As per a 2015 survey by Nasscom (the National Association of Software and Service Companies) India has paved the way to secure the third position in the world with three to four startups emerging every day, primarily in the areas of e-commerce, consumer services and aggregators. The report also states that total funding in 2015 had grown by about 125% from a year earlier. Various campaigns launched by the government – Start Up India, Make In India, Digital India, National Policy for Skill and Entrepreneurship – and various other policy measures in the form of tax rebates have contributed to a favourable startup ecosystem.
A startup may seek funding for varied reasons. Funding can provide capital required to back its business plan or the pace at which it aims to grow, visibility and reputational benefits, a mentor that will constantly guide it in making critical business decisions, risk allocation and other benefits.
Legal due diligence
A startup may go through various stages of fundraising, including angel funding, seed round funding and growth/early stage funding. After the angel funding stage, an important exercise that a startup will have to go through during a fundraising process, after having executed a term sheet, is a legal due diligence.
A legal diligence exercise is typically conducted at the seed and the growth/early stage rounds of funding and identifies: (a) risks associated with the investment; (b) a risk mitigation plan; and (c) a list of items that would need to be inserted in the definitive documents in the nature of conditions precedent to funding, conditions subsequent, representations and warranties to be obtained from the founders, and indemnities.
Most startups spend a lot of time developing their business and tend to neglect various legal and regulatory compliances. The importance of a legal diligence cannot be underestimated given that the investor will not write the cheque until they are satisfied with the outcome of a legal diligence. Given the above it is important for startups to put their house in order before commencing fundraising initiatives.
Key aspects
A legal due diligence on a startup will cover five main areas: (a) cap table; (b) regulatory; (c) intellectual property; (d) agreements; and (e) employment.
Cap table: This includes a thorough check on the issued and paid-up share capital of the startup. Startups often fail to make important filings with the Registrar of Companies or other regulatory bodies and have many small shareholders. It is important for a startup to have a clean and a short list of shareholders on its cap table as the lack of such a list could be a nuisance during subsequent rounds of funding.
Regulatory: Obtaining appropriate registrations and approvals for the nature of the business is also very important. Startups often tend to take risks at the early stages, which come to haunt them when they grow. It is imperative for startups to seek appropriate legal advice at the inception stage. Another regulatory aspect to be considered in cases of foreign investment is the foreign direct investment norms. Since most startups operate in the area of business-to-consumer e-commerce, some structuring could be needed to facilitate the investment.
Intellectual property: It is important for startups to ensure that the intellectual property which is a valuable asset of the company is protected adequately. This may include registering the intellectual property and entering into detailed employment agreements, containing comprehensive intellectual property assignment clauses, with members of the research and engineering team. Founders should also ensure that they are not violating any employment terms of any previous employers. Startups often fail to take adequate steps to protect their intellectual property.
Agreements: It is important for startups to document their arrangements with suppliers, vendors, consultants, etc. Startups generally are lax and fail to put in place formal arrangements with third parties, which could help resolve a dispute.
Employment: Various labour laws impose penalties for non-compliance, in view of which it is important for startups to understand the applicability and compliance requirements of the relevant labour statutes.
Conclusion
The key to successful fundraising is recognizing and accordingly preparing for diligence exercises and investor scrutiny from the inception stage. Being prepared prior to even thinking of fundraising will go a long way in ensuring a satisfactory outcome when a fundraising opportunity arises.
It is also important to look at due diligence as a housekeeping exercise and be open with potential investors about non-compliance. This will help build a positive, trusting, working relationship and establish the groundwork for an ongoing partnership.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
