. Unconditional bank guarantees
4. Set-off against future payments

Representations and Warranties Insurance (“RWI”) could be a substitute or augment the

traditional indemnification mechanisms.

There are benefits of an RWI policy for both buyers and sellers in a deal/transaction. For sellers,
it eliminates any requirement for escrow or holdback that would otherwise reduce the money
received by the seller at closing, provide a cleaner exit with fewer contingent liabilities incident to
the sale. For the buyers, the bid looks much more attractive as indemnification is protected by a
third-party insurer, they can also increase the indemnity amount which otherwise would have
been highly-negotiated by the seller. For both parties, the process for negotiation and finalizing of
the transaction document is expedited and as the insurance covers all losses, sellers might not
be resistant to agreeing to post-closing indemnities in the deal as well.
What are Representations and Warranties?

In case of breach of any representations or warranties in the transaction document, the rise of
indemnity claims is almost always provided for. For the uninitiated, a ‘Representation’ is a
statement of fact about the current state of the business made by a seller to the buyer or by a
buyer to the seller in a purchase agreement[1]. A ‘Warranty’ in simple words, guarantees the
accuracy of the representation[2] and ensures compensation in case the representation so made
is false. Representations and warranties are negotiated clauses of the transaction and the scope
of representations and warranties depends greatly on the nature of transactions.

REPORT THIS AD

The terms ‘Representation’ and ‘Warranty’ are not defined in the Indian Contract Act, 1972,
however the Madras High Court in the case of All India General Insurance Co. Ltd. and Anr. v.
S.P. Maheswari[3] made a distinction between the two terms. The High Court said that those
representations which are made the basis of the contract are known as warranties, and
otherwise a representation simpliciter is rather something collateral which only has a tendency to
induce the other party.

Even after an exhaustive due diligence process, it is difficult for a buyer to know everything
relevant to the purchase, so these representations and warranties fill in gaps in the buyer’s
knowledge of a company.

RWI Policies for transactions, an Introduction

It is important to know that there are no “one size fits all” RWI policies offered by insurance
companies. Typically, parties go for tax insurance or a transaction-based insurance policy, we
will concern ourselves with the latter for this discussion.

An RWI is thus an insurance policy used in deals to protest losses arising due to the breach of
representations made in the transaction documents. Every transaction is a different transaction
and thus, every RWI policy is tailored according to the specific transaction. Each RWI policy is
negotiated to match up with the terms and language of each transaction.

What are the types of R&W Insurance available for transactions?

Typically, transaction insurance policies cover either the ‘buy-side’ or ‘sell-side’, however in terms
of practice a buy-side policy is more prevalent. The distinct features of them both are discussed
below:

1. Buy-side policy: In this the RWI policy is acquired by the buyer in the transaction. The
advantage of this type of policy is that a direct claim can be made against the insurer
without pursuing the seller for the same. The purchaser is able to recover its losses while
at the same time ensuring a clean exit for the seller. It is important the transaction
documents require a recourse-based buy-side insurance policy, wherein the seller is
liable to indemnify the counterparty in case the insurer does not make a payment under
the claim to the buyer. The buyer under this type of RWI policy gets additional time to
detect and report problems and gets an effective indemnity in public deals as well where
it will otherwise be difficult to recover such losses.
2. Sell-side policy: These policies are acquired by the seller in order to limit their losses. A
sell-side policy will typically cover the capped indemnity under the agreement along with
any additional defense cost for related litigation. A sell-side policy also reduces the
liabilities associated with post-closing breaches of representations and warranties such
as claw-back liabilities wherein the seller is required to make good the losses if any
breach with respect to representation and warranties occurs after the closure of the deal.
 A seller may also opt for RWI policy if he is a minority investor but bound to indemnify a
buyer via a joint or several liability. A sell-side policy is typically preferred by PE and VC
funds in order to give a ‘clean exit’ to its investors.

How to negotiate and obtain RWI policy during a transaction?

An RWI policy is typically completed in multiple stages, starting from the pre-indication strategy
wherein the buyer or seller reach out to RWI broker for discussing the objective of the policy,
then the broker submits important documents to RWI insurer specifying the details of the
transaction as discussed in the pre-indication stage. Once the insurer is selected and paid an
underwriting fee and provided with all the relevant documents, a diligence call is arranged
between the insurer, the parties to the deal, and their legal representatives. A first draft of the
insurance policy is soon provided by the insurer after the diligence call. It is important that the
language of policy should be in line with the language in the transaction agreement. The final
policy is generally negotiated in advance of the closing date of the transaction. The insurer then
provides a ‘binder’ to the policyholder that legally obligates the insurer to bind coverage at the
time of signing or closing. Once the binder is signed, the policy becomes binding.

REPORT THIS AD

Structure of an RWI policy should not be ambiguous and it should clearly mention what is
covered and who is covered under the policy. As a general rule, a claim under the RWI policy is
triggered only when there is a breach of covered representation and warranty. The RWI policy
should also mention whether the insurance is provided on ‘first party’ (providing coverage to the
policyholder) basis or ‘third party’ (providing coverage to another party based on policyholder’s
liability to another party) basis.

Limitations

Though RWI policies are instrumental in limiting the liabilities of the seller and buyer but there are
certain limitations to them, we shall list a few of them below:

1. Unlike a typical promise of indemnity, RWI policies will always be limited to a cap based
on the amount consideration in the deal/transaction, in developed jurisdictions, it is
typically 10% of the purchase price.
2. RWI policies only cover breaches of those representations and warranties that are
explicitly mentioned in the agreement. It does not cover breaches that are ancillary to the
covered representations and warranties.
3. RWI policies tend to contain numerous exclusions which are common to many types of
insurance policies. These exclusions are generally with respect to corruption,
environment, and bribery.
4. RWI policies exclude claims wherein the insured may have had knowledge prior to the
effective date of the policy of certain facts which could give rise to the breach of
representations or warranties.
5. Transactional RWI policies will not provide coverage for tax risks that might result from
transfer pricing agreements.
6. RWI policies can totally exclude certain issues identified in the buyer’s due diligence
process.
7. Unlike indemnity payments, proceeds from an RWI policy may be considered as net
taxable income in India.
Relevance of the Indemnity clause in transaction documents is still not
diluted

Inclusion of RWI in the transaction agreement would still not cover every liability arising from
breach of covered representations and warranties, thus there will be certain aspects where
indemnity provision under the transaction document would still hold value.

1. In determining the loss bearing capacity of parties till the payment retention amount for
the RWI policy.
2. In determining who will bear the loss arising from the items excluded from the coverage
under the RWI policy.
3. Provide for de-minimis amount i.e. the minimum loss to borne before making a claim
under the indemnity provision.
4. In cases where parties commercially agree to include a recourse-based insurance policy,
an indemnity provision in the transaction document proves helpful to enable the buyer to
enforce a claim against the seller.
5. RWI policies will always have cap on the recoverable amount and typically have a life of
3-6 years post the closing of the deal. An indemnity provision however, can still cover a
higher amount of indemnity or provide a longer time frame than what is provided under
the RWI policy.

Conclusion

An RWI policy provides an option to parties involved in M&A/Investment transactions to allocate

the risk associated with the transaction to a third-party, and thus proceed with the deal
themselves spending less time on negotiating the indemnity clause. It has become an important
tool in any restructuring process as it offers greater flexibility when compared to traditional
methods for addressing the liabilities (such as holdback, escrows, etc.). As the Indian market
matures further, it is important for RWI policies to get tailored as per the need of the Indian
market. Inclusion of RWI in the transaction agreements proves instrumental in boosting the
confidence of investors seeking to make exits in providing indemnities to potential buyers.
However, an RWI policy too has certain limitations and a well-drafted indemnity clause in the
transaction document is still needed to bring clarity on those aspects on which the RWI policy
falls short.

Term Sheets – Negotiation and Tips – Part 1

So, you have found someone (a VC) who wants to back you with the money you so desperately
need. Just sign above the dotted line. Well, not so fast…

A term sheet is a non-binding document that lays out the important terms under which the VC or
angel investor will make an investment in a company. A term sheet is used as a framework for
discussion, negotiations and clarifications, before the final share holder agreement is drafted. (A
share holder agreement or SHA is a binding document which legally formalizes the transaction.)

Since the term-sheet is the basis of the final SHA, it covers critical aspects like valuation of the
company, control over decision making, exit options and how the investor’s capital would be
protected against downside. Since a term sheet is usually drawn by an investor, it is usually
loaded in favor of the investor and usually designed to protect the capital that the investor invests
in the company, and to protect the investor from any action that may be detrimental to the
investor’s financial interest in the company. It is therefore important that entrepreneurs
understand the terms of a term sheet, do their homework well, decide on what terms they are
comfortable with and what they are not comfortable with, and then, discuss the same with the
investor. It is advisable to consult a lawyer who understands term sheets, and can advice you
about what terms to be flexible on and what terms to accept. And most importantly, help you
understand the consequences in case there are terms that are not in the best interest of the
venture or the entrepreneur.

A term sheet, at a high level, can be broadly divided into two buckets – the commercial and the
legal component.

www.investopedia.com is a good place for you to begin with for understanding the concepts and
definitions.

Commercial Legal

Valuation Board Composition, Protective Provisions (Veto Rights)

Liquidation Preference – 1X, 1X+ participatory Investor Rights- ROFR, ROFO, Tag, Pre emptive Rights

ESOP Founder Vesting

Dividend Exit mechanism

Founder Vesting Information & Registration rights

Anti Dilution- full ratchet, broad based

The reason why we present it this way is that, while “commercials” can be negotiated quite a bit,
the “legal” part of it cannot be negotiated to the same extent. Founders need to pick their battle J

REPORT THIS AD

This post briefly touches upon valuation and liquidation preference.

Valuation.
Valuation can be broken down into pre-money and post-money valuation. The pre-money
valuation is what the investor values your entity as of current date. The post money valuation is
the sum of the pre-money valuation and the investment amount. To give you an example, if your
company is valued at INR 3,00,00,000 and the investor is putting in INR 1,50,00,000, then the
post money valuation is INR 4,50,00,000. The valuation helps the investor determine the stake
he would like to take in your entity.

TIP: In early stage investment, valuation is more of an art, unlike later stage companies which
would have revenues and a prior history to base valuation on.

While valuation is the most important aspect, the entrepreneur should evaluate the other benefits
too – marquee investor, network, opening doors with large enterprises, recommending a smart
employee, probably their ability to obtain brilliant exits. Take a look at their portfolio and probably
speak with the company founders to get a better perspective of the “value add”.
The scale that the business can achieve and the founders ability to exhibit that in the plan, truly
helps. Also, the founder should not forget in exhibiting their commitment to the scale.

Being educated of valuation numbers in other startups similar to yours or what the market is
generally garnering helps.

Like in any other negotiation strategy, having more than one offer increases the negotiation
strength, but in depressed markets having one offer itself is difficult. Watch, if you are being
extremely desperate and also showing it.

The best strength, ofcourse, remains in building a rock-star product / startup.

Some of our experiences, if that is going to help you:

Buzz in cloud –

Context: A data center with a very large tract of land allotted by the government, with prior
experience of having built a data center, very senior management team, at a time when “cloud” is
a buzz word.

Outcome: This should get great negotiation strength, right? Not necessarily, the desperation was
so high to have money in the bank, that literally nothing was negotiated.

REPORT THIS AD

Media Moghul –

Context: Senior management professional with immense execution capabilities in India’s richest
company, was never an entrepreneur, about 48 years old, no team, just a ppt of the idea, no
proof of concept yet. There’s nothing to negotiate? Not quite, the idea is so immensely scalable
anywhere in the world, had the ability to stretch into multiple different business segments,
founder charms enterprises to give him extremely expensive equipment with a growth-story.

Outcome: We close the deal with investment terms that one can dream of.

India education story –

Context: Two founders who studied finance in NY, think of a product in technology (have no
knowledge of tech), outsource the entire product build to a vendor with no contract or IP
ownership terms discussed (well, there was an email broadly describing royalty payments and
equity sharing etc.), extremely ambitious, projections of revenue and early traction very
promising, very aggressive valuation expected by the founders.

Outcome: The term sheet was signed-up with the aggressive valuation with a clause that, if the
numbers portrayed were not reached, then the valuation would be adjusted. The deal fell through
during due-diligence, due to incorrect portrayal of number of earlier users, early revenues were
not true, no IP owned, the tech vendor disappeared without giving out the source code.

Dividend
Dividend in simple words refers to a percentage which provides a share in the profits of the
company. If the investment uses ‘preference shares’ as the instrument, then from legal
perspective the instrument has to mention the rate of dividend. A typical dividend clause reads as
cumulative or a non-cumulative clause.
 TIP: Investors look for big exits and not the small money in the form of dividends. From a
founder perspective, keep the dividend rate low, can be as low as 0.001% and non-cumulative.
(i.e. dividend is only paid for the year it is declared in, as opposed to an accumulation till the year
it is declared).

Liquidation Preference

Liquidation preference in simple terms determines how the pie is shared in case of a liquidity
event.(the money sharing clause when there is an exit). The clause also determines the
sequence of pay-out.

REPORT THIS AD

Liquidation event typically includes IPO, company buy-back, promoter or promoter led buy-back,
trade sale, merger, acquisition, strategic sale (which may lead to change of more than 51%
control), dissolution or winding up and the like.

The term sheet will specify the ‘preference’ the investor will get over other shareholders
(founders/other early investors). The term sheet carries the multiples of returns the investor shall
get, in the case of liquidation.

The clause also would also detail whether the investor just participates (i.e. to the extent of his
shareholding percentage) or wants a 1x + participatory, also known as double-dip (i.e. the
investor gets to take his investment amount first and then participate in the remaining proceeds).

Though majority of the deals in India are 1x + participatory, we have seen few deals with 1.5x +
participatory. It was in one deal we saw 2x+ participatory and interestingly it was from a social
impact fund.

E.g. if the investor invests Rs.1 cr for 25% stake in your startup, and the term sheet stipulates a
2x return for the investor. Lets examine a Rs. 10 cr exit.

 If just participatory right, the investor gets 25% of Rs. 10 cr = Rs. 2.5 cr.
 If 1x+ participatory, the investor gets Rs.1 cr + Rs.2.25cr = Rs. 3.25 cr.

So, you negotiated hard for a 25% dilution during the valuation clause?

What’s the money that the founder makes if there is a small exit, say Rs. 5 cr.?

TIP: From a founder’s perspective, you may think of negotiating just participatory right.

If individual angel investor, he may evaluate but from institutional investor perspective, his math
doesn’t add up for providing a return to their limited partners (the investor in the fund).

You may want to think of limiting the extent of participation in the remaining proceeds after the
initial 1x. Uphill task, but we try.

If you have had some great experience, please share.

Term Sheets – Negotiation and Tips – Part 2

NEGOTIATING FOUNDER VESTING CLAUSE IN EARLY STAGE
TERMSHEETS
In Part 1(refer to https://novojuris.wordpress.com/2013/08/27/term-sheets-
negotiation-and-tips-part-1/), we pointed out on negotiating a few ‘commercial’
aspects. In this post we detail Founder Vesting. Please note, that Founder Vesting is a
clause one would see in early stage investments, since the bet is on the jockey
(founders) more than the horse (startup).
In early stage, specially so in the technology space, where the founders would have
spent time on building the POC or got early customer traction, the cash investment
‘may be’ very small. Also, the investment is based on the execution capabilities of the
founders and the startup team. When an investor is taking the risk, he would like the
founders to be tied in to the startup as well. If the founder has invested substantial
money, then he/she should think through, if a vesting clause is required at all.

While ‘vesting’ typically is used to express ownership in shares over a period of time,
you will note that founders are already ‘owners’ of the shares, when the investor
takes a stake. So, this clause on vesting describes treatment of shares if a founder
leaves the startup.

Some details of the clause before we delve into negotiation tips:

 Vesting period: The years that vesting would be spread over and points in time (monthly/
quarterly / annual)
 Percentage of shares vesting.
 An exiting founder: Treatment of shares on who would hold / transfer. Would the reason
of leaving important in determining the pricing?
 Accelerated vesting events.
VESTING PERIOD: Here are some of our experiences:
Majority of the cases, the vesting is a 4 year period. A friendly investor typically does
a three year vesting.

Tip: If the founder has been working on the startup for a while (more than 1-2
years), then it’s a good point to ask for an upfront vesting of about 25% to 50%. We
have seen between 20% and 35%, being accepted by most early stage investors.
Tip: Annual vesting is logistically easy to implement / understand. We believe that
since the founder already owns the shares, the logistics of ‘vesting’ do not need any
additional step other than the arithmetic calculation should an exit situation arise. A
monthly vesting should be okay(i.e. an equal number of shares over the vesting
period which might read as 1/36th or 1/48th number of X shares.)
Tip: While all the math and formula is in place, please try and get a table which
describes the exact number of shares in the shareholders’ agreement. While you may
think this is just a presentation, we have found that it provides complete clarity.
If the founders already have a founders’ agreement, most investors would like to
honor it. Also, a founders’ agreement has really helped in sorting co-founder issues
very amicably.

Now, for the tough one, TREATMENT OF SHARES:

A key component of the ‘vesting clause’ is determining the treatment of shares,
should a founder leave during the vesting period.
Statistics as per our database (it may be skewed and may not be a good
representation of the Indian scenario): Nearly 8-10% of the investments at some
point face co-founder issues. The percentage is very low / negligible before
investment. Most cases arise, when there is traction by investors and prior to
investment. It raises its ugly head again, prior to Series B or when progress (scale) is
not as expected.

We will share our experiences of the many reasons for co-founder issues, very
shortly. For this post, we would like to broadly classify the reason as Good Reason or
Bad Reason (Cause). ‘Cause’ is generally defined and includes acts such as
misconduct, absenteeism, embezzlement, theft, abetting strike and the like. ‘Good
Reason’ is that which is not a ‘cause’ and intended to cover change in the founder’s
role, pivot of the company business which may mean founder’s skill irrelevant or not
the right person. The biggest discussion typically is classification of ‘non-
performance’ of a founder, which we believe is subjective.

This is what we generally see in early stage investments.

Cause
Good Reason

Vested Unvested Vested Unvested

The
Promoter can
retain or Transfer to
Transfer Transfer to sell to the
to remaining the employee remaining employee
Treatment shareholders welfare trust shareholders welfare trust

At fair
Price At face value At face value market value At face value

TIP: Since investor’s stake holding is a function of valuation, then an exiting

founder’s shares should go to continuing founders or ESOP? The argument is around
the increased risk of the investor and therefore the claim of the investor to be eligible
for a percentage of such exiting founder’s shares. Founders need to think about
having the shares available to remunerate new hires or a replacement. Hence, it’s a
good idea to have an ESOP Trust to hold the shares.
Founders’ Agreement, which clearly details the vesting schedule, has saved the
company from letting the founder walk away with a big chunk.

ACCELERATION: Termsheets do provide for acceleration of vesting in cases of

acquisition, merger and sale of business. There would be some detail for untoward
incidents of death / disability.
Here are some examples of the clauses:
The shares held by the Founders would get unlocked in equal annual installments
over a period of 4 years from the Second Closing by the Investors. If a Founder
decides to leave the Company at any time before such period, the locked shares
would have to be sold at face value to the existing shareholders and that the
Investors will be given the first option to purchase the said shares. Should
Investors decline to purchase the shares, such shares shall be sold to the other
shareholders, in proportion to their shareholding. Such shares, at the Investors’
discretion, may also be placed into an ESOP trust to be made available as incentive
for attracting other senior employees that may be required to take the company
forward.
The Shares held by the Founder shall be locked in for a period of 3 years. 25% of the
Shares held by each Founder shall vest on the execution of the Definitive Agreement
(“Released Shares”) the remaining 75% of the shares held by each Founder
(“Restricted Shares”) shall vest monthly over a period of 3 years (“Restriction
Period”). The treatment of shares in case of determination of the Founders
employment during the Restriction Period shall be detailed out in the Definitive
Agreement.
It is important to recognize that the vesting clause works for both – the founders, as
well as the investors.

NEGOTIATING TERMSHEETS: BOARD REPRESENTATION

– PART 3

We covered interesting tips on negotiating the ‘commercials’ of a termsheeet

– https://novojuris.wordpress.com/2013/08/27/term-sheets-negotiation-and-tips-
part-1/and https://novojuris.wordpress.com/2013/09/03/term-sheets-negotiation-
and-tips-part-2/.
Negotiating commercial aspects of the termsheet is kind of expected unlike ‘controls’
(please see Part I of this series). Most investors would give a standard response of
‘style of investment’ and ‘these are minimum controls to retain our investment in the
company’ and shy away from negotiating. They do have a point here.
If you take a loan from a bank, there is a requirement of an asset guarantee,
corporate guarantee and/or many a times, a personal guarantee. Banks also have
monthly information and reporting requirements. There is an interest that is paid,
on the loan which is the ROI the bank works on. If the loan is a large one, there will
be certain matters which require the bank’s prior approval. Compared to the bank
loan, an early stage investment does not require such guarantees. What they do
believe in is the founding team and the scalable idea, with no guarantee of getting
back their investment amount. With this perspective, you could negotiate the
‘control’ aspects. No, we aren’t trying to be philosophical, but suggesting that you
prioritize your list of things to negotiate.

Board Composition:
Here’s how the mechanics work: In a company, the decisions are made at two
forums, meeting of board of directors and shareholders’ meeting. The powers that
vests with the board, is then delegated to the CEO and others in the company.
In a board, one director has one vote. While in a shareholder meeting, one share gets
one vote. (This is where a majority (51%- ordinary resolution) and (75% – special
resolution) voting requirements matter). When an investor takes a 26% stake, she
gets a veto voting right on important matters, without which, special resolution
matters cannot be decided by the company.

Also, in a limited liability company, the investor gets a control by having a

representation in the board and having veto rights on a list of really important
matters called ‘Reserved Matters’. This means that without the investor’s consent,
the agenda items listed in Reserved Matters cannot be decided upon by the rest of
the board, though the rest of the board form a majority.

Before you think it is very prestigious to be a Director of the Board, let me quickly
add that it does come loaded with liabilities, duties, responsibilities under various
statutes (labor laws, tax laws, economic laws, securities related laws and Companies
Act.) When there are non-compliances, it is the directors who are held responsible.
So, you also have a few institutional investors who do not take a director’s position
but opt for a ‘board observer’s position’ which is not a legal position and does not
carry voting rights.

Board Composition or the size of the board, determines the ratio of the founder-
to-investor representation on the board. The number of board seats for the investor
should be relative to the size of the investment.
In India, we typically see that more 15 – 26% shareholding calls for one board seat, in
early stage investments (the range covers angels, angel networks, micro VC’s, seed
stage, series A). We also see that the investor gives away the right should their
shareholding fall below 5%. This is limited only to board seat and others, such as
right to receive information or veto on shareholder related Reserved Matters
continue.

Some tips: (most of it is common-sense do you say?)

 The lead investor gets a board seat – This payments company with a really
soft spoken founder: We witnessed a not-so-fun round of negotiation, when 3
institutional investors, totaling to about Rs.1.5 crores of investment, each asking
for a board seat and each investor having a really long list of Reserved Matters. It
was quite a task to trim it to one board seat and one common Reserved Matters
list.
 If in a large network of individual investors, get the decision making done
through one person, so that the investor group dynamics are minimized and the
founder can focus on business – This feedback company founder thanks us quite
a bit for this tip.
 If co-investment, the decision making can be as a group. But, it does come with
its challenges during ‘exit’ scenarios.
 It is suggested to have an odd number (as opposed to an even number) of
individuals on the board, so that there is no ‘tie’ in the decision making.
 It is ‘nice’ if the founding team has a majority of directors, the dynamics of the
number should work in their favor. But, if the Reserved Matters (typically a list of
about 25 to 30 items, which covers nearly all important aspects of business
decisions) require an investor’s affirmative consent, then, do you think it helps?
 Ensure that the Independent Director is indeed independently appointed and
takes independent decisions in the interest of the company. – The investor in this
deals company said, ‘Oh, we’ll get you an independent director who adds
tremendous value to your business.’
We enjoy many discussions with entrepreneurs. But this one comes to my mind
when I write. It was a majority stake sale (51%) that we recently completed and the
BITSian founder, true to his engineering (as in, logical thinking) background comes
up with an entire working of 49%:51% stake and is adequately represented with a 25
member board seat. You get the point.

Keep the board size small + meaningful.

NEGOTIATING TERM SHEETS – EXIT STRATEGY – PART 4

The most critical aspect in any investment deal for the investors is the exit clause,
which is when they get to see the return on investment. In a typical early stage
investment deal, the options are initial public offering (IPO), strategic sale to a third
party, company buy-back and in a few deals (rare), we see promoter / promoter led-
buyback. In this post, we touch upon some of these exit avenues.

The termsheet would refer to the exit options and also refers to the definition of
Liquidation Event.

Liquidation Event covers

1. Winding up. i.e. things don’t go well and the company needs to be shut down.
2. Consolidation, merger, reorganization where the current majority of shareholders do not
continue holding a majority after such corporate actions or change in control of more than
50% shareholding. Sale of more than 50% shareholding to another party.
3. Transfer of substantial assets.
Given that the investor will have to repay his investor (limited partners or LP as we
call them), the time-horizon is driven by the LP’s terms in the fund. We generally see
5 years to 7 years for investors seeking exit.

In early stage investment, (example, incubators, accelerators, mentors, friends and

family round, individual angels), we have seen that they would like to retain flexibility
of exiting (either full or in part) at the next round of investment. This is a point that
the entrepreneur has to be conscious about, because this has an impact on the deal
closure timelines.

Tip: Angels may not be angels. (Please don’t get us wrong. Angels provide huge
strategic value and the money required in the formative stages of the startup).
In one particular case, we saw that the an angel network actually negotiate the
investment terms to an extent that it was becoming a Series A investment deal breaker,
because (i) they were not consulted by the founder prior to signing the Series A
termsheet and (ii) wanting rights like the Series A investor without participating in the
investment round. We finally figured that the underpinning thought of the angel
network was to get an exit and at a price higher than the Series A round. This is where
experience of handling investment deals becomes critical and probably founders’ soft-
skills.
In earlier posts we have discussed that the investors are keen on big exits and multiply
their investment amount and not so keen on the dividend amount.

Tip: Typically in a friends and family round we have seen high dividend rates or a
request for return of investment money when the business becomes ‘life-style
business’. In these cases, a founder can think of structuring the deal as optionally
convertible debentures (if investor is in India).
You would now realize that there is an interplay of instrument, dividend rate, exit
option and liquidation preference.

The clause on Exit talks about the process of exit while the clause on liquidation
preference details the distribution of the money received on exit.

Let’s look at strategic third party sale (also called as trade sale). The exit can either
be for only the investors or all shareholders. M&A (Mergers & Acquisitions), of
privately held company is the most popular type of exit strategy. Merger is typically
through a court process wherein two or more entities combine and shares of the
acquiring entity is exchanged. Acquisition, could be either asset sale or entity sale.
Asset sale is where the acquirer cherry picks the assets and many a time leave the
liabilities behind. Entity sale is typically done as a share purchase agreement. Now,
each of these are big topics to write about, since there are many nuances including
taxes, if it is a majority stake-sale and the like. In all of these scenarios, the purchase
price is determined by the acquirer. If the investors like the deal they should exit?
Tip: Remember we said the investor wants to see the investment amount multiply?
During exit, the investor evaluates the growth potential of the company, IRR (internal
rate of return) on the investment amount and many other external factors. It is
recommended that some base / floor price of exit (formula / fair market value /IRR)
is determined, because if there is no exit provided within the 5-7 year horizon, then it
gets linked to default-drag along right. (Default Drag Along Right is the ability of the
investor to drag the shareholders and sell it to a party at the price /terms that the
investor determines with such third party, only if the promoters have not been able to
provide an exit)
Super Tip: Super important for the founder to not provide for a plain Drag Along
Right, where the investor can drag at any point in time and have only Default Drag
Along Right.
In a buy-back of shares by the company, there are laws, rules and regulations
governing such buy back. Up until recently, buy-back was also used to overcome the
dividend distribution tax and the recent Finance Act, 2013 which imposes a 20% tax
on the company undertaking the buyback, very much like dividend distribution tax.
Another recent development is the cooling off period between buy-back in the new
Companies Act 2013 as compared to the Companies Act 1956. Earlier, we had a board
approval process for 10% of equity shares and shareholder approval process for 25%
for shares. While a cooling off period of one year had been prescribed between two
successive buy-backs authorized by the board of directors, however enabling provision
was captured where a buy-back of up to 10% of the paid up equity capital and free
reserves of the company by way of a board resolution, immediately followed by another
buy-back of up to 25% of the total paid up equity capital and free reserves by way of
shareholders’ resolution
The new Companies Act 2013 prescribes a cooling off period of one year between two
buy-backs which means multiple buyback in a year is not possible. This could have an
impact of reducing the ability to give a timely exit to private equity investors even in
cases where the company may be sitting on surplus cash.

Tip: We recommend that the promoters think about having a floor price (IRR may be
a good one), so that an exit discussion gets enabled.
While providing for a Promoter or Promoter led buy-back seem to be a great
option, generally, we do not see that listed as an option in early stage investment.
Strange, isn’t it? Do you think it is a notion that the early stage promoter would not
have the money to buy-out or is it because the price and terms would not be favorable
to investors?
Though the term used is ‘buyback’ the transaction is a secondary sale of shares
between two shareholders.

Tip: Given the changes in taxation, promoters need to understand the concept of
withholding of taxes. In one particular case, the Singaporean investor was not willing
of the promoter to withhold taxes (completion of this transaction was a dependency
on a Series B deal) and finally the promoter under took a sub-optimal route of having
a stronger indemnity clause.

We would really love to hear your experiences and thoughts.

In the next post, we will discuss other exit options.

NEGOTIATING TERMSHEETS: EXIT

OPTIONS – Part 5
In the previous post ( read Part 4 here) , we discussed a few exit options. In this post we discuss
about IPO, which is the preferred option in most investment deals. Many a time, even the early
stage investment agreements capture quite a detail.

As captured in the previous post, investors invest to exit with big returns and investment decisions
are targeted towards startups which can create those great exits. Promoters on the other hand,
may or may not have the same urge to ‘exit’ but the vision could be to create a long term successful
organization. However, the investment agreements require the promoters to enable or provide exit
to the investors, lest the investor may trigger its ‘default drag along right’. It is very imperative to
have clarity on the exit mechanism in the agreements including the timing of such exit or the
decision tree (sequencing) of various exit options.

Tip: While one of the ways is detailing for all exit options to be provided in 5-7 years from
investment date (IPO, trade sale, strategic third party sale, company buy-back), a smart way would
be sequence the exit. Example IPO in 6 years, else provide for strategic third party sale after 6
years, beyond that time the investors can pressurize the promoters for a company buy-back at a
pre-agreed IRR and only if nothing works, only then can the investors trigger their default drag
along right. In one particular case, the company was not scaling up to the expectation and the
investor after 2 years of investment, couched a drag along as a third party sale. The promoter did
not make any money nor did he get a great salary during the investment (because it was a small
series A round).

Of the many exit options available, IPO (initial public offering/ listing of securities on stock
exchange) is one of the most popular exit option, because when there are right market conditions,
an IPO option is likely to enable the investor to realize very high returns. However, as always,
there is a flipside as well. The economic conditions for going public, is both the growth and scale
of the company and very importantly external conditions which are not within the control of the
promoters. There are very high costs involved in carrying out the IPO process, very high levels of
information disclosures, strict regulatory requirements and restrictions. Another key point is that,
the investors will exit when its shares are actually sold on the stock market, which might not happen
concurrently with the IPO and accordingly the investor might be exposed to fluctuations and
other market risks that are related after the IPO is carried out.

Tip: In order to protect a small IPO, which would enable investors to exit but may become burden-
some for the promoters, it is a smart negotiation point to have a ‘qualified’ IPO, which provides for
a total amount, which is sufficiently large to guarantee an IPO in major stock exchanges.

Given the importance of exits, even early stage investment deals capture IPO in detail. IPO can
be either through issuance of new shares or offer of existing shares for public subscription. IPO
can be either in India or outside of India. While there are many regulatory requirements that a
company needs to ensure before getting into a scheme of an IPO, some of the eligibility criteria for
a company to fulfill are, Net worth of Rs.1crore in each of the preceding 3 years. Net tangible
assets of at least Rs. 3 Crores for each of the preceding 3 years along with track record for
distributable profits for 3 out of immediately 5 preceding years. There are requirements of lock-in
of promoter shares. Hence, the clauses in the SHA, wherein the investors shall not be treated as
promoters and not subject to lock-in requirements as per the listing guidelines.

While IPO on main stock exchanges is great, there are other platforms like SME Exchange. There
are two basic criteria for determining the status of SME are capital and profits. Capital requirement
is for a company to have minimum paid up capital of Rs. 1 crore and a maximum of Rs. 25 crore.
Profit criterion is for a company to have distributable profits in two out of last three financial years.
The amount that can be raised from the public is upto Rs. 25 crores. To facilitate the listing there
are two platforms available in India BSE-SME Exchange and EMERGE –NSE.

A quick look at the other eligibility requirements for SME IPO:

Maximum Post Issue capital of Rs. 25 crores

 Minimum number of members for a public issue is 50

 Market making is mandatory for 3 years
 Underwriting is required for 100% of the issue size (Merchant Bankers to underwrite 15%
in its own account)
 Issue lot size is dependent on the number of shares based on IPO price band
 Trading lot size is multiples of Rs.1 lakh.
 After listing the requirement of minimum number of members is not required to be
continued.
 Companies listed on SME Exchange can anytime migrate to the main Bombay Stock
Exchange, provided shareholders’ approve.

While there certainly are benefits in SME listing, it might be a tad unappealing to investors who
want bigger exits with greater liquidity on the markets.

Listing without IPO for SMEs: SEBI’s new ‘Listing Of Specified Securities On Institutional Trading
Platform) Regulations, 2013’ preamble states to provide easier exit options for informed investors
like Angel Investors, VCFs and PE etc to provide better visibility, wider investor base and greater
fund raising capabilities to such companies. These initiatives to help in greater exit opportunities
and create liquidity for these investors. Further, SEBI has proposed to relax few norms for the ITP
listing, where minimum amount for trading or investment on the ITP will be Rs 10 lakh and such
companies would also be exempted from offering up to 25% of its shareholding to public through
an offer document in order to get listed. There are further eligibility criteria that are listed by SEBI
for availing the listing on ITP.

Further provisions are proposed where companies listed on the ITP will not have access to public
money, can continue to have private placement rounds. Therefore, listing can be done without an
IPO and the expenses associated with it. The biggest advantage is that it is economical and less
procedural as compared to the IPO process.

Traditionally, the investment agreements have envisaged listing outside of India as well. Specially
so, if the investment fund is not based in India. So, clauses related to IPO in the USA with demand
rights, piggy back rights etc. are captured. Piggyback rights entitle investors to register their shares
when a company goes public. Whereas, demand rights requires the company to conduct a public
offering and is a superior right compared to the piggyback rights.

Tip: Savvy promoters should negotiate for piggyback rights alone. We also understand that
promoters can ask for the same right.

More often than not, during the early stage investment the promoters are keen on getting the
investment and scaling businesses. Many a time, exits specially IPO looks like a distant dream
and the focus on these clauses is usually less of a priority during negotiation. We would love to
see workshops/ seminars on ‘exit options’ and we could share our knowledge.

Our second customer at NovoJuris, Pennywise Solutions got acquired by Ogilvy and it is very
satisfying to see these success stories. Even more satisfying is the squeaky clean due-diligence
report of the company that Ogilvy was thrilled with. We’ll share this experience (‘sell-side
experience’ as they call) pretty soon. Read article here.

Tip: While there are termsheet level discussions for acquisitions that come by, many a time we
have seen the deal fall through for non-compliances. We urge the promoters to take compliance
seriously. It is boring but very important.

We would really love to hear your experiences and thoughts.

DUE DILIGENCE

Today’s competitive forces have brought a paradigm shift in the mindsets of the
investor community, that focuses more on business ground rules than ever before.
Profitability is not the only parameter which plays a role. Preferably, the
product/business must also exhibit a trend of sustainable development in revenues
along with good corporate governance.

To ensure good corporate governance, what is required is an intensive and thorough

Due Diligence (“DD”). In the private equity scenario, it can make or break a deal.
More often than not, this being a condition precedent, it is an onus on the
entrepreneur to support the DD process. The DD process essentially intends to
ensure compliance to all applicable laws, identify gaps, ascertain risks and take a
final decision.
DD Vs Audit:
Now, the DD process is somewhat different from an Audit process. Audit aims at
bringing to the fore; a true and fair picture of the current status, however, DD aims at
negative assurances i.e. identifying risks, if any. Moreover, the Audit process is
generally defined and scoped out on the basis of the ‘laws of the land’, but DD is
somewhat more scoped out to ‘deal-specific and limited issues’.

The Process:
DD usually starts at the inception of a deal. It has become a legal yardstick which
enables prospective investors to enter into a transaction.

Recently there have been many instances where concerns were raised, both privately
and publicly, about the intensity; quality and timelines of due diligence carried out
by professionals around the world. Especially in India, which has witnessed major
corporate scams over the last decade or so, it is critical to deploy a structured
methodology for carrying out effective Due Diligence.

Due diligence usually involves looking into the various aspects/divisions of a

company, subject to the ticket size of the investment. Depending on the industry, a
high net worth deal would probably involve an intensive DD process covering all
aspects – Legal, Financial, Secretarial, IT, HR and others. The process covers –
reviewing documents; seeking more information; identifying gaps and providing a
solution to all identified issues. All this is clubbed into one document – commonly
referred to as the DD Report.

Takeaway for Entrepreneurs

The investment community is very highly networked and it becomes imperative for
the entrepreneur to ensure that he times his pitch accordingly.

The best trick to succeed in this game is to ‘anticipate’. An entrepreneur, who can
anticipate Due Diligence, will ensure the compliances are in place even before he
starts to pitch the investors.

Technology can play a vital part in ensuring that documentation is in order. Online
data rooms like Dropbox, Box and other cloud services are excellent platforms to
record and keep – all executed contracts; originals of the licenses procured and other
related documents – in one place.

An entrepreneur today, needs to and must think ahead, making sure that his
company proactively responds to any Due Diligence that the investor may wish to
undertake. This will substantially reduce the turnaround time for closing the deal
with his investor. It is critical for the entrepreneur to close the deal, expedite the
transaction and get the money in the bank.
Another simple, yet effective tool for an entrepreneur is to be painfully honest and
share their concerns (if any), for a long and effective relationship with their investor.
Early stage investors definitely like to follow this cardinal principle – ‘the bet is on
the jockey and not the horse’, therefore, it is highly recommended that the
entrepreneur be open and expressive with the investor.

Experts Required:
Contrary to the general belief, that professionals like lawyers and company
secretaries should be hired when the business relays substantial growth, we strongly
suggest that they be hired BEFORE any legal contracts and agreements are signed!!
Simply put – prevention is better than cure. Most entrepreneurs enter into multiple
contracts, agreements and understandings with their employees, customers, clients
and shareholders in the initial stages, which usually haunt and hurt their businesses
in the future.

The most common and vulnerable areas of concern are –The Founder’s Agreement,
Intellectual property protection, promises made to certain employees etc. Hence, it is
always advisable to know on what you are riding on and to make sure you have
control over it.

Conclusion –
A study conducted by Standard & Poor’s has revealed that in India, there is a direct
relationship between corporate governance and market value. The takeaway here
being that – investors definitely take DD into account when deciding where to put
their money. It also states that “only companies above a certain threshold of
governance level, trade at a premium”. Hence, Due Diligence plays an important role
in the investment scenario. A ‘clean’ company is a huge attraction to a potential
investor.

MANDATORY REGISTRATION – ESI

A business entity needs to procure, few of the registrations as per various state and
central laws, depending upon the eligibility threshold provided under each act.
One of the essential registrations, subject to Employees’ State Insurance Act, 1948
(ESI Act), is employee state insurance registration.

Employees’ State Insurance Scheme of India, is an integrated social security

scheme aimed at providing social protection to workers in the organized sector and
their dependants in any contingencies related to health due to an employment injury
or occupational disease. The scheme tailored to provides full medical facilities to
insured persons and their dependants, as well as, cash benefits to compensate for
loss of wages or earning capacity in different contingencies. Some of the provisions
are as under –
I. Applicability:
Any business employing more than 10 people shall be required to mandatorily
procure the registration under the ESI Act.
There has been amendment in the definition of ‘Factory’ and the previous
categorization of 10 employees with power and 20 without power, has been
omitted. Any establishment employing more than 10 people is required to
get registration mandatorily.
II.Contribution:
The ESI Scheme is mainly financed by contributions raised from employees covered
under the scheme and their employers, as a fixed percentage of wages. The rates of
contribution are:

A Employees’ Contribution 1.75% of Total Wages

B Employers’ Contribution 4.75% of Total Wages

In a situation where all employees are drawing above Rs. 15,000/-, you still need
registration, we file a letter that there are no employees who draw a
gross salary lesser than Rs. 15,000 per month and therefore no
contribution, filing of returns etc. is still required. Therefore ESI
registration is purely from a compliance perspective.
III. Collection of Contribution
An employer is liable to pay his contribution in respect of every employee and deduct
employees’ contribution from wages bill and shall pay these contributions at the
above specified rates to the Corporation within 21 days of the last day of the Calendar
month in which the contributions fall due. The Corporation has authorized
designated branches of the State Bank of India and some other banks to receive the
payments on its behalf.

Contribution Period and Benefit Period

There are two contribution periods each of six months duration and two
corresponding benefit periods also of six months duration as under.

Contribution Period Corresponding Cash Benefit Period

1st April to 30th Sept. 1st Jan of the following year to 30thJune

1st Oct to 31st March of the year following 1st July to 31st December of the year following

IV. Wage Limit:

The existing wage-limit for coverage under the Act, is Rs.15,000/- per month (w.ef.
01/05/2010) That is, all employees earning up to Rs. 15,000 per month are
applicable for ESI Contribution. Employees earning Rs. 15,001 per month and above
are exempted from ESI Contribution.
The wage ceiling for coverage of an employee with ‘disability’ is Rs. 25,000/- per
month (w.e.f. 1/April/2008).

V. Penal Provisions for Delay in payment of contribution:

 Period of Delay Rate of Damages (%)

Less than 2 months 5%

2 to 4 months 10%

4 to 6 months 15%

6 months and above 25%

VI. Maintenance of Records:

In addition to the Muster roll, wage record, and books of Account maintained under
other laws, the employer is required to maintain the following registers for ESI:

1. Employees’ Register in new Form 6

2. Accident Register in new Form -11 and

3. An inspection Book.

The immediate employer is also required to maintain the Employee’s Register for the
employees deployed to the principal employer (if any).

VII. Registration Procedure:

Registration of an Employer:
The Factory or Establishment to which the Act is applicable is to be registered within
15 days by submitting an Employer’s Registration Form (Form-01) to the concerned
Regional Office and obtain an identification number called the Code number which is
to be used in all the Correspondence relating to the Scheme. The Form 1 should be
accompanied by a Form 3 (Return on Declaration).

Documents Attached with Form 1:

a) Documents relating to the constitution of the Factory/Firm/Establishment,

b) Evidence in support of the date of commencement of production/business/first

sale,

c) List of partners/ Directors with their addresses,

d) Copy of the PAN

e) Address proof like pass port/voter identity card, month wise employment
position etc. are the essential documents.
Registration for Employee:
At the time of joining the insurable employment, an employee is required to fill in a

Declaration Form (Form1) and submit a family photo in duplicate to the employer,
which is to be submitted to the ESI Branch Office by his employer.

The employee is then allotted an insurance number for the purpose of his
identification under the scheme and issued a temporary identity card for availing
medical benefit for self and family for a period of three months.

Thereafter, he is provided with a permanent photo identity card. A person once

registered need not register again in case of change of employment. The same
registration can be transferred from one place to the other.

Registration fees:
There are NO Registration fees applicable for Employees’ State Insurance Scheme.

Time limit for Registrations:

The entire process takes about 30 days.

VIII. Recent Amendments:

There have been quite a few amendments post ESI Amendment Act, 2010, some of
them summed as below:

 The definition of ‘dependent’ now includes “widow, a legitimate or adopted son who
has not attained the age of twenty-five years, an unmarried legitimate or adopted
daughter.
Definition of Employee: includes any person employed for wages,
a) Directly employed by principal employer

b) Employed by or through immediate employer or under the supervision of

principal employer or his agent.

c) Whose services are temporarily lent or let on hire to the principal employer and
contract of service has been entered into.

d) Apprentices engaged under Apprentice Act, 1961 and includes apprentices whose
training period has been extended to any length of time.

 Definition of Family: It has been amended to include “dependant parents, whose

income from all sources does not exceed such income as may be prescribed by the
Central Government” and “a minor brother or sister wholly dependent upon the
earnings of the insured person”, provided parents are not alive and insured is
unmarried.
 Definition of Factory: It now states “means any premises including the precincts
thereof whereon ten or more persons are employed or were employed on any day of the
preceding twelve months, and in any part of which a manufacturing process is being
 carried on or is ordinarily so carried on, but does not include a mine subject to the
operation of the Mines Act, 1952 (35 of 1952), or a railway running shed”.
Thus the definition has now deleted the segregation on basis of number of employees
in premises which uses power and without aid of power. Now it is just 10 employees,
employed in a previous year.

 Social Security Officers: The Inspector(s), appointed under ESI Act, shall now be
referred to as Social Security Officers.
 Section 51E: Insertion of new section, which states: “An accident occurring to an
employee while commuting from his residence to the place of employment for duty or
from the place of employment to his residence after performing duty, shall be deemed to
have arisen out of and in the course of employment if nexus between the circumstances,
time and place in which the accident occurred and the employment is established”.

Registering a Society

If you are contemplating starting a not for profit business, one of the options
available is registering a Society under Societies Registration Act 1860.

This is a Central Act, but registrations are jurisdictional, depending on the location of
the office.

Registration is simple and so is dissolving the society. There are a few compliances
and very little monitoring from the Registrar.

Purpose.
A Society can be formed for the following purposes:

Charitable societies, the military orphan funds or societies established at the several
presidencies of India, societies established for the promotion of science, literature, or
the fine arts for instruction, the diffusion of useful knowledge, the diffusion of
political education, the foundation or maintenance of libraries or reading-rooms for
general use among the members or open to the public or public museums and
galleries of paintings and other works of art, collections of natural history,
mechanical and philosophical inventions, instruments, or designs.

Registration Process.
Any seven or more people subscribing to the Memorandum and filing the same with
the Registrar along with a fee. Usually the process takes about 15 days. The Registrar
would provide a Registration Certificate.

The Memorandum contains: Name of the Society, Objects for which the Society is
being registered, the rules and regulations of the Society, Governing Council
Members.

Legal Status.
Separate legal entity. Society can sue and be sued in its own name. A registered
Society can hold property (moveable or immoveable), if not vested in the trustees,
shall be deemed to be vested with the governing council.

Compliances.
Annual General Meeting shall be held annually. Accounts shall be presented to the
Members and approved. The same along with the list of governing / management
committee members shall be filed with the Registrar.
Dissolution / Winding up.
Any number not less than three-fifths of the members of any society may determine
that it shall be dissolved. Property and liabilities gets disposed / settled. Intimation
shall be filed with the Registrar.

There are other legal avatars for starting a not for profit business, i.e. Trust or a
Section 25 company under the Companies Act. Hope to write about them sometime.

How to choose your legal avatar?

Posted on August 22, 2008by novojuris

You are planning to start on your own. How do you choose the legal form you need
to operate as?
Some of the parameters you need to consider are taxability, registration
requirements, legal compliances, continuity, ownership and very importantly,
liabilities.
The options range between a sole proprietary concern, partnership or a limited
liability company. India does not have limited liability partnership yet and is still
being debated as a concept. There are many other forms like the Hindu Joint Family
business, registered society too.
Here’s the feature comparison:
Limited liability
company
(includes Private
limited and public
Sole proprietary limited
Features concern Partnership firm companies)

Unlimited
liability. Liability
Unlimited extends to the
liability. Liability individual’s Limited liability.
extends to the private property Limited to the
Liability of individual’s for satisfaction of extent of shares
business debts private property. partnership debt. held but not paid.

In a private
Minimum and
limited company
maximum no. of Minimum 2 but
the minimum is
people One person not more than 20.
two and
 maximum is 50. In
a public limited
company the
minimum is seven
and no limit on
maximum.

Has a corporate
It does not acquire personality
a separate legal distinct from the
Separate legal No separate legal personality even if individuals who
entity status entity registered. are its members.

Memorandum
Charter and Articles of
documents None Partnership Deed Association

Registrations
required to start.
Other
registrations
required are
under the purview
of separate
legislations such
as service tax, Register the Incorporate the
professional tax, Partnership Deed company with
PF, ESI etc. as with the Registrar Registrar of
applicable. None. of Firms. Companies

Dissolved on the
death of a
partner, unless
there is a contract
to the contrary. Perpetual.
Can be terminated Terminated
by voluntary through
Dissolved on the action of prescribed
Termination / death of the sole dissolving the winding up
continuity proprietor. partnership. processes.

The property of
Ownership of Property belongs Property belongs
the firm belongs
property to the individual. to the company.
to the partners
 and they are
collectively
entitled to it.

Only a registered
partnership firm
can sue or be
sued. Else,
action may be
brought in the Since a separate
Not a separate name of the legal entity, a
legal entity, hence members either company can sue
the individual can individually or and be sued in its
Capacity to sue sue or be sued. collectively. own name.

The key differentiator between private limited and public limited company to
consider while starting up, are the numerous legal compliances applicable to a public
limited company even though the company may be closely held among just 7
members.
To mention a bit about the current income tax slabs applicable:
Sole proprietary
concern Partnership firm Company
Taxed as an individual.

Tax Slabs:
Upto Rs. 1,50,000 : No
tax
Rs.1,50,000 to
Rs.3,00,000: Taxed at Taxed as a partnership
10% firm. The profits from
Rs.3,00,000 lakhs to partnership is not Taxed as a
Rs.5,20,000: Taxed at included in the partner’s company. Dividend tax to
20% (individual’s) be paid by the company.
Rs.5 lakhs to Rs. 10 tax return.Tax Slabs:
Lakhs: Taxed at 30%. No Tax Slabs:
surcharge Upto Rs. 1 crore: Taxed Upto Rs. 1 crore: Taxed
Above Rs. 10 Lakhs: at 30% + cess at 30% + cess
Taxed at 30% + Above Rs. 1 crore: Taxed Above Rs. 1 crore: Taxed
surcharge at 30% + surcharge + at 30% + surcharge +
cess cess
Limited Liability Partnership
Posted on January 15, 2009by novojuris

LLP, a legal form available world-wide is now introduced inIndiaand is governed by

the Limited Liability Partnership Act 2008, with effect from April 1, 2009.
<link> http://www.mca.gov.in/MinistryWebsite/dca/actsbills/pdf/LLP_Act_2008_
15jan2009.pdf. LLP combines the advantages of ease of running a Partnership and
separate legal entity status and limited liability aspect of a Company.
Here are some of the main features of a LLP

 LLP is a separate legal entity separate from its partners, can own assets in its name, sue
and be sued.
 Unlike corporate shareholders, the partners have the right to manage the business
directly
 One partner is not responsible or liable for another partner’s misconduct or negligence.
 Minimum of 2 partners and no maximum.
 Should be ‘for profit’ business.
 Perpetual succession.
 The rights and duties of partners in LLP, will be governed by the agreement between
partners and the partners have the flexibility to devise the agreement as per their choice.
The duties and obligations of Designated Partners shall be as provided in the law.
 Liability of the partners is limited to the extent of his contribution in the LLP. No
exposure of personal assets of the partner, except in cases of fraud.
 LLP shall maintain annual accounts. However, audit of the accounts is required only if
the contribution exceeds Rs. 25 lakhs or annual turnover exceeds Rs.40 lakhs.
A LLP is indeed advantageous because of comparatively lower cost of formation,
lesser compliance requirements, easy to manage and run and also easy to wind-up
and dissolve, no requirement of minimum capital contributions, partners are not
liable for the acts of the other partners and importantly no minimum alternate tax
(as of date). But, LLP cannot raise money from the public.

The process for incorporating a LLP is pretty simple. The flow chart here
depicts it clearly http://www.llp.gov.in/.
The Registrar of Companies (ROC) is the authority having jurisdiction over the
incorporation. The steps required are:

Decide on the Partners and the Designated Partners

 Obtain Designated Partner Identification Number (DPIN) and a digital signature

certificate.
 Decide on the name of the LLP and check whether it is available.
 Draft the LLP agreement
 File the LLP Agreement, incorporation documents and obtain the Certificate of
Incorporation.
In order to help you decide on which legal form to choose, here’s a feature
comparison between the LLP, Partnership firm and a Company:

Features Company Partnership firm LLP

 Compulsory
registration required
with the Not Compulsory
ROC. Certificate of compulsory. Unregistered registration
Incorporation is Partnership Firm will not required with the
Registration conclusive evidence. have the ability to sue. ROC

Name of a public
company to end with
the word “limited”
and a private Name to end with
company with the “LLP”” Limited
words “private Liability
Name limited” No guidelines. Partnership”

Private company
should have a
minimum paid up
capital of Rs. 1 lakh
Capital and Rs.5 lakhs for a
contribution public company Not specified Not specified

Legal entity Is a separate legal Is a separate legal

status entity Not a separate legal entity entity

Limited to the
Unlimited, can extend to extent of the
Limited to the extent the personal assets of the contribution to the
Liability of unpaid capital. partners LLP.

Minimum of 2. In a
No. of private company,
shareholders maximum of 50 Minimum of 2. No
/ Partners shareholders 2- 20 partners maximum.

Foreign
Nationals as
shareholder Foreign nationals can Foreign nationals cannot Foreign nationals
/ Partner be shareholders. form partnership firm. can be partners.

The income is taxed at The income is taxed at

Taxability 30% + surcharge+cess 30% + surcharge+cess Not yet notified.

Quarterly Board of
Meetings Not required Not required.
Directors meeting,
 annual shareholding
meeting is mandatory

Annual statement of
accounts and
Annual Accounts and solvency & Annual
Annual Annual Return to be No returns to be filed with Return has to be
Return filed with ROC the Registrar of Firms filed with ROC

Required, if the
contribution is
Compulsory, above Rs.25 lakhs or
irrespective of share if annual turnover is
Audit capital and turnover Compulsory above Rs. 40 lakhs.

High Perception is higher

creditworthiness, due Creditworthiness depends compared to that of
How do the to stringent on goodwill and credit a partnership but
bankers compliances and worthiness of the lesser than a
view disclosures required partners company.

Less procedural
Very compared to
procedural. Voluntary company. Voluntary
or by Order of By agreement of the or by Order of
National Company partners, insolvency or by National Company
Dissolution Law Tribunal Court Order Law Tribunal

Protection provided
to employees and
partners who
provide useful
information during
Whistle the investigation
blowing No such provision No such provision process.

But, LLP might not be a choice due to certain extraneous reasons, for example, DOT
would approve the application for a leased line only for a company; Angels / VCs
would be comfortable investing in a company.
Use of Funds – private equity

In private equity deals, investors would like their investment to be used for business
of the company and usually do not like it to be used for reimbursement of pending
founders’ salaries or repayment of loans and the like.

Shareholders agreement typically has a clause on ‘Use of Funds’, which describes the
use of the investment amount. This clause may reference the business plan
presented to investors or to the budget / business plan which is approved at the
board meeting annually.

The use of funds could be towards capital expenses or working capital. However, any
expense beyond the budgeted numbers would perhaps need the investor’s prior
approval or the list of Reserved Matters (we discussed about Reserved Matters
here http://novojuris.com/2013/09/12/negotiating-termsheets-board-
representation-part-3/) may provide for some hard numbers beyond which it
requires the investor’s approval.
Founders while bootstrapping would have invested money into the company which

 May get capitalized. Please note, the shareholding percentage to the total capital might
still remain the same.
 The company may reimburse from the profits earned by the company over a period of
time, however, the money may not earn interest.
 The investors may be willing to repay / reimburse the amount in full/or in part. The
founders have to ask for the same, around the time of signing up the termsheet.