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Exploring Investment Instruments for Startups: Advantages, Risks, and Considerations
The rapid growth of start-ups in India has garnered support and assistance from the government as well as numerous industrial sectors. Entrepreneurs have received several incentives and benefits to establish start-ups in order to promote the growth of the Indian economy. The key to their growth and success is 'financing and funding,' which is frequently a challenge for these entrepreneurs.
During the early stages, funding is typically provided by internal sources such as friends and family or the founder himself. This is known as 'Seed Capital,' and it assists in turning a business idea into something viable, attracting additional financiers. After this stage, startups typically seek outside investment, typically from private individuals known as 'Angel Investors.' This contributes to a certain level of advancement and stability in the business. However, the most common source of start-up financing in India is through Venture Capitalists or Private Equity, which is accomplished through a variety of methods and instruments, some of which are discussed below.
There are two types of financing:
The former comes in the form of loans and External Commercial Borrowings (ECBs), which come with a high interest rate and a collateral requirement. Given the nature and insecurity of these startups, debt financing is frequently dismissed as a viable option for such entrepreneurs.
Equity financing, on the other hand, carries a high risk factor because there is no guarantee of repayment if the venture fails toper form. A private equity investor or venture capitalist invests in a company's shareholding by subscribing to the equity share capital. This significantly aids in the expansion or diversification of startup ventures.
Over the years, a recent development in equity financing has emerged to balance the interests of startup entrepreneurs and investors. Subscribing to Convertible Instruments such as Compulsory Convertible Preference Shares (CCPS) and Compulsory Convertible Debentures (CCD). These hybrid options are advantageous because equity share ownership does not guarantee a fixed return on investment and does not provide any special rights or preferences. Furthermore, by issuing convertible securities, the founders retain control over the venture's management and decision making.
While other unconventional forms of investing, such as "crowdfunding" and "incubation," are now available, investors prefer hybrid securities because they are more secure. The most notable instruments are discussed further below-
These are referred to as "deferred equity instruments" because they must be converted into equity shares when their maturity period expires. They are hybrid securities because they are converted from debt (debenture) to equity share and thus have characteristics of both.
A company may issue a CCD under Section 71(1) oft he Companies Act of 2013. Given the nature of these hybrid securities, the Supreme Court held in Narendra Kumar Maheshwari v. Union of India that" any instrument that is compulsorily convertible into shares is ultimately regarded as equity and not as a loan or debt."
However, according to the RBI Guidelines, they are treated as equity for all financial statements and records but not as Company Share Capital. Thus, it can be deduced that, while they provide security to investors in the form of debentures, they are ultimately converted into shares. They can be issued if converted to shares within 5 years of issue, according to Rule 2(1)(c) of the Deposit Rules.
Because the early stages of a start-up are inherently unstable, the entrepreneurs frequently lack assets and cash flow. This makes determining an accurate valuation of the company difficult, which is a requirement for investors who pool their resources. This is when investors choose such securities.
If the startup venture fails to deliver, the investors are still protected because they are obligated to receive interest with the promise of receiving dividends on the equity shares in the future. Furthermore, the startup will eventually have to issue shares rather than risk depleting its cash reserves. Furthermore, unlike certain other hybrid securities, they encourage foreign investment. As a result, their subscription benefits both parties the majority of the time.
However, there are some drawbacks to CCD subscription, which is causing investors to gradually shift to other hybrid securities. While the original intent of this instrument was to reduce the difficulty of valuation, ventures are now required to obtain a 'Valuation Certificate' from the appropriate certifying officer prior to investment. They must also comply with FEMA guidelines, SEBI regulations, FDI regulations, and tax procedures. This significantly increases the compliance requirements that must be met, making the investment process more difficult.
Obligatory Convertible Preference For two main reasons, shares are the preferred choice and most popular among investors.
Furthermore, if the business is successful, the preference shares are converted to equity shares, increasing the investors' opportunities for capital growth and profit retention.
The main advantage of these shares is that their conversion is linked to the company's performance. This allows private equity investors to balance any disparity in the venture's valuation expectations, as the general valuation method is inefficient in the case of start-ups due to the lack of a profit and loss account to show.
In this case, investors contribute resources when the company is undervalued and eventually convert their shares to equity, yielding a higher dividend, without pooling additional resources when the venture is overvalued. Furthermore, it helps start-ups avoid cash-flow exhaustion because, unlike CCD, this security is not a "debt" or "loan" that must be paid back with interest. This strikes a balance between the interests of investors and entrepreneurs.
However, this hybrid security, like convertible debentures, is infamous for the hefty load of compliance requirements and paperwork that is involved, primarily the requirement for a valuation certificate.
Sections 42, 62, and 55 of the Companies Act of 2013 govern the issuance of these shares. Furthermore, because the instrument is eventually converted into equity, foreign investment is permitted, making compliance with FDI policy and FEMA regulations mandatory. Similarly, the provisions of the Income Tax Act of 1961 must be followed. The issuance of these shares also confers certain rights on the shareholders, limiting the venture's promoters' decision-making power.
While CCPS and CCD are the most commonly used investment instruments in India, some venture capitalists are now employing different methods that have proven successful in the international economy. They are as follows:
Convertible notes are issued as a 'debt instrument' to fund a venture in the form of a loan. The investor can convert this instrument into an equity share in the company, which is usually done when the venture receives additional funding. This is based on a threshold set by the investor, which, if not met, requires the venture to repay the principal amount as well as the accumulated interest to the investor.
While the basic concept of a convertible note is the same as that of a CCD, this instrument has proven to be less expansive and user-friendly due to the absence of several compliance requirements, most notably the valuation report and certificate.
As a result, ventures that are unable to produce a substantial valuation report are also eligible for funding. However, only'recognised' start-ups are eligible to issue convertible notes in India, according to the RBI Regulation and The Companies (Acceptance of Deposit) Rules, 2014. The transferability of these securities in India is governed by exchange rules, which require conversion within 5 years of the issue date.
This instrument is thought to be highly efficient in terms of security, which on the one hand caters to the interests of investors, but on the other hand introduces a great deal of uncertainty to start-ups because there is no guarantee whether investors will/will not convert their securities, as in the case of CCD and CCPS.
SAFE is commonly referred to as a 'equity derivative contract,' as it converts the initial capital invested into future company stock based on contractual terms and conditions.
The primary reason for SAFE's success in countries such as the United States, Singapore, and Germany is that there is no interest, unlike a debt instrument or loan. There is also no maturity date or mandatory conversion period, allowing for greater flexibility and negotiation. Instead of terms and schedules, they are based on certain contingent events, the occurrence or non-occurrence of which determines the investor's interest to either:
Furthermore, because it is a contract rather than a security, the parties have complete control over it (investor and entrepreneur). This enables them to tailor the clauses to their specific situation, financial capabilities, and proposed business model, striking a balance that benefits both parties.
Finally, because SAFE agreements do not pay interest or have a maturity date, they cannot be classified as a 'debt.' Similarly, because there are no dividends or other shareholder rights, it cannot be called "equity." This renders the instrument untrustworthy and insecure to a large extent, which is the primary reason for its failure in India.
The India Simple Agreement for Future Equity is a template-driven standardised agreement that is gaining popularity due to its simplicity and efficiency. It is a hybrid of all of the above instruments because it is neither a debt nor an equity, but it is regulated by the Company Law as a CCPS, making it sound and secure. It is convertible upon the occurrence of specified events and is appealing to both investors and founders.
In the event that the startup fails, all assets remaining after paying off the liabilities are returned to the investors. In accordance with the limited liability concept, the company, not the founders, is liable for repayment. In the event of success, however, it is convertible on the occurrence of the event.
Finally, it is free of the time-consuming documentation procedures required for CCDs and CCPS. As a result, despite being relatively new, it is a growing concept that is being adopted by a number of ventures and investors in the country.
SAFE provides great flexibility to the capital structures of the start-ups as the sale of equity shares will not cause the note-alternative securities to convert. However, deferring the valuation can have certain negative effects. A SAFE note with a valuation cap essentially has the same effect as an anti-dilution provision and may act as a ceiling for the subsequent financing round. It also creates additional risk for the company. For instance, if the company is valued significantly lower in a subsequent funding round than when the SAFE notes were issued, then the holders of the notes will be entitled to take a much greater percentage ownership of the company upon conversion. Moreover, having no maturity date is troublesome for investors to declare a default.
Since SAFE converts to equity shares based only on some future event, it is important for parties to negotiate what exactly such triggering event for conversion shall be. Depending on its terms and despite the identified triggering events, there maybe certain scenarios in which the triggers are not activated and the SAFE is not converted, leaving the investor with anything. Although the possibility of this is very unlikely in the case of iSafe notes, since they essentially take the form of compulsorily convertible preference shares.
Here are some common questions and answers about startup investment instruments in India:
Q: What are startup investment instruments?
A: Startup investment instruments are financial products that are used to invest in and support the growth of startups. These instruments typically offer investors the opportunity to buy a share of a startup's equity in exchange for capital, and may also provide additional benefits such as voting rights and access to the startup's profits.
Q: What are the different types of startup investment instruments in India?
A: Some of the main types of startup investment instruments in India include:
Q: What are the advantages of using startup investment instruments in India?
A: Some of the main advantages of using startup investment instruments in India include:
Q: What are the risks of using startup investment instruments in India?
A: Some of the main risks of using startup investment instruments in India include:
Q: How can investors choose the right startup investment instrument in India?
A: Choosing the right startup investment instrument in India can be challenging, and investors should carefully consider their own financial goals, risk tolerance, and investment horizon before making a decision. Some factors that investors may want to consider when choosing a startup investment instrument include the startup's business model, its stage of development, and the terms and conditions of the investment. Investors should also carefully research the startup and the market it operates in, and seek professional advice if necessary.
Following a thorough examination of the most prominent hybrid instruments for start-up investments, it is clear that there is no 'one' definite approach to take for all ventures and investors. While some are concerned about tedious compliances, others may be concerned about the security or valuation of the company. As a result, it is critical to assess the situation of each instrument and choose the best investment strategy.
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