Q&A: process for venture capital investments in India

Process

Do parties normally use term sheets? If so, what is normally covered in such term sheets?

It is common to use term sheets before executing definitive documentation or until an agreed long-stop date in Indian venture capital deals. Term sheets will typically cover the key terms of the investment including the instrument of investment, conditions precedent, governance rights such as board and observer, affirmative voting rights and special quorum and exit rights. Investor protection rights related to downside or anti-dilution protection, promoter lock in, share transfer restrictions and liquidation preference are also commonly addressed. While the term sheets are generally preferred to be kept non-binding, it is common to agree to an exclusivity period to facilitate good faith negotiations for the deal.

What are the standard documents for a venture capital transaction, and who prepares them? Are there popular forms for such documentation in your jurisdiction?

A venture capital equity transaction will generally have a securities subscription agreement and a shareholders’ agreement (or a restated and amended shareholders’ agreement in subsequent rounds of funding). In the case of a secondary investment deal, structured to provide exit to an existing investor, a share sale agreement is executed along with a ‘deed of adherence’ for the incoming investor to be bound by the terms of the existing shareholders agreement. It is increasingly common to see employee stock schemes and management incentive contracts in growth stage companies.

A venture debt transaction will generally have a loan agreement, debenture trustee agreement and applicable security documents.

Typically, the investor’s counsel prepares the definitive documents. There are no popular templates although certain terms can be considered market standard.

What is the normal process and timing of venture capital investments in your jurisdiction?

Parties typically sign a non-binding term sheet or memorandum of understanding, followed by legal and financial due diligence, valuation, and negotiation of the definitive documents. While closing is contingent on regulatory approvals and other conditions precedent, typically a venture capital investment transaction can close within two months of signing the term sheet.

What closing conditions are common in venture capital transactions?

Closing conditions are largely linked to due diligence findings and the identified risks that can be mitigated prior to the investment. The need for sector specific regulatory approvals is also assessed, for instance, Reserve Bank of India approval may be attracted for investments in micro-lending and certain fintech products, while approval of relevant tax authorities may be needed for a change in shareholding of companies located in tax incentive zones. Approval of the Indian government may be needed for foreign investments originating in countries sharing a land border with India.

Are venture capital transactions ever divided into multiple closings? If so, how and why?

It is common to see venture capital investments in India staged into multiple closings based on performance milestones for the target company and founders.

Economic terms

How is the company valuation and investors’ purchase price usually determined in venture capital transactions?

Since the typical target for venture capital investments are early-stage ventures, there may not be sufficient historical data to support valuation. Indian companies often prefer to use the discounted cash flow method of valuation. Investors need to assess management projections and parameters such as the existing customer base, potential market penetration and quality of management while estimating the valuation. In addition, Indian exchange control regulations require that shares issued to non-resident investors must not be at a price lower than the fair market value.

The requirements for determining fair market value (FMV) vary in primary issues and secondary transfers of shares. In a recent amendment, the 'angel tax provision’ was made applicable to non-resident investors with effect from 1 April 2024. This makes any excess consideration received by a closely held company above the FMV of the shares issued deemed as income of the company taxable at the applicable corporate tax rate. Issues may arise due to differing views regarding the fair value of shares for the purposes of the angel tax provision. Similar valuation conflicts may arise in the context of conversion of convertible instruments into equity shares with a pre-agreed conversion ratio or price.

In September 2023, new provisions were introduced under the angel tax regime recognising different methods of valuation of shares, such as a comparable company multiple method and option pricing method in addition to net asset value-based method and discounted cash flow method.  

Further, it was clarified that angel tax shall not apply to investments into ‘start-ups’ recognised by the Department for Promotion of Industry and Internal Trade, subject to certain compliances and conditions. Further, investments received from sovereign wealth funds, international or multilateral organisations have been exempted from angel tax. Investments from endowment funds, pension funds or broad-based pooled investment vehicles or funds (other than hedge funds) incorporated in certain notified countries shall also not be subject to angel tax. The notified countries include Canada, the United States, Norway or Japan, but certain jurisdictions commonly used for undertaking investments into India such as Mauritius, Singapore and the Netherlands were excluded.

What do investors typically require for option pools or equity incentive arrangements in connection with venture capital transactions?

Indian unlisted companies are allowed to issue employee stock option plans (ESOPs) to their permanent employees and non-independent directors (including employees and directors of holding and subsidiary companies). Promoters and directors holding more than 10 per cent of the company’s shares are not typically eligible to receive ESOPs, except in the case of start-ups. Investors typically expect there to be conditions for the vesting and exercise of ESOPs, such as mandatory time gap between grant and vesting of options, restrictions on altering the terms of the ESOP scheme, and other financial parameters. 

In India, ESOPs are the most common. Other such incentive plans used are phantom options, restricted stock units and stock appreciation rights.

Earn-out structures, while popular globally, have restrictions under Indian foreign exchange laws, as it is not permitted to hold back more than 25 per cent of consideration paid for shares and the period for the holdback or escrow cannot exceed 18 months. Therefore, earn-out payments are often structured as management fees.

What are the normal provisions governing dividends, distributions, redemptions or other profit distributions in venture capital transactions? Are there any legal limits thereon in your jurisdiction?

Indian companies can declare dividend only out of profits or free reserves. Redemptions could be structured as a share repurchase or ‘buyback’ by the company, subject to limits in a financial year.

Dividends distributed by Indian investee companies are taxable in the hands of the shareholder at rates that differ depending on the residential status of the shareholder, their legal form, as well as the availability of treaty benefits in the case of non-resident shareholders. Dividend distributed to a non-resident shareholder will be subject to withholding tax requirements.

How are venture capital investments treated in portfolio company sales or liquidations?

Transaction documents usually build in the right of venture capital investors to receive proceeds of ‘liquidity events’ in priority to other shareholders. Liquidity events could range from sale of all or substantially all assets of the company, any change of control of the company to an actual winding up or dissolution of the company. If a company is insolvent and has to be liquidated, statutorily other claimants such as workmen and secured creditors would have precedence in the receipt of proceeds of liquidation.

In the case of sale of assets of the company or a change of control of the company, it may be difficult to apply the consideration received to pay the investors and requires other mechanisms for implementation.

What anti-dilution protections are typically built into the terms of venture capital securities?

Transaction documents will typically include a covenant to seek prior approval of the venture capital investor for any new issuance by the company. There is usually a right to participate in future fundraising by the company. These pre-emptive rights allow the investor to maintain its shareholding percentage.

Dilution protection provisions are also built in to allow the investor to subscribe to shares at nominal value (subject to any pricing restrictions under Indian foreign exchange laws) in a down round. In the case of convertible instruments, the conversion ratio can be adjusted as an anti-dilution mechanism.

What pre-emptive or pro rata investment rights do venture capital investors usually receive?

Venture capital investors receive pro rata rights to subscribe to any new issue of capital, including in the case of subscription to convertible instruments where a deemed conversion is taken to calculate the participatory rights of the investors. Other pro rata rights include the right to participate in any secondary sale, right to participate in any distribution made by the company or receive liquidation proceeds.

What rights do venture capital investors normally have over insider sales of securities of portfolio companies?

It is common for founders and venture investors holding preferred stock to negotiate a right of first refusal in any transfer of shares by the other shareholders with a view to keep the shareholding in the company consolidated. Venture investors typically have rights of co-sale or tag along rights in any transfer of shares by the founders and in change of control events. Further, founders generally insist on placing restrictions on any transfer of shares by investors to competitors of the company, by way of consent rights or right of first refusal.