This article attempts to provide a snapshot of a typical early stage venture capital investment in a company and the key rights available to a venture capital investor in an investee company. The nature of an early stage investment round varies from the subsequent rounds, as the company grows.
(a) Investment Opportunities:
Venture capital equity investors typically have a team on the ground in India to help scout for investment opportunities and help pursue them. Under Indian law, a business presence would be required to ‘house’ them, and the preferred option is a wholly owned subsidiary set up as a company.
(b) Investment Vehicle:
Typically a venture capital investment is made either as (i) a direct investment; or (ii) under the special route for venture capital investment i.e. foreign venture capital investment, which has certain benefits over other route.
While the investment can be made in both, equity and preference instruments, the most common instrument through which the venture capital investors make investment is compulsorily convertible preference shares (“CCPS”). This is primarily for two reasons: (i) liquidation preference available to the holder of CCPS at the time of liquidation; and (ii) gaps in valuation for determining the price of instrument can be bridged through the conversion formula as conversion of these instruments can be at an actual valuation rather than projected valuation.
(d) Indicative List of Rights Available to Investors:
Generally, the flexibility to negotiate investor rights gets diluted in the later stage funding rounds, as the approval of the erstwhile investors is required to amend the existing shareholders agreement. The erstwhile shareholders are usually not willing to re-open/negotiate the rights that are already available to them unless the new rights that are being proposed are more favourable than the rights already available to them. Some of the typical rights that may be available to a venture capital investor are discussed below:
1. Dividend Rights: Under Indian law, companies are permitted to freely repatriate their profits by way of dividends in respect of the equity participation of its shareholders. Investor’s dividend rights depend upon the kind of securities subscribed to by them. Investors subscribing to CCPS carry a preferential right to dividend, at a pre-identified percentage.
2. Voting Rights: Generally, if the instrument subscribed to by the investor is a CCPS, then he has right to vote only on resolutions placed before the company which directly affect the rights attached to the CCPS and, any resolution for the winding up or for the repayment or reduction of company’s equity /preference share capital. In such a case, investor may prefer to subscribe to a small portion of equity shares so as to enable them to attend shareholders meeting and cast votes. Alternatively, investors holding CCPS can negotiate the voting rights on an ‘as if converted basis’ for enjoyment of similar rights to an equity shareholder, even without subscribing to the equity shares.
3. Indemnity Rights: In the transaction documents, investors may obtain robust warranties and indemnities from the promoters and the company, on a joint and several basis. However, the indemnity is usually subject to caps which vary depending upon the stage of investment. For example, in an early stage of funding, promoters may be willing to provide uncapped or significantly high caps compared to later stage funding.
4. Right to appoint Directors: Investors may have a board representation right in terms of appointment of at least one (1) director, which is typically linked to the shareholding percentage of the investor in the company and is subject to a minimum percentage of shareholding in the company. Such director’s presence is usually agreed to be mandatory towards counting the quorum for the board meetings and passing of any affirmative vote matters.
5. Affirmative Vote Matters: A fairly elaborate list of matters is commonly seen, requiring the affirmative consent of the investor / investor director who hold at least a minimum percentage of shareholding in the company.
Typically in a transaction document, the affirmative voting matters inter alia include transactions relating to mergers/ amalgamations/ restructurings of company and/or it subsidiary; commencement of winding up, insolvency or bankruptcy proceedings; acquisition of other businesses/ joint ventures; sale of company’s and/ or its subsidiary’s assets; closure of an existing business or commencement of any business; any alteration of authorized or issued share capital and terms thereof; amendments to the charter documents; appointment or termination of key employees; change in management; approval of the annual accounts; making inter-corporate investments or providing loans or guarantees; creating charge or encumbrance over the assets; declaration of payment of dividend or distribution of profits or commissions; listing of capital stock; related party transactions, etc.
6. Transfer Restrictions: The transaction documents typically provide the following restrictions on transfer of shares in a venture capital investment:
(i) Restriction on promoters: Shares of the promoters are usually locked in during the entire investment period. In cases where transfer is permitted, it is subject to ROFR / ROFO / tag along rights in favour of the investor. However, the rights are generally diluted in the later stage funding and some liquidity may be granted to the promoters.
(ii) Restriction on investors: Investors typically do not have any transfer restrictions except restriction on transfer of shares to the competitors. However, in case of inter-se transfer among investors, there could be a ROFO/ROFR right available to other investors.
7. Exit Rights: Generally, the investors get exit rights in following events: (i) initial public offering (IPO); (ii) buy back of securities; (iii) strategic sale; (iv) drag along rights on the entire shareholding of the company (which may get accelerated and have penal consequences in case of an event of default).
While this article covers the typical early stage venture capital investment and the key rights available to an investor for such investment in India, the actual rights available to the investor will depend upon the type of the company, sector of the company, nature of investor, negotiating leverage, etc., and therefore same will have to be examined on a case-by-case basis.
The views and opinions expressed in this article are those of the authors alone and do not necessarily reflect the official position of AZB & Partners or the position of any other agency, organisation, employer or company.
Jasmin Karkhanis, Partner
Arpit Sinhal, Associate