U.S. VC Process for Indian Startups
As an India-based startup, closing on U.S. venture capital is similar to doing so if your company was completely US-based, with a few notable differences. In the past several years, I’ve represented several India-based startups through venture capital financings. To name just a few, clients have included Freshworks (formerly FreshDesk), WizRocket, and Shopalyst. They, along with other clients, have closed financings with the India-based or branches such as Accel Partners, Kalaari, Sequoia, Helion and Matrix, and not to mention with several US venture capital counterparts.
The common denominator with these entities is that such investment has come through a Delaware corporation. Note that even India-based VCs will invest in Delaware entities, although they of course invest in a private limited or another country’s entity (e.g., Singapore). There’s many different reasons to structure the investment through the US entity, such as making the financing compatable with future US-based investments or just speed. And, of course, there are different tax reasons which either make the US-entity favorable or at least neutral with respect to a foreign jurisdiction registration.
My India-based clients tend to relay to me that the biggest difference regarding the venture capital process when you’re incorporated in India and outside India can be seen in how quick or how delayed the investment process can be closed. India has government regulations on foreign investment coming into the country; VC funding for a company incorporated in India will have to cross certain clearance checks, and sometimes may need approval from the finance ministry, and this delays the process. For a company incorporated outside (i.e., Delaware), the process is much swifter, since these regulations are not applicable.
So, this post is intended to highlight some of the differences, and provide a general overview of the process and how it works in the US as opposed to in India. But the reality is, it’s not that different. I’ll also walk you through the various documents you will likely find having to execute to complete the financing process.
The Private Limited Entity
Most India-based startups either have an existing private limited or will form one soon after incorporation of their US entity. The private limited will typically house the India-based employees and will handle most, if not all, of the development work of the startup.
The presence and incorporation of this private limited into the financing will actually result in the majority of the differences between a financing solely in the US and one in India.
The private limited most typically ends up being a subsidiary of the US corporation and all investment during a financing will go through the US corporation in order to make sure that any IP owned or developed by the private limited is now owned by the US corporation (where their money is being invested).
Making a private limited entity a subsidiary is a time-consuming process (based on Indian law and regulations), the timeframe can vary here, but it usually falls between 60 and 180 days. Although some clients have experienced longer delay. Therefore, we sometimes see finalization of the subsidiary process as a post-closing covenant, in order to avoid delaying the financing.
Some VCs require that each founder enter into an employment agreement with the private limited to further ensure that all IP is protected. Others will include a laundry list of conditions to close relating specifically to the subsidiary (comply with all Indian law, transfer domain names/IP to the US corporation, that the US corporation form a private limited, etc.). Of course, then there are those VCs that will insist on both…
Also, sometimes the private limited will have to become a party and signatory to the financing. Whether or not the private limited will become a party usually depends on the importance it plays in the startup and how long it has been around, though the VC could just want to be extremely careful and include it regardless. Similarly, the VC will want to make sure that the private limited will also be subject to various representations and warranties, protective provisions and sometimes they will even want the VC director, if there is a representative of the VC on the company’s board of directors, to also be on the board of the private limited in order to further protect their investment.
The Venture Capital Term Sheet
Unlike in the US, the process generally begins with the founders receiving a term sheet from a VC prior to having formed a US corporation. As discussed above, sometimes the founders will have a private limited based in India, and sometimes they will not. Because of these issues, the VC will generally have each founder sign the term sheet. Another reason for the founder execution is that India-based financings sometimes include the requirement that founders make certain representations and warranties in the stock purchase agreement, where founders making representations and warranties in a US-based VC deal is somewhat rare.
In the US, a term sheet is usually not given until well after the formation of a US corporation and therefore, the corporation itself, and not the founders, can execute the term sheet, and founder representations and warranties are less common.
Most of the venture capital deal terms are similar to US terms. Economic terms like liquidation preference, anti-dilution, etc. are usually similar to their counterparts in US-based venture capital financings. Control terms like board seat(s), board observers, and protective provisions (i.e., investors’ right to approve certain actions) are also prevalent. However, there tends to be more protective provisions in an India-based US VC financing than a US-only VC financing.
There are sometimes customary India-based terms incorporated relating to the potential exit. Usually, they will have a period of 5-7 years and if an exit does not occur by then, the VCs will require that the startup purchase their shares back or assist them in selling them to a different entity of the VCs choice. This is much more robust than a typical “redemption” provision in the certificate of incorporation.
And, similar to US-based venture capital financings, many founders in India-based startups assume that once the term sheet is signed, the deal is about closed. But in reality, there’s still a long way to go.
The Venture Capital Closing Procedure
Typically, and regardless of geographical location, the startup’s lawyer will draft all of the documents for the financing (these documents are to be discussed in more detail later on) as well as create a pro forma for the round. Although in India, it is sometimes customary that the investors’ counsel drafts the documents.
The pro forma is used to calculate the price of the stock issued through the financing and also helps to provide a general overview of the ownership of the startup’s equity after the financing. India-based VCs usually want to hammer out the pro forma prior to full execution of the term sheet, while US counterparts tend to let that happen during the drafting of the documents.
Prior to the execution of any documents and the wiring of money, unfortunately, there is a lot of due diligence that must be done. Basically, the VC and their lawyers (as well as the company lawyer) will want to make sure that all of the company’s documentation is in order with respect to: (i) the incorporation, (ii) the stock issuances to founders (and any employees, if applicable), (iii) IP filings and transfers, and (iv) financials. And, if there are any issues, they will need to be solved at this point, which could delay the process.
Overall, the whole process, including the term sheet negotiation, due diligence, document drafting, back and forth regarding the documents, execution and wiring, usually takes about 4-6 weeks. Unfortunately, there is not really a way in which to expedite the process if you want to have it done correctly (or at least due a reasonable amount of diligence and/or negotiation on the deal documents). And deals can certainly (but hopefully not) take more than 6 weeks. Sometimes the closing is delayed because there can be more hurdles to get wires across, either because of internal procedures at the VC or simply due to regulatory issues.
The Venture Capital Transaction Documents
The actual documents used, as well as their forms and language, will vary by financing. Our goal with this section is to give a general and brief overview of what we like to call the “transaction documents” so that you have an idea of what you are getting yourself and your startup into. For the most part, but, there is some degree of uniformity because the transaction documents used in India-based venture capital financings, like their counterparts in the US, are usually derived from the National Venture Capital Association (NVCA) legal documents.
1. Stock Purchase Agreement (SPA): This is the main document of the venture capital financing): As the name implies, this is the document by which the shares are actually purchased. The SPA includes terms such as: the price, number and class of shares purchased, the representations and warranties of the startup and most of the time the founders (as well as the investors) and the conditions to close.
A couple of additional things to note regarding the SPA: (i) if you have convertible debt, the holders of said convertible debt will also be a party to the SPA as well and will use their outstanding debt to purchase the shares at this financing, (ii) conditions to closing here are usually longer and more detailed than in US venture capital financings, although it doesn’t technically lengthen the process and (iii) because the company is de facto international, there’s usually more representations and warranties about FCPA and other international issues.
2. Restated Certificate of Incorporation (COI): The restated COI the only document that is actually filed with the secretary of state. The different economic and control rights of the respective classes and/or series of shares will be set forth here. Thus, your COI which might have been 2 pages upon incorporation can end up being 20+ pages now.
Perhaps the most important, or at least the most discussed and negotiated, part of the COI is the liquidation preference. Basically, the liquidation preference provides downside protection for the investors. For example, if the company sells for a price at or near the total money put into the company by the investors, they will just get their money back and the rest of the stockholders will get nothing. On the other hand, if the company has a very successful sale, then the investors will generally forgo their liquidation preference in order to take just their pro rata amount of the sale.
The COI will usually also contain protective provisions or, in other words, actions that will require investor approval. These generally include, but are definitely not limited to: (i) authorizing additional stock, (ii) changing the rights of the stock held by the investors, (iii) consummating a liquidation event, (iv) changing the authorized number of directors or (v) paying or declaring any dividends.
Other common terms in the COI are anti-dilution protection and redemption rights. Basically, anti-dilution protection will grant additional shares to the investors, without additional consideration, upon the occurrence of certain grants of stock in order to protect the investors. Certain stock grants are excepted such as: (i) stock option grants to employees, directors, consultants and other service providers, (ii) common stock issued for business purposes or (iii) common stock issued upon conversion of the investors’ preferred stock. Redemption rights basically mandate that the company must purchase back the investor shares, providing downside protection for the investors in addition to the liquidation preference.
3. Investors’ Rights Agreement (IRA): The IRA deals with additional rights of the investors that aren’t set forth in the Restated Certificate. Some of the main additional rights are: (i) information rights (financial statements, inspection, etc.), (ii) board observer rights, (iii) preemptive rights (iv) and registration rights. The IRA may also include some post-financing covenants that deal with FCPA compliance, insurance, employee agreements and stock grants, and director indemnification.
4. Right of First Refusal and Co-Sale Agreement (ROFR): The ROFR gives the investors the right of first refusal and co-sale rights, if any. In other words, the startup has to offer the investors any securities they sell in the future (with customary exceptions for things like option issuances to employees) and if any of the key founders wishes to sell their stock, the investors will have the right to do so as well. Generally, the investors will have the ROFR only after the company. Occasionally, we do see investors in India that want to have the ROFR prior to the company, which is something that is not common as in the US. Further, VCs in India can tend to desire and negotiate better ROFR and co-sale rights than US counterparts.
5. Voting Agreement: A Voting Agreement is common especially if the investors are getting a board seat, which will usually be controlled by the main investor/VC. The Voting Agreement ensures that the investors will be able to maintain said board seat. This agreement also usually contains a drag along provision. Of note, the drag along when dealing with India-based startups is usually longer in nature than in US-only deals. There can also be extensive voting provisions regarding the private limited subsidiary, or soon to be subsidiary, of the company. Investors may insist on having these provisions regarding the subsidiary in order to ensure that the control they are granted over the company filters down to the subsidiary.
The Venture Capital Ancillary Documents
Same caveat as above, the documents will vary by financing. But, you will only see some of these ancillary documents as they vary more widely than the transaction documents discussed above. “Ancillary documents” are no less important than the transaction documents but they are generally less controversial.
1. Consent of the Board: The consent of the board of directors is an ancillary document that you will most certainly see every time. Basically, this consent summarizes the transaction and serves as the corporate approval of the transaction. This written consent is in place of a physical meeting (which, technically, could also work) and investors will generally require that the written consent be used, for the sake of recordation. The following things are examples of what are typically approved via board consent: (i) authorizing the filing of the Restating Certificate, (ii) the financing and all financing related documents themselves, (iii) increases to the option pool, (iv) indemnification agreements for the directors, (v) increasing the board size and appointing the new investor director(s), (vi) amendments to RSPAs (if vesting schedules are being modified or added), and (vii) restated bylaws. This list, though, is definitely not exhaustive and the board consent will vary by financing.
2. Consent of the Stockholders: Similar to the consent of the board, you will see the consent of the stockholders in every transaction. Again, this is a summary of the transaction but it is generally shorter than the consent of the board because the approval of the stockholders is not required for every single part of the transaction. Again, this is in place of a physical meeting of the stockholders. At a minimum, the stockholders’ consent will approve: (i) the restated certificate, (ii) the financing (typically), (iii) the indemnification agreements, and (iv) any increase to the option pool.
3. Management Rights Letter (MRL): MRLs usually give the investor certain rights. Usually these rights include: (i) the right to attend board meetings and receive all documentation/information that the board members receive (if the investor is not represented on the board), (ii) the right to inspect the books and records, and the facilities of the startup, and (iii) generally, the right to advise and consult with the startup founders/management. If a VC asks for an MRL it is because one (or more) of the investors in the fund is a pension plan basically subject to ERISA. This means that there are rules and regulations that must be followed. And, since pension plans make up such a large pool of potential investors and if all these rules and regulations had to be followed, said potential investors would never be invested in VCs, an exception was made. In order to take advantage of this exception, the VC has to have the above-described rights.
4. Indemnification Agreements: Indemnification agreements protect board members. If you are going to have an investor on the board, they will almost always ask for an indemnification agreement. It is also a good idea for all of your board members to have one, including the founders. Basically, the company will indemnify the board members for decisions they make which result in liability. While there are typically indemnification rights in the COI and the Bylaws, an indemnification agreement gives the directors more comfort in knowing that they have a direct agreement with the Company regarding such rights and that this agreement can therefore only be modified with said director’s consent.
5. Legal Opinion: The legal opinion is not always seen and tends to appear only in larger deals. The attorney for the startup will certify (offer an “opinion”) as to the current status of the startup in terms of its cap table and standing.
6. Founder Stock Restriction Agreements: These agreements can take different forms (such as just a “Founder Agreement” or an amendment to a prior agreement) but all do just about the same thing: restrict founder stock. Most investors will want to make sure that the founders have certain vesting and other restrictions attached to their stock and will include these desires in the term sheet, if any. These will usually be seen if there is a change in the vesting schedule. Most VCs in India (like their US counterparts) are usually fine with reasonable vesting schedules and will not reset the vesting clock entirely to go back on a 4-year schedule.
7. Founder Agreements. These agreements typically deal with restrictive covenants, such as non-competition and non-solicitation. The India-based VCs also typically desire a bit more coverage here than US counterparts.
As mentioned before, there are a lot of similarities between raising money in the US and doing so in India. However, there are also differences for the most part based on the Indian private limited entity and customary terms in India-based financings. The India-based VCs and companies do a great job of closing on typical US-based terms, but with some accommodations based on the startup’s fact pattern or customary terms in India.