In Part 2 we look at raising money through issuance of equity shares.
A company can raise money by issuing shares to existing shareholders or new investors, and this process is fairly simple as long as all investors are Indian residents.
Pros: Since the investment is being made in the shares of your company and is not being provided as a personal debt to you or as a loan to your company, there is no question of returning the investment at a later date and in most cases there is no requirement to provide dividends.
Cons: With third party capital you are bound to give up certain amount of control (Term Sheet), and always remember that the third party investor is looking for an exit, whether it is short term or long term. You should be very careful while negotiating exit clauses and try to avoid any form of excruciating promoter buybacks, where the promoter will end up having to buy back the shares of the investors mandatorily after a certain time period (and usually at a certain profit margin) in case they fail to provide an exit.
The biggest challenge when raising equity capital in the early stage is valuation. How do you agree how much dilution is ok? Wondering what we are talking about? Read our blog on the Valuation Game and how it affects your shareholding as a promoter in your startup.
Compliance check: While issuing shares always ensure that you obtain a valuation report for the shares from a merchant banker and do not undervalue them during issuance, since there can be severe tax implications in case you decide to issue shares at a price lower or higher (in case of angel investors) than the fair value.
Things to look out for: Do think about the dilution that the founding team will be facing. Considering that at an early stage the valuation of the company will be quite low, you may end up becoming a minority shareholder in your own company in case you raise too much money through the equity route at early stages. Also have a shareholders agreement in place which clearly identifies the rights of each party and ensures that there is no room for confusion at a later date. Equity investment in a private company can be uncharted territory for friends and family and make sure that you educate them on the risks involved prior to the investment.
With the Startup India series we plan to answer the ten most commonly asked common legal questions which we get asked. In the next part we answer “Raising money by issuing convertible instruments”
At LexStart we advise startups at various stages of growth on disclosure related compliances and non-disclosure arrangements. You can reach out to [email protected] with any specific queries that you may have.
Disclaimer: Please note that the article above is for information purposes only and represents the views of the author and should not be construed as legal advice.