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?

Parties in Indian venture capital transactions almost always use a non-binding term sheet to establish key commercial understandings before drafting definitive agreements. Typically, only provisions such as confidentiality, exclusivity, governing law, dispute resolution, costs and term/termination are legally binding.

A typical term sheet for venture capital transactions covers the investment structure and amount, instrument type, valuation (including any caps or floors), the scope and timeline of due diligence, and key investor rights. These key investor rights often include board representation, information and reporting rights, anti‑dilution protection (usually broad‑based weighted average), pre‑emptive rights, liquidation preference, exit timeline and options, and transfer restrictions (including founder lock-in and vesting of founder shares).

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

The standard documentation includes a term sheet, a securities subscription agreement (for the issuance of new shares) and a shareholders’ agreement (governing investor rights and corporate governance). If the investment round involves a secondary transaction, a share purchase agreement is also used. The investor's counsel typically prepares the initial drafts, while the company’s counsel negotiates the terms and manages the disclosure schedules. There are no standard official forms in India; most transactions rely on customised law-firm precedents. In subsequent funding rounds, it is typical for parties to use the transaction documents from the previous round with limited mark-up and negotiation. Investments involving offshore companies that have raised foreign capital in their offshore holding or operating entities follow the prevailing market-standard documents.

In the United States, there are widely recognised standard forms for early-stage venture capital investments, such as the simple agreement for future equity and model subscription and funding documents (such as the investors’ rights agreement, voting agreement, right of first refusal and co-sale agreement, etc) that are based on templates prescribed by the National Venture Capital Association. These templates are frequently used as starting points for negotiations and have contributed to greater standardisation and efficiency in US venture capital financings. While India does not have official standard forms, practitioners may refer to these US precedents for guidance or adaptation, especially in cross-border or internationally structured deals where the holding company is based in the US.

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

The typical process begins with execution of the term sheet, followed by due diligence. Usually, negotiation regarding definitive transaction documents is conducted in parallel with due diligence. The execution of the transaction documents is typically dependent on the completion of due diligence and the analysis of due diligence findings to ascertain if there are any critical issues or pre-signing conditions that need to be addressed at the execution stage. The timing can vary significantly, taking anywhere from one to four months on average. Seed or early-stage financing rounds are often consummated more quickly since the business is fairly new and the scope of diligence is limited. In contrast, subsequent funding rounds can sometimes take longer, although due diligence conducted earlier and transaction documents agreed during the previous rounds can help expedite the process. Subsequent rounds typically only require top-up due diligence focused on the period since the last investment, and the terms from previous rounds are often followed with limited changes. In regulated sectors, closing may take longer if it is dependent on third-party or regulatory approvals.

What closing conditions are common in venture capital transactions?

Closing in Indian venture capital transactions is contingent on the satisfaction of a defined set of conditions precedent. These commonly include the rectification of issues identified during legal, financial and tax due diligence (such as formalising intellectual property ownership, updating statutory books and records, completing statutory filings, ensuring appropriate title to shares, obtaining necessary contractual consents, etc); the completion of all corporate authorisations for the share issuance (including board and special shareholder resolutions); securing a valuation; and securing all necessary regulatory and contractual approvals. Depending on the investor's jurisdiction and the target's sector, these approvals may include prior government approval for investors from land-bordering countries, competition clearance where applicable thresholds are met and approval of the relevant regulator in sectors where foreign investment falls under the government approval route.

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

It is common – and often preferred – for venture capital transactions to be divided into multiple closings. Multiple closings are more common in funding rounds that have multiple participating investors, as the timelines for their internal approvals and the internal process for confirming fulfilment of the conditions precedent usually vary. Multiple closings allow the company to receive and use committed funds from investors who are in a position to close earlier than other investors participating in the funding round. At times, multiple closings are also undertaken wherein funding is structured in tranches and linked to achievement of specified milestones, including revenue targets, regulatory approvals, etc.

Economic terms

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

In Indian venture capital transactions, valuation is initially negotiated based on business traction, future projections and market benchmarks, but it must adhere to legal and regulatory requirements. The Companies Act 2013 requires that any issuance of shares via private or preferential allotment must be supported by a valuation report from a "registered valuer", and the issue price cannot be below this valuation. For foreign investments, India's foreign exchange regulations require that the price be no less than the "fair value", which is determined in accordance with internationally accepted pricing methodologies. For convertible instruments, a conversion formula must be specified upfront and the price determined under that formula must not be below the fair value as determined at the time of issue.

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

Investors typically agree to the creation of a pre-approved legally compliant option pool that is sized according to the company's hiring plan and compensation structure. Standard terms include eligibility criteria, vesting schedules and well-documented provisions for leaver (including bad leavers) and change-of-control scenarios. The Employee Stock Ownership Plan (ESOP) for founders and key managerial personnel typically involves clawback provisions that vary depending on the scenario in which the founder/key managerial personnel separate from the company. The structure and terms of the option pools or equity incentive plan are typically negotiated to balance the company’s need to hire and retain talent while ensuring that the investor’s shareholding is not diluted and the beneficiaries of the option plan do not have any additional leverage in bad leaver scenarios.

From a legal standpoint, the primary equity incentive mechanism for private companies in India is the ESOP. The establishment and administration of ESOPs are governed by the Companies Act 2013 and the Companies (Share Capital and Debentures) Rules 2014, which set out detailed requirements for eligibility, vesting, exercise and disclosure. Promoters and directors holding more than 10% of the company's equity are generally ineligible to participate, although an exception exists for startups recognised by the Department for Promotion of Industry and Internal Trade.

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?

Profit distributions in Indian venture-backed companies are governed by both the investment agreements and the Companies Act 2013. Under section 123 of the Companies Act 2013, dividends can only be declared and paid out of current or accumulated profits after accounting for depreciation, and not out of capital. While preference shareholders are entitled to receive any agreed dividend ahead of ordinary shareholders, most venture capital instruments are compulsorily convertible rather than redeemable. This is also prevalent in transactions involving foreign investors, since subscription to redeemable instruments is restricted for foreign investors under the foreign direct investment regime. Consequently, investor liquidity is typically achieved through secondary sales or share buy-backs, not redemptions. If redeemable preference shares are used, they must be redeemed out of distributable profits or the proceeds of a fresh issue of shares.

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

In the event of a sale or liquidation of a portfolio company, the treatment of venture capital investments is determined by the shareholders' agreement and the company’s articles of association. On a company sale, investors holding preference shares typically have a liquidation preference, allowing them to receive their investment amount back (often with a preferred return) before any proceeds are distributed to ordinary shareholders. Investors also negotiate exit rights such as drag-along and tag-along clauses in the shareholders' agreement, which become applicable in the event of a sale or liquidation. In a formal winding-up, statutory requirements dictate that creditors are paid before shareholders; any remaining surplus is then distributed according to the contractually agreed liquidation preference.

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

Venture capital investment terms typically include anti-dilution provisions that adjust the investor’s conversion price downward if the company subsequently issues shares at a lower valuation (a down round) or entitle the investor to receive additional securities. This protection is usually structured as a broad-based weighted-average adjustment. Investors also secure pre-emptive rights that allow them to maintain their pro-rata shareholding by participating in future financing rounds. These rights commonly include negotiated exclusions that do not trigger anti-dilution adjustments, such as shares issued under an employee option pool, conversion of existing convertible securities and bonus issues.

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

Venture capital investors typically enjoy pre-emptive (pro rata) rights that give them the opportunity to invest in future funding rounds, thereby ensuring that they retain and maintain their ownership percentage and preventing dilution of their economic and voting interests. The right is an option – not an obligation – to invest, and is essential in ensuring that the economic position of the investor is not compromised as the company raises further capital. These rights are usually used for new issues of equity or equity-linked securities, subject to customary exclusions such as employee option grants.

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

Venture investors typically secure controls over the sale of shares by insiders (such as founders, employees and early shareholders) to ensure alignment and to manage the company's shareholder base. Core protections include transfer restrictions and consent rights over significant insider sales; a right of first refusal or first offer, allowing the investor to purchase shares before they are offered to a third party; and tag-along rights, allowing the investor to sell a proportional number of its shares alongside the insider and on the same terms. Investors also commonly require founder lock-in periods, notice for proposed transfers and compliance with applicable laws. Furthermore, the transaction documents typically have strict restrictions in relation to sales to competitors.