Starting Up? The First Few Steps And Precaution In Structuring

While setting up a company in India, it is very important for the founders to understand the regulations and various aspects related to shareholding, the appointment of the board, issuance of various types of shares and the agreements amongst cofounders.

The first crucial aspect is executing the ‘Founder’s Agreement,’ which specifies the founding team, their roles and responsibilities and compensation, the business operations and exit clauses, among others. Having such an agreement reduces the element of any future surprises and it can act as the reference book when any disagreement starts.

How to structure the board of the company is the next crucial step. A company is registered and regulated under the Companies Act, 2013 in India. The management of the company is conducted by the Board of Directors based on the powers provided through the Articles of Association of the company.

Every company must have a board of directors, which can have a maximum of 15 directors and a minimum of three directors in case of a public company, two in case of a private company and one in case of ‘one-person company.’ Generally, the promoters try to keep the board lean and appoint the minimum numbers required. There is no requirement of having a board of directors if the startup is structured as a partnership firm or as a Limited Liability Partnership (LLP).

While setting up the company, the authorized share needs to be specified in the Memorandum of Association, which means such capital as is authorized by the memorandum of a company to be the maximum amount of share capital of the company. When a company raises money through investments, it has to issue shares to investors, in every round.

However, any value of shares issued should not exceed the authorized share capital. And, if there is such a situation then the company needs to increase its authorized share capital first before issuing new shares. In respect of this, paid-up share capital refers to the share capital that has already been issued by the company, and for such shares payment has been made by the shareholders.

There is no minimum paid-up capital requirement for a private limited company. This requirement of zero paid-up capital, makes it an attractive option for startups, as this means low compliance cost. However, the authorized share capital cannot be below than INR 1 lakh.

The types of shares that are issued to founders depends on the Founders’ Agreement entered into between the founders. The common equity stock which signifies the ownership of the company is issued to the founders, these are known as Founder’s Shares.

On the other hand, the investors participating in funding rounds are generally issued compulsorily convertible preference shares, or any different kind of preference shares. The preferential shares do not carry with themselves any voting rights, however, they are prioritized, in case of payment of dividends and priority of payment if the company winds up.

Hence, depending on the situation, the startup issue either common stock or preferred stock. This is in line with the Companies Act, 2013 wherein a company can issue two kinds of shares: equity and preference shares.

Preference shares such as cumulative preference shares, non-cumulative preference shares, redeemable preference shares, and compulsorily convertible preference shares can be issued. Equity shares, on the other hand, demonstrate equity ownership in the company.

Founders form an integral part of the startup entity and it is imperative to retain and reward them as the startup grows. This also gives confidence to the subsequent investors. There are multiple ways to go about it and Employee Stock Options or ESOPs and sweat equity are the two most important options available.

ESOPs are the principal instrument used to incentivize the employees, including founders. Though previously not allowed, the government, through a notification, has allowed the startups to issue ESOPs to promoter or promoter group, or any director who indirectly holds 10% or more equity in the company.

However, this exemption would cease for a startup as soon as it crosses the threshold of ten years, from the date of its incorporation or registration. Lastly, the actual allocation of shares under the ESOP scheme only happens either in case the option is exercised, or in case the liquidity event is triggered.

Sweat Equity shares are equity shares issued to the directors or any other employee of the company, at a reduced price or for considerations (other than cash) such as contributing to the growth and success of the company through value additions, or contribution in nature of the IPR.

Startups can only issue up to 50% of their paid-up capital in the form of sweat equity shares, up to 10 years from the date of its incorporation or registration. In contrast, in sweat equity, the shares are immediately allotted to the employees.

It becomes important to explore the existing options under the above aspects while preparing any strategy for starting a business. There are multiple other concerns but these come back for discussions at every round of investment and in matters of control and share of profitability in the company. Taking right advisory on these aspects would eventually be a cost-effective exercise when compared to the consequences of acting sans sound advisory. It is always better to worry now than be sorry later!

The article was written by Neeraj Dubey (with assistance from Vibham Raman/Associate)