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Why Entrepreneurs Need to be Mindful of Certain Things Before On-boarding an Investor

Why Entrepreneurs Need to be Mindful of Certain Things Before On-boarding an Investor
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The influx of capital at the right time is crucial for a startup’s sustenance. In fact, nowadays there is even a reality TV show called Shark Tank being aired in which wannabe entrepreneurs pitch to investors, the so-called sharks, which makes for quite an entertaining watch.

It is imperative to keep in mind that while the investment of capital might be vital in assisting the startup scale up its operations, the investors are just that, as the name suggests, Sharks! Do not get me wrong, an investor will bring a lot to the table apart from money, but at the end of the day, the investor is there for one and one thing only – a handsome return on his investment.

And this is exactly why, entrepreneurs needs to be mindful of certain things before on-boarding an investor.

One of the basic mistakes committed by entrepreneurs, is to delay bringing in a lawyer. While it is true that the commercials of a transaction fall primarily in the non-legal domain, I have been witness to situations wherein the parties have finalised the commercials, only for me to come in at a later stage and having to burst the entrepreneur’s bubble that the structuring of the transaction is off or what the entrepreneur thought was a great victory for him and his startup in the commercial negotiations, will not fly in the spirit, let alone the letter of the law.

In fact, at the early stage of any transaction, what lawyers do best is to draw the boundaries of what is possible and let the parties play within the boundary in any manner to their liking.

The sneaky jibe of investors being sharks aside, it is beyond doubt that investors do bring a lot to the table. The very fact that it is in their interest that the startup does well, ensures that the investor will assist the startup in a variety of manners apart from just pumping in money, which can range from bringing in know-how of a particular sector or operations, to helping the entrepreneur network with and explore opportunities with the investors’ connections.

This however is dependent on how accessible the investor is. Entrepreneurs in their euphoria of having secured funding, often fail to do their homework and conduct a background check on how involved the investor has been in its other investments.

Even in the event, a startup is content with just the money coming in, from a company secretarial perspective (in the Indian context), it is essential that the startup is not chasing the investor (whether an individual or a nominee of a fund) for signatures, whether it is for investor consent on certain protected matters or something as routine as shareholder resolutions.

This becomes doubly important when an investor appoints a director to the board of the startup since majority of the decisions are taken at the board level and if at this stage, the director’s presence and/or availability is sketchy, that could potentially derail the timelines internally set by the startup.

Employee Stock Options (ESOPs) is a benefit given as an option to employees of the company to purchase and subscribe to shares of the company at a future date at a pre-determined price. Investors are big fans of ESOPs. And why should they not be?

An ESOP scheme permits a startup to attract and retain talent which in the long run enables the startup to prosper and in turn, for the investor’s shareholding to appreciate. It is exactly due to this argument, I am a strong proponent of the investor contributing to the ESOP pool.

Usually an investor asks the founders to first dilute to create an ESOP pool and then dilute again (along with the ESOP pool) to allot shares to the investors. Ideally, the founders should first allot shares to the investors and then dilute, so that even the investors are diluted to a certain extent while creating the ESOP pool.

This is a negotiable term and often entrepreneurs, oblivious to significance of the timing of the creation of the ESOP pool, end up accepting the former and diluting twice.

Having more than one investor is extremely common. There are often multiple rounds of financing and hence the terms such as Series A, Series A1, Series B Shares and so on and so forth.

It is critical to keep in mind that the investor who was the first one to pump in money and hence took the greatest risk will always want to have the best terms and conditions in relation to his investment.

That said, subsequent investors who follow this first investor, will push for the being on the same level playing field as the first investor, and often the same terms are in fact, extended to the subsequent investors.

Therefore, entrepreneurs have to play hardball with all investors and especially the first one, since it is this investor which sets the tone of the negotiations for the subsequent round of fundings.

With multiple investors come multiple exits. Sometimes, an investor may choose to transfer his shareholding to a third party since usually there is no restriction on transfer of investor shareholding as long as the third party is willing to execute a deed of adherence to the transaction documents.

While these transaction documents, inevitably have a non-compete clause for the founders, non-compete should be a two way street. What this entails is not that the investor cannot invest into the start-up’s competitor (this is ideal but no investor is willing to tie itself to this covenant), but that the investor should not be able to sell its shareholding in the start-up to a competitor. The last thing an entrepreneur wants is to have is a rival breezing in through the door and having a look around, let alone control the start-up itself.

Often investments into startups are from foreign based funds. For example, most investments into India are made by Mauritius based funds, despite the parent entity being based in the US, UK, or elsewhere.The fact that the parent entity is from a country like the US or the UK, results in a situation wherein the transaction documents clearly impose an obligation on the Indian startup to adhere to certain foreign laws.

For example, the US laws expressly require all US corporations and their subsidiaries to adhere to the Foreign Corruption Practices Act, 1977 (“FCPA”) and failure to do so, results in significant penal fall out. Therefore, these funds insist on including clauses on anti-corruption. While the obligations under the FCPA are quite clear, sometimes it is more difficult to understand what is required to be done in order to comply with the rules under the Internal Revenue Code of the US which prohibits “Passive Foreign Investment Companies” and “Controlled Foreign Corporations” (in some cases).

Since these are non-negotiable points from the investors’ perspective, these clauses (along with severe indemnities) are included as is in the transaction documents without the founders really understanding what is required under these laws.

Therefore, it is imperative, especially since no Indian lawyer would be able to advise the start-up on these foreign laws, that the investor provide a list of the dos and don’ts and simplifies the obligations on the start-up in order to ensure that the start-up is able to ensure actual compliance.

Edition: December 2016

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