Pradyumna Nag
There are a lot of questions about funding and the right way to work with them. Considering the changes in the Companies Act, 2013 which has changed some of the basic fundamentals and imposed some restrictions for investor protection, the challenges faced by startups have increased.
So we thought that putting these thoughts together in an instructional FAQ would help as part of our ‘Practitioners Guide’ series.
Disclaimer: Please note that these are our answers based on our experience in being advisors on various Seed/ VC/ PE/ Technology collaboration transactions.They are for the limited purpose of educating founders. The facts and the procedure to be followed can vary significantly based on the exact nature of the transaction and the stage of the business.
How can I receive funding into my venture?
There are primarily only 2 ways in which money enters and rewards leave the business.
| Debt
(Loans, Debentures, Guarantees, LCs, Convertible Debentures) § Harder to access for most start-ups § Usually taken when business is likely to generate cash flows in the near future § Expensive in the short term, Cheaper in the long term § Utilization is primarily for shorter gestation based purposes – marketing of a B2B product, new factory premises, new equipment, working capital § Usually comes with covenants on how the funds need to be put to use |
Equity (Common Stock, Equity shares, Preferential shares, Convertible Debentures) § Easier to access for most start-ups (as cash required is not in relation to their asset base but their ability to generate future value) § Usually taken when expenditures are in longer gestation activities such as product R&D, customer acquisition, content development, platform development § No outflow in short term, Really expensive in the long term § Occasionally comes with covenants on how the funds need to be put to use |
Where do start-ups go wrong?
Roopa’s Notes:As a start-up, one of the things Founders fail to understand is that Equity carries a rate of interest of between 20-30% (sometimes as high as 40%). Businesses tend to think that the fact that they are saving current cash flow and pushing repayment liability is the only consideration. Equity on an average costs the Founders 2.5x to 3x more than debt does.
Nag’s Notes: What is important is the long term value that this person/ institution brings to you. If the value is as short-lived as the cash brought in, you need to reconsider parting with Equity. For a great VC, we have seen Founders chose lower valuations. Further, Equity does not mean that you don’t need to repay a VC/ PE. They are a business just like you. Just that they need to see viable ways to access returns from investing in you.
For the purpose of this document, we will delve a little deeper into the second one – EQUITY, where most start-ups/ mid-sized companies wish to have more clarity.
Ok. For Equity, what options do I have for my raise?
2 ways provided by Companies Act, 2013 –
- Private placements
- Rights and Bonus issues
Where do start-ups go wrong?
Dilip’s Notes:A private placement is when an offer at a certain valuation is made to potential investors. Investors need to bring in the required capital for the valuation fixed in the offer for private placement. Investor discussions are usually the first activity that happens in such cases and term sheets get signed. The offer is then made and noted in the respective places. A rights issue on the other hand is made to investors who are already shareholders of the company. An offer is made to all the existing shareholders to subscribe at a certain value and every shareholder has a right to offer his interest to subscribe.
Nag’s Notes: There is a logical reason that the 2 routes of placement have been provided. Private placement is the right route for a new investor who is coming in at an agreed upon valuation. During our consulting of start-ups, we have encountered several circumstances where the minimum capital requirement of INR 20,000 (as explained in the table to follow) of face value cannot be fulfilled especially at the seed stage. Founders tend to take a shortcut method here at times to comply. This might not always be the right way in the long term scheme of things.
What is a Private Placement really?
Private Placement is a term that is often heard of but rarely understood in its entirety. Let’s look at a few pertinent questions.
When you are making an offer to issue new equity shares (to less than 200 persons/ institutions), you need to comply with certain provisions of Companies Act, 2013.
Ref:Section 42(2) of the Companies Act, 2013
Where do start-ups go wrong?
Roopa’s Notes:A common problem that persists in the system is a lack of understanding of Private Placement. There have been many instances where companies have resorted to other ways of structuring an investment which are perceived to be less cumbersome. They may issue shares to investors through the rights issue channel since it does not require a Valuation Certificate by a registered valuer or a requirement to adhere to the provisions relating to the minimum face value of the equity instruments.
Dilip’s Notes: There are a few things that a Founder should be aware of when choosing the route to be followed.
- Private placement allows for a valuation exercise to be conducted which may be a logical arms-length basis for an investor discussion.
- It sets the precedent and valuation parameters in stone. This can be leveraged in future rounds of funding.
- It is a lot cleaner way since it ensures that companies comply in letter and spirit of the law.
Bordia’s Notes:The ideology behind the law is the most important aspect. Though it seems slightly hard to comply with, it is instated to ensure that investors are protected (especially smaller investors coming in at the seed stage). It also prohibits a company from accepting too many such small tranches of investment to bypass the rules relating to acceptance of deposits.
Can we have a better understanding of Private Placement?
Issuing capital in securities through Private Placement would require an in-depth understanding of the provisions laid out in the Companies Act, 2013 which mentions the manner, restrictions and provisions for Private Placement.
Ref:Section 42(2) of the Companies Act, 2013 read with rule 14(1) Companies Rules, 2014
We understand that a Private Placement as mentioned above is any offer of securities or invitation to subscribe to securities to 200 people or less in a financial year. The section requires that any such offer made is only through the issue of a Private Placement Offer letter and as per the prescribed conditions. This should be accompanied with an application form for the persons receiving the offer letter to indicate their acceptance.
Exception – 200 people or less does not include employees or institutional buyers.
Key procedural aspects for a private placement
- Special Resolution needs to be passed approving the Private Placement terms
- A private placement offer letter needs to be created and circulated
- Offer should not be made to more than 200 people
- Only one kind of securities can be issued under one offer
- The subscription should not be for less than INR 20,000 face value
- The price should be based on the valuation conducted by a Registered Valuer
- Allotment of securities should happen within 60 days of the receipt of Application monies
What is the documentation required?
A complete record of private placement offers in PAS 5, offer letter in form PAS 4, along with prescribed other details need to be filed with the RoC within 30 days. Form PAS 3, a return of allotment of securities, must be filed with the RoC within 30 days.
Key questions that are on Founders’ minds?
| What should the number of shares offered for a single round be?
The Offer size should be a minimum of INR 20,000 face value of the securities. Dilip’s Notes: This means that if your authorized capital is INR 100,000, you will need to issue not less than 16.67% (20/120) of the capital of the company. |
What should be the price? Can the securities be issued at any price?
The price of the securities should be based on a valuation certificate given by a Registered Valuer. Nag’s Notes: A reasonably justified valuation is based on the exercise conducted by a valuer. There are no rules of thumb here. Simply speaking, a $ billion company may have an authorized capital of less than USD 100,000 also. What is important, is the valuation itself. |
| Is there a restriction on using the application money? When can I begin to use the proceeds?
The application money must be received in a separate bank account and cannot be utilized for any purpose other than for allotment of securities or repayment of monies. Further, any securities in relation to an offer made under private placement must be allotted within 60 days of receipt of the application money. Roopa’s Notes: It is important to not utilize the money till the same has been issued and filed with the authorities. The maintenance of a separate bank account is also one of the most important aspects which can ensure that this does not happen. |
What do I need to do? Do I need to obtain approval from shareholders?
A special resolution(not less than 75% of existing shareholders) has to be passed approving the private placement. Bordia’s Notes: The simple logic for this is thatany capital related transaction affects the shareholding of all the current promoters and investors. This provision protects all the shareholders from instances of future misunderstandings. |
How different is a Rights issue?
Rights Issue means offering shares to the existing shareholders(only) in proportion to their existing shareholding. Procedurally, there is no requirement for a valuation certificate for rights issue.
Roopa’s Notes: A particular existing shareholder can choose not to subscribe to the offer if he so wishes to but each shareholder is granted with the same rights as everyone else.
What is the benefit of taking the right Private Placement route?
Private Placement requires the price to be based on the valuation by a registered valuer thus the price is determined on a logical and justified basis. It also acts as an internal benchmarking exercise and helps outline the milestones.
Nag’s Notes: An investment done through Private Placement provides complete transparency of the entire transaction and reduces the complicationsduring a Due Diligence at the times of subsequent rounds of funding/ investment.
On this document
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