The Indian startup ecosystem has raisings the bars for the worldwide startup community. Angel investors have played an influential role by assisting the startups financially and helping them grow in the market under their support and guidance.
Though the process of angel funding for startups looks like an easy process, it involves multiple complicated steps and formalities that an investor, as well as the startup firm, needs to complete to make a successful angel funding for the startup.
So you’ve finalized the desired startup you want to fund out of the multiple startups looking for funding and don’t know what to do next? In this article, we’ll be discussing the legal process of angel investing.
Legal Process of Angel Investing in India
1. NDA- Non Disclosure Agreement
2. Company Valuation by CA
3. Due Diligence
4. Subscription or Loan Agreement
- Subscription Agreement
- Loan Agreement
5. Shareholder’s agreement
6. Investment Terms & Negotiations in Termsheet
- Liquidation Preferences
- Warrants Coverage
- Conversion Rights
- Automatic Conversion
- Anti-Dilution Rights
- Redemption Rights
- Voting Rights
- Dividends
- Board Participation
- D&O Insurance
- Pre-emptive/pro-rata rights
- Information Rights
- Expiration of Letter
7. Post Investment Support
1. NDA- Non Disclosure Agreement
Both the parties, investor and startup, need to sign a Non Disclosure Agreement under which the rights and exclusivity of the meeting and pitch are maintained between both the parties, securing the chances of idea theft & misuse under any circumstances.
As an angel investor, it becomes essential to sign an NDA to be able to access the company information to help evaluate potential startups and thereby invest in good startups.
The Non-Disclosure Agreement also includes the ‘non-disclosure’ of the terms of investment and the amount of investment being discussed amongst the startup and the investor.
2. Company Valuation by CA
One must be ensured that the company’s valuation has been evaluated by a certified Chartered Accountant to ascertain the true equity value of the company for moving ahead to the next step of investing in the startup. Once the company’s valuation has been estimated, the price per share for the company will either be issued at par, discount or a premium.
Note: The Income Tax Act 1961, Section 56(2)(viib) allows registered startups to avail of a tax exemption on the amount of investment received.
3. Due Diligence
Due diligence is essentially an investigative step in which the investor reviews all the documents pertaining to the preferred startup, which includes evaluating the firm’s future market potential before moving ahead with the funding process.
An investor must ensure he follows the diligence process involves cross-questioning to verify critical assumptions and figure out the avoidable mistakes.
4. Subscription or Loan Agreement
An investor needs to specify how he’s willing to invest his angel funding into a startup by signing up the subscription agreement or the loan agreement.
Note: An angel investor can provide funding to a startup by either buying shares in the company via the Subscription Agreement or lending money to the company via Loan Agreement.
a) Subscription Agreement
A subscription agreement states an investor’s intent to buy shares and his qualification to buy such shares in the company.
It provides that the startup agrees to sell a specific number of shares at a particular time & price so that the subscriber becomes a shareholder. In return, the subscriber agrees to buy the shares at a specific time & a particular amount.
b) Loan Agreement
A loan agreement is a document that specifies the mutually agreed promises, in the form of debentures or other debt instruments) amongst the investing party and the startup.
By signing a loan agreement, the investor acquires his investment returns by funding the amount as a loan for a specified interest to be paid after a specified time period.
Note: Investors often choose a combination of equity and debt while funding a startup.
5. Shareholder’s agreement
Often people confuse shareholder’s agreement with the subscription agreement when, in reality, both serve a different purpose. A shareholder’s agreement defines the relationship among the shareholder, setting out their rights in the company.
The contract specifies the investor’s shareholder transfer rights along with other clauses.
6. Investment Terms & Negotiations in Termsheet
At this point, an investor needs to negotiate on the terms and conditions of the investment agreement, which is then formulated into a Termsheet.
As an investor, ensure the critical agreement clauses are taken care of in the Termsheet. Some of the essential Termsheet clauses to keep in mind are:
a) Liquidation Preferences: An investor can secure his investment when a startup is either looking to wind up or rearrange certain aspects of a company by asking for a specifies liquidation preference that assures his investment security.
He can either choose a participating or non-participating liquidation preference.
For example–> An investor invested INR 10 crore in a startup. Now, if the company is valued at INR 20 crore at the time of its exit and the angel investor asked for a 1x liquidation preference, he’ll be walking away with INR 10 crore when the company shuts down.
b) Warrants Coverage: Warrant Coverage stands as the agreement between the company and the investor or shareholder, where the company issues a warrant equal to a decided percentage of amount worth of investment. It allows the investor to acquire shares at a designated price.
For example, an investor purchases 1,000,000 shares of stock for Rs 5 per share, totaling a Rs 5,000,000 investment. The company grants a 25% warrant coverage, and issues to the investor Rs 1,000,000 in warrants. Technically speaking, the company guarantees 200,000 additional shares at an exercise price of Rs 5 per share.
c) Conversion Rights: The conversion rights define an investor’s right to convert the Series A preferred shares into shares of regular stock at any time at the pre-decided conversion rate.
d) Automatic Conversion: Automatic conversion is a clause that allows the investor’s stock to be automatically converted into common stock at the applicable conversion rate at:
- The closing of a firmly underwritten public offering
- Or the written consent of holders of the majority of the outstanding preferred stock.
e) Anti-Dilution Rights: An anti-dilution provision provides an option, security, or merger agreement that gives the investor the right to maintain his percentage ownership in the startup firm by buying a proportionate no. of shares of any future issue of the security.
f) Redemption Rights: A redemption right allows angel investors of preferred stock to require the startup to repurchase their shares after a specified period.
g) Voting Rights: The voting rights define the rights of a shareholder in matters of corporate policy. Voting rights vary across different instruments, and there are cases when the voting majority is required to take corporate action.
h) Dividends: Dividends serves as a return guarantee for an investor. Startups often do not pay dividends on a regular basis. Often investors permit startups to accumulate their dividends by growing the preferred size over a period. Once the investment period ends, i.e., during the startup sale or IPO, the preferred dividend would grow, benefitting the investor from the fixed return.
i) Board Participation: Board participation gives the investor ar group of investors the right to be elected for the position of the board of directors at the company if desired.
j) D&O Insurance: The D&O insurance is the liability insurance payable to the directors & officers of the company. It is paid as the reimbursement for the losses or advancement of defense costs in case an insured individual suffers a loss as a result of legal action brought for the alleged wrongful acts done in their capacity as the directors & officers.
k) Pre-emptive/pro-rata rights: Pro-rata/pre-emptive rights grants investors the right, but not the liability, to maintain their level of ownership throughout subsequent financing rounds.
l) Information Rights: The company, under the information rights, is obligated to share the following with their investor:
- Audited annual financial statements not later than 90 days after the end of every fiscal year
- Unaudited quarterly financial statements not later than 45 days after the end of each quarter & comparison of such quarter’s results with the results projected by the firm’s annual budget, and more
m) Expiration of Letter: Expiration of letter defines the validity of the letter or term sheet. The sheet is considered invalid if the company doesn’t return the original or faxes the executed version to the investor within the before the expiry period.
7. Post Investment Support
Your final investment procedure has been completed, and now you’re an official angel investor in the startup firm. The startups provide quarterly reports to their respected investors.
Angel investors are usually willing to provide advice that would help startups with their operations and merge their industry knowledge for the betterment of the startup firm.
The terms of the agreement between an angel investor and a startup vary from investor to investor. You can modify your own terms with the help of an attorney who will guide you through the process, while he handles the intricate details involved in the investment process.
