Laws Before Investing In A Startup

Introduction

Investment is the cog that makes the startup ecosystem run smoothly and successfully. It is what provides the startup financial backing in exchange for a stake in the shares or equity of the company. As a startup, even though you might have a unique and innovative industry-changing idea you may be left behind in seizing the market due to a lack of funding and assets holding you back from running. 

It has been established that the startup ecosystem in India is one of its major economic success stories serving as the home to the third-largest startup ecosystem in the world and despite the economic struggles of 2020 due to the covid-19 pandemic still managed to raise close to $17 million, second only to China in the Asia-Pacific region.

As the startup ecosystem grows and becomes more robust in the country, so does the investor landscape. This leads to an environment of heightened competitiveness and lucrative opportunities for both entrepreneurs and investors alike. However as the competition increases amongst the startups, the ideas become more innovative leading to investors being more picky and selective with where to invest their money. An investor’s goal is to look for ventures that will provide them tangible, guaranteed, successful returns. They choose where to invest their funds by checking a startup’s credibility, viability and the future long-term potential the start-up is projecting. 

As an entrepreneur in a competitive climate, it can be a tricky game of balancing. Not only do you require a good idea it also needs to be backed with data and numbers and needs to be communicated efficiently. A good idea is not enough, it is essential to also have a pitching strategy to impress the investors. 

Things to keep in mind as an investor

But before a startup goes in for pitching the business before the investors, it should be very well understood that an investor shall not put his money in a startup until and unless they find it rewarding. Thus It’s no surprise to learn that the founders of new startups often spend a majority of their time focused on growing their business by developing, refining and marketing their product or service, hiring great people, and working tirelessly to get potential investors excited enough about their ideas and business plan to make an investment in it and try to automate your fundraising business.

However, in the rush to move things forward as quickly as possible and get investments and funds allocated for their startups fast, many other important matters are swept to the side at the early stages. 

As a startup founder, you should not be hesitant to negotiate investment contracts in any meaningful way. Raising funds from the investors comes at a cost in the sense that there are various factors which an investor considers before investing in a startup. 

The legal attributes that an investor should keep in mind while making an investment in a start-up.

1. Registration and Incorporation of a company

As an investor, it is essential to check if a company has been registered and incorporated in order to be able to accept funding. The list of investors/board members along with the articles of association and the memorandum of association provide legal documentation in the event of any dispute that may arise during the course of business. If a new investor is accepted, changes need to be made in the respective official company documents including the name and duties of the new investor and their share in the company as well as documents held by government offices.

2. Non-Disclosure Agreement 

A Non-disclosure agreement is essential to protect the interests of the company or startup in this case. As a startup pitches their ideas or products to a lot of investors, in cases where deals don’t work out it is advisable to sign an NDA to protect the interests and information of both the parties involved. An NDA is such a type of agreement where both the parties, Investor and startup, need to consent and sign a Non-Disclosure Agreement under which the rights and exclusivity of the meeting and pitch are kept between both the parties, making sure that theft of Idea and misuse of it under any condition is not possible. 

3. Transparency in the sources of funding

Source of funding simply implies where to get your financing from. This could be angel investors, institutional investors, venture capitalists (VC), credit sharks, bank loans, private loans, acquiring from friends and family, and so on. It is imperative to recognize at what stage the business is at and the source of funding the business requires. The instrument of funding is the manner by which funding will be received by the company as far as deposits, assets, innovation, IP rights, and so on. The rules for paying taxes are contingent upon the source and instrument utilized for funding. There should be transparency maintained while clarifying both of these.

4. Company Valuation by CA

One must ensure that the company’s valuation has been evaluated by a certified Chartered Accountant to ascertain the true equity value of the company for moving ahead to the next step of investing in the startup. Once the company’s valuation has been estimated, the price per share for the company will either be issued at par, discount or a premium.

5. Complying with all laws and regulations 

The company must ensure that it complies with all regulations and laws with respect to its business and operations. Due diligence can be a daunting reality for startups hoping to receive investments. They may come across as intrusive, but as an investor, it is essential that a start-up does so and checking it before investing in it is crucial.

6. Investment Terms & Negotiations in Term Sheets

The term sheet sets out the terms on which your investor is going to give a start-up funding, be that by taking equity in the organization, a convertible note, or any other idea. It will likewise set out any conditions a startup should meet so as to effectively pick up subsidizing. It will also incorporate choices about the weakening of offers and dynamic rights. The term sheet isn’t a legally binding agreement but can be prepared by the side of the startup or the investor’s, but in either case, it is important to seek advice from a solicitor to ensure that each term is understood, so that your lawyer may negotiate the most favorable terms possible on your behalf.

7. Shareholders’ Agreement 

The primary purpose of a shareholders’ agreement is to identify the terms regarding the management of the startup, share transfer restrictions and exit rights of the investors. It also provides for the appointment of the investor’s directors on the board of the startup and provides the structure of the board. 

8. The Last Agreement 

The last agreement with the measure of investment in return for equity or shares should be drawn up between the business and the investing party. This agreement affirms that the investor is a shareholder in the organization and the transaction has been recorded in an official report. When the agreement is executed, the payment is made using an escrow account to the organization’s official bank account and the organization can use the funds as proposed. The reason for this agreement is to solidify the terms and conditions between the parties and reach a consensus on the agreement. This understanding will be enforceable, official and considered as the last/final agreement. The new ownership of equity needs to be mentioned in the company’s articles.

9. Dissolution/Exit Strategy

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

Author Bio:- Namita Gupta is a content strategist and author with a keen interest in financial topics. She has 5+ years of writing content for different publications. In her free time, she loves to play badminton. You can catch her on Twitter at @namita_g30

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