Negotiating Early-Stage Investments In India

The best way to predict your future is to create it. The journey of a startup is fraught with challenges, but mastering the skill of negotiation can turn the challenges into the opportunities. Almost all the current high valued startups had negotiated aggressively in the past, to protect their rights and interest. 

Imagine the conversation in the 1980s between Microsoft, a fledgling software company without a ready-made operating system, and IBM, a dominant player in the hardware industry wherein IBM struck a deal with Microsoft to provide an operating system to IBM for their new personal computers.

The real genius lay in negotiation with IBM, wherein Microsoft instead of selling the operating system outright, retained the rights to license that operating system to other manufacturers. IBM failed to foresee the explosion of the personal computers market, agreed. The licensing rights not only allowed Microsoft to become a critical player in personal computing but also laid the foundation to become one of the most powerful companies of the world.

Another example of negotiation genius could be WhatsApp’s acquisition by Facebook. Apart from valuation and other commercial rights, founders of Whatsapp fought tooth and nail for the continuance of WhatsApp’s strict privacy standard, end to end encryption of the messages and no ads. Facebook agreed to these terms and conditions, which was a significant deviation from its business model.

India has the third largest startup ecosystem in the world, and it is riding high on creativity. In the coming years, we can overthrow all the incumbent champions of any field. When we delve into such a vastly paced ecosystem of early-stage startups, it is essential to understand that negotiation table is where dreams meet reality. 

On one hand founders come with a vision of innovation and ambition and on the other hand, investors come with a pragmatic sense of business, but the true challenge lies in bridging the gap. 

In this high-stakes environment, where every term sheet detail can shape the future, mastering the art of negotiation is not about securing funds – it is also about building a relationship that can withstand the tumultuous journey of entrepreneurship.

For both entrepreneurs and investors, understanding the intricacies of early-stage investment negotiations is paramount to success in this dynamic market. This guide provides a detailed overview of key issues and standard positions in venture capital financing rounds in India, offering valuable insights into the complexities of deal structuring, governance, and exit strategies.

From the types of securities offered to the nuances of founder obligations and liquidation preferences, we’ll explore the essential elements that shape early-stage investments in the Indian context. Whether you’re a founder seeking funding or an investor looking to capitalise on India’s startup boom, this comprehensive breakdown will equip you with the knowledge to navigate negotiations effectively and make informed decisions in the fast-paced world of Indian venture capital.

Types Of Securities

• Preference shares are usually created with a set of “preferred” economic and governance rights relative to those enjoyed by the equity shareholders and are distinct from equity shares (which the founders typically hold). Investors may also be offered compulsorily convertible debentures, where the commercial agreement is for the investors to get a portion of the pay-out in the form of coupon/ interest. Neither preference shares nor compulsorily convertible debentures can be redeemed/ cancelled by the company and must contain provisions for mandatory conversion into equity shares.
• However, the investors may opt for convertible notes, compulsorily convertible debentures and debt instruments depending on the residential nature of the investor and the commercial terms related to the investment.

Valuation And Investment Amount

• Typically, a round size and the percentage stake in the company for the investors participating in the proposed investment round is commercially determined. However, as a regulatory matter, the entry valuation must be supported by an independent valuation report from a professional valuer – usually there is headroom between the regulatory valuation and the commercial entry valuation to allow for post-closing adjustments to the conversion ratio (including for anti-dilution protection).
• In early-stage funding rounds, investors usually insist the company reserves a certain percentage of shares (in the range of 10% to 15%) as a notional employee stock option pool (ESOP) for the benefit of the employees. This is usually taken out of the promoter’s share or sometimes shared between the investors and founders on a disproportionate basis.

Further Funding And Valuation Protection

• Investors usually obtain a pre-emption right requiring the company to first offer any future shares to the investors before offering to any third party. Investors may also seek a mop-up right, a right to subscribe to the unsubscribed portion of the shares offered to existing investors. In early-stage funding rounds, a mop-up right may not be fully aligned with the company’s interests of diversifying their capitalisation table and if agreed to, the company may negotiate to limit the mop-up right to be exercisable only until the next funding round.
• Anti-dilution rights deal with dilutive events which otherwise reduce the value of the shares held by the investors (relative to the price paid by them at the time of investment). Anti-dilution is usually affected through adjustment to the conversion price of the preference shares/ debentures (in case of foreign investors, this is subject to the pricing guidelines under the exchange control regulations). Typically, anti-dilution protection is offered on a broad-based weighted-average basis. In the past, full ratchet was also prevalent.

Governance and Information Rights

• The number of board seats is a matter of negotiation and depends on the overall size of the board as well as the size of the investment being made. In early-stage funding rounds, the founders would want to maintain a majority on the board and insist on appointment of additional nominees to top-up the additional board seat occupied by the investors to maintain parity on the board .The investors in such instances assess whether the collective shareholding of the founders forms a majority on the capitalisation table. In case the investors exercise their right to nominate a director/observer to the board, the company may seek to protect its business by imposing that the appointed directors on its board are not the same as on the board of its competitors – investors push for the flexibility to be able to carry out investments in competing business without any restrictions.
• Typically, where a company has multiple institutional investors, consent rights are usually exercised on the basis of a certain investor majority (a typical formulation could be 75% of investors with holding above a minimum threshold, say 3%). Typically, this majority percentage is determined in such a manner that no individual investor has an effective veto (i.e. if any investor holds 25% of the aggregate investor holdings, then this threshold may be set at 60%). 
• Irrespective of whether the investor has a right to appoint a director or observers, investors insist on standard information rights such as the right to receive: (i) audited and unaudited financial statements of the company; (ii) certified true copies of minutes of meetings; (iii) business plan, annual budget and headcount for the following financial year; (iii) any litigation involving the company/regulatory notice; (iv) notification of any event which is likely to cause material adverse effect; and (v) audit reports. In large size deals, investors generally negotiate that a big four audit firm is appointed as its statutory auditor.

Share Transfer Restrictions

• In case of any proposed share transfers by the shareholders, depending on the existence of share transfer restriction provisions (in the form of a right of first offer or a right of first refusal), the price discovery is either amongst the shareholders (if structured as a right of first offer) or third-party purchaser. Transfer restrictions provide the investors the first opportunity to purchase the shares (pro-rata to their shareholding) if they desire to do so. In certain cases, the investors may also seek mop-up rights in these scenarios. Typically share transfers by institutional investors are not subject to such ROFO or ROFR restrictions but share transfers by the founders, employees, and angel investors would be subject to these restrictions.

• Where the share transfer is by the founder, the above rights are typically paired with a tag along right, which allows the investor (who has not participated in the right of first refusal/offer) to partially exit (pro-rata to their shareholding) from the company along with the selling shareholders. Where such transfers constitute a change of control, typically investors get a full-tag. Where the holdings of the founder/ promoter get diluted significantly (i.e., promoters hold less than 25% of the company), this tag-along right may be amended such that on any change of control transaction (including sales by investors) the other investors will have a full tag. 

Founder Obligations

In order for the founders to be incentivised to continue running the company, the following obligations with respect to their shares in the company are generally negotiated: 

• A lock-in period (typically 3 years to 5 years or linked to the complete exit of the investors) during which the founders cannot transfer their shares, without the investors’ consent. Founders may seek to provide for exceptions to the restrictions on share transfers and the investors typically agree to exempt certain transfers for estate planning purposes up to a certain threshold (ranging from 2% to 5%). 
• Vesting schedule determines the intervals in which the shares held by the founders’ vest – typically restriction applies to 75% of their shareholding vesting in monthly intervals over 3 to 4 years (measured either from the date on which the founders have purchased the shares or from the closing date) and 25% are treated as already fully vested. 
• Good leaver and bad leaver: The company’s right to buy back the shares held by the founders, triggers if the employment of the founder ceases for any reason. In “good leavers” situations (such as death, disability or dismissals for other than cause), shares are bought back at the fair market (current) value of their shares, while in the “bad leavers” situation (such as ‘Cause’ based termination events), the shares are bought back at the nominal value of their shares (the value at the time when they received the shares). The investors typically would want both the vested shares as well as the restricted shares to be bought back in a bad leaver situation. 
• Cause events (that include fraud, gross negligence, theft, breach of employment agreement executed by the founder, disparaging statements that are adverse, to the interests of the company) prompt the investors to terminate the employment of the founder and also exercise their right to call an event of default. 
• The founders and key employees are required to undertake that they will not directly or indirectly engage in or carry-on similar business as the company. Non-compete and business exclusivity clauses are primarily drafted to capture such restrictions – the period of non-compete is a matter of negotiation and usually ranges from the period of employment up to 3 years post the termination.

Exits

The investors rely on contractual promises made by the founders to facilitate an exit either by creating liquidity through IPO or by sale to third parties or by buying out the investors stake:

• IPOs: As per the securities law in India: (i) existing shareholders can sell their shares in the IPO if (a) their shares are included in and registered as part of the offering and (b) such shares have been held by the selling shareholders for a period of at least 1 year prior to the filing of the Draft Red Herring Prospectus with Securities Exchange Board of India; (ii) upon listing, the special rights vested in a shareholder (under a shareholders’ agreement) fall-away; (iii) no convertible securities are permitted to remain outstanding as on the date of filing of the Red-herring Prospectus and convertible equity instruments are converted at agreed terms; and (iv) the entire pre-issue share capital is required to be locked in for a period of 1 year after the IPO to ensure an orderly after-market. 
• Trade Sale is preferred if (i) market conditions are unfavorable for IPOs or (ii) listing is not desired at the time of the exit. Acquirers in a trade sale typically conduct due diligence and ensure that the sellers underwrite the risks and liabilities identified. Acquirers address their concerns by way of price adjustments, indemnities, warranties and other protections. Investors may have to provide representations and warranties and consequent indemnities, in relation to the instruments being transferred as well as operations of the company, depending on the operational involvement of such investors in the company. It may be noted that warranty and indemnity insurance is not very common in India and both timelines and premiums on insurance coverage are substantially higher than in mature markets. Despite the above, as part of the deal documents, investors typically negotiate provisions to limit the obligation to provide representations and warranties only to fundamental warranties and title to shares.
• Buybacks by an Indian company is subject to the buyback offer being made to all shareholders. The proposed limit for a buyback is 25% of the cap table. For an effective exit through this route, the other shareholders would need to waive their right to participate in the buyback process. Investors obtain contractual commitments from founders and other shareholders agreeing not to tender their shares in any buyback so as to not exhaust the statutory limit. This is not a very popular route to achieve exits since the pay-out for the buyback must be made out of profits/ reserves of the company and cannot be financed through other means.
• A drag-along right allows investors to force a sale of the company if certain conditions are satisfied such as if the exit has not been provided within the exit period or as a consequence of event of default. The types of transactions triggering the drag, majority requirements for triggering the drag-along right, price protection for the drag (including the shares held by the founders), and the distribution of proceeds of the drag sale are typically negotiated given that this involves a squeeze out of the founders. A drag along right is useful from the perspective of a majority shareholder who has the option to drag along the minority shareholders in the company. The promoters may also seek to protect themselves from being ‘dragged’ with a minimum price requirement if the sale transaction is unfavourable. Drag against other institutional investors is uncommon though it is quite common against angel investors and employees holding shares of the company.

Liquidation Preference

• In specific liquidation events (where the company is being liquidated or is sold in an M&A transaction), the liquidation preference governs the distribution of sale proceeds and may take a shape of (i) non-participating liquidation preference (equals the investment amount along with any accrued and unpaid dividends); and (ii) participating liquidation preference (the equals the investment amount along with any accrued and unpaid dividends plus any surplus proceeds available for distribution on an as-converted to equity basis). The latter is more common;   
• If the liquidation proceeds are inadequate, investors generally negotiate for the entire proceeds are distributed inter-se on a pro rata basis. The remaining shareholders (if any) and the founders are required to waive their right to receive proceeds from the liquidation event in such circumstances. 

Termination Rights

• Investors seek termination rights: (i) if the conditions precedents are not fulfilled; (ii) material breach of the warranties; (iii) there is a material adverse change; (iv) the updated disclosures qualifying the warranties are not acceptable to the investor. To help enforceability, the investor may seek to make the trigger dependent on its opinion, and the company may seek to limit instances of terminations based on opinions of the investors and would prefer to set an objective test for the termination event.

Conclusion

The culmination of a deal is a summation of various factors, where the both the parties try to protect their interests and at the same time cede some ground to accommodate the other party. The art of negotiation does not include strong arming the other party to get a favourable deal, it is an exercise to create a win-win situation for both the parties. Even seemingly impossible deadlocks and conflicts can be resolved if we shed the assumption that our only sources of leverage are money and muscle.

As rightly said by Tom Wingfield “Yes, I have tricks in my pocket. I have things up my sleeve. But I am the opposite of a stage magician. He gives you illusion that has the appearance of truth. I give you truth in the pleasant disguise of illusion.” Effective negotiators know that how you articulate or structure your proposals can be as important as what you are proposing.