If you are an early-stage founder or an investor who invests in early-stage companies, you’ve heard of ‘convertible notes’. The popular version(s) of convertible notes in the Indian market are adaptations of Y Combinator’s popular “SAFE” structure (Simple Agreement for Future Equity). As the name suggests, the SAFEs promise a simple, quick and process-light means to raise capital.

Under Indian corporate law and exchange control laws Indian companies are permitted to issue convertible notes if they satisfy the following conditions:

• Company should be registered as a startup with the DPIIT (Department for Promotion of Industry and Internal Trade, Ministry of Commerce).
• Each convertible note issued by the Company should be at least of an amount of INR 25 Lakhs.
• The convertible note should be converted into equity shares or repaid within 5 years.

An important attribute of Indian convertible notes is that they are not priced, i.e., the exact value/valuation at which the investment is made is not decided at the time of the investment. Exact pricing of the investment is usually deferred to the next institutional round (the notion here is that with the capital raised through convertible notes, the Company would have a chance to build out enough to generate valuation metrics). Accordingly, the convertible note is issued with an understanding that it will be converted to the Company’s shares based on the valuation at which the next round of funding is raised by the Company. Usually, the conversion is at a discount to the next round valuation and is often subject to a valuation cap and/or a valuation floor. Thus, while the exact valuation is not decided, the investor and the founder make certain assumptions on the valuation range that the company has or is likely to achieve.

The general rule under Indian corporate law is that when a company raises external capital, it needs to justify the valuation at which the capital is raised with the support of the report of a valuer. Similarly, under our foreign exchange laws, when capital is raised from a foreign investor, the company has to justify the valuation at which the capital is raised with the support of the valuation report of a chartered accountant or a SEBI registered merchant banker. In contrast, for issuing convertible notes, the Company need not obtain such valuation reports. Similarly, the regulatory filings and processes for issuing convertible notes are simpler than those required for issuing equity shares, convertible preference shares, or convertible debentures.

Another significant attribute of convertible notes is that the investors usually take very limited rights in the company- in terms of reporting, consent requirements and other governance rights. This is recognizing the fact that the company is (usually) in very early stages, working with a lean team and limited resources, and can ill afford the costs associated with elaborate reporting and governance regimes. All this leads to contractual documentation which is simple and short (in contrast to 100+ pages of contractual documentation in a normal funding round).

The simplicity of documentation (and thereby minimized contract negotiations), and permissibility to defer the valuation, make a convertible note round usually quicker and more economical to close than a priced round (or even an unpriced round structured as a variably priced convertible preference share or convertible debentures round). No wonder, convertible notes have become a popular funding structure for infant startups.

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JoyceLaw is a boutique corporate law firm with a special focus on the startup ecosystem. JoyceLaw represents several founders and startup companies who are at various stages of their lifecycle. We routinely work with our clients in a broad range of matters including fund raise, structuring and documentation of strategic initiatives and partnerships, business structuring, general corporate and commercial matters, ESOPs, regulatory compliance, etc. If you would like to know more about topics discussed in this article, please reach us at knowledge@joycelaw.in

In this edition of Deal Terms Demystified, we look at “Anti-Dilution”, a standard term one will encounter while raising capital from institutional investors (lately many angel rounds also have this term).

What is Anti-Dilution?

Anti-Dilution protects your existing investor(s) in case the company raises a down round in the future. To understand this better, let’s look at an illustration:

– Founders own 900 shares that constitutes 100% of Company A. Investor X invests Rs. 100 in A and receives 100 shares, i.e., an ownership of 10% (i.e., at a pre-money valuation of Rs. 900 and a post money valuation of Rs. 1,000) (see our post on pre and post money valuation). Now founders own 90% and X owns 10% and founders’ ownership has a value of R.s 900.

– In the next round investor Y invests Rs. 80 in A and receives 111 shares, i.e., an ownership of 10% (i.e., at a pre-money valuation of Rs. 720 and a post money valuation of Rs. 800. This is a down round.

Post down round, the value of X’s shares falls to 72 (the down round dilutes X’s ownership by 1%, i.e., 10% of 10 per cent ownership, or 9% ownership. The value of X’s diluted ownership is 9% of 800). Thus post the down round (without factoring in any Anti-Dilution) X and Y would own 19% (9% + 10%). The founders would own 81%. Based on down round valuation, the founders ownership would have a value of Rs. 648 (81% of 800).

Investors hedge the risk of a down round through Anti-Dilution right.

How does Anti-Dilution work?

With Anti-Dilution, earlier investors who invested at valuations higher than the down round valuation get more shares (or the right to get more equity shares when their preference shares are converted).

If one were to give full protection against devaluation in a down round, a pre-down round investor’s ownership in the company would have to be hiked to a level which has the value (based on post down round post money valuation) equal to the capital invested by such investor. In the above illustration, X’s ownership needs to be bumped up from 9% to 12.5% to achieve this. If so, X and Y would own 22.5%. Founders would own 77.5%, valued at Rs. 620 (77.5% of 800).

Current Market Standard: Anti-Dilution on Broad-Based Weighted Average Basis

The Anti-Dilution model explained above is called ‘full ratchet anti-dilution’. The current standard practice in India (and most western markets) is the ‘broad-based weighted average anti-dilution’ model.

The number of additional shares to be given to an Anti-Dilution protected investor under the broad-based weighted average method is as follows:

A / {(B+C)/(B+D)}

A = Number of shares which were bought by protected investor at valuation higher than down round valuation;

B = Total number of shares issued by the company until the down round;

C = Total number of shares which would have been issued in the down round at the valuation at which the protected investor bought its shares; and

D = Actual number of shares issued in the down round

Applying this formula to our above illustration, let’s see how X’s ownership increases:

100 / (1080/1111) OR 100/0.97 = 102

That is an increase of 0.2% in X’s ownership under the broad-based method. This contrasts starkly with the 3.5% increase in ownership under the full ratchet method.

Broad-based weighted average anti-dilution method is more favourable to the founders (and earlier stage investors not protected by Anti-Dilution) as the dilution for them is lower.

By favouring broad-based weighted average method for Anti-Dilution, professional institutional investors have made the Anti-Dilution term more palatable to the founders, even if it exposes the investors to the risk of value loss.

Founders take note:

Anti-Dilution protection for financial (institutional) investors is a universally standard term in the Indian market, so one should not harbour hopes of negotiating it down. But pay attention to the Anti-Dilution formula and validate that it bears out Anti-Dilution on broad-based weighted average model.

Watch this space for the next instalment of Deal Terms Demystified. In the meanwhile, feel free to share this post with your friends and colleagues you feel would find this helpful.

Pretty much every institutional investor term sheet and shareholders’ agreement would have a section titled “Liquidation Preference”. Let’s try to demystify Liquidation Preference (“LP”).

No $ for you until I get my $$$ back in full

Yes! That’s one way to understand LP. LP is downside protection for the investor in case the company is sold cheap. Upon investing, an investor would hold a certain percentage of ownership in the company.

In a simple world, if the company is sold, the investor would receive the percentage of the sale price which is equal to its ownership percentage in the company. But what if that percentage of the sale price is less than the capital invested by the investor? LP addresses this situation.

Under the LP clause, the investor has the right to receive the money it invested (or a multiple of that, depending on the commercial understanding) before any other shareholder receives any amounts. Let’s see how LP works through some simple illustrations. (Please note that the illustrations are based on the current Indian market standard model for LP).

Suppose the investor invested 100 for a 10% ownership in the company.

A. The company is sold for 2500. The investor would receive 10% of the sale price or 250. The rest of the shareholders (i.e, owners of 90% of the company, including the founders) get 2250 pro rata (i.e., each shareholder’s ownership percentage in the remaining 90%).

B. The company is sold for 250. Without LP the investor would have received 10% of 250, or 25. With LP, the investor receives 100. The rest of the shareholders get 150 pro rata.

C. The company is sold for 90. Here, LP allows the investor to receive the entire 90. The rest of the shareholders end up not receiving anything.

Let’s say two investors invested 100 in 50:50 ratio (for a company ownership of 5% each). Here, the pay-out to the investor(s) will be split equally between the two investors in all three scenarios.

What if the two investors invested in different rounds (i.e., at different valuations). Investor “X” bought a 7% ownership in the company for its 50 and Investor “Y” bought a 3% ownership in the company for its 50. What would X and Y receive in the three scenarios above?

In A above, X would receive 7% of 2500 (or 175), and Y would receive 3% of 2500 (or 75).

In B and C above X and Y would share the pay-out in proportion to the respective amounts that they have a right to receive (i.e., 50 each, or each investor is entitled to 50% of the pay-out). Thus, in scenario B above, X and Y get 50 each. In scenario C, they get 45 each (50% each of the total pay-out in each scenario).

No $ for you until I get my $$$ back in full

LP is a standard and non-negotiable term in startup funding deals in the Indian market (as well as the US, western Europe and most other jurisdictions).

The prevailing market standard is LP protection of 1X of capital invested, and pari passu distribution to investors of various rounds.

• “1X” means the maximum amount an investor may take under scenarios B and C above is the amount of capital it has invested.
• “Pari passu” distribution means that amongst investors that invested in various rounds there are no priorities or preferences for distribution. This is opposed to a model where a later round investor has a preferential right to its money vis-à-vis the previous round investors.

Useful tip: Founders’ and other non-investor shareholders’ position (in terms of what they get paid in a company sale) does not change regardless of whether LP distribution is pari passu or preferential amongst the investors. But their position changes depending on the amount for which LP protection is given (i.e., 1X LP versus a higher multiple of the investors’ capital).

Watch this space for the next instalment of Deal Terms Demystified. In the meanwhile, feel free to share this post with your friends and colleagues you feel would find this helpful.

Investment/financing deal term sheets and agreements contain a number of commercial and operative terms, which sound technical and complicated. While many of these are standard terms, it is essential that parties have at least a working understanding of these terms to enable them to negotiate the deal, and have an appreciation of what they’re signing up to. Over the next few months we would be putting out short articles at regular intervals explaining some of the common deal terms. Without further ado, let us go to the topic at hand.

Pre-Money & Post-Money Valuation:

• “Pre-Money Valuation” is the valuation of the company at which investment is made.
• “Post-Money Valuation” = Pre-Money Valuation + amount invested in the round.

Investor’s ownership percentage is determined based on Post-Money Valuation. (The pre-investment cap table gets ‘diluted’ by Investor’s ownership percentage). The price per share at which the company issues shares to the investor is as follows:

Pre-Money Valuation X total number of shares (including shares in the ESOP pool) on the cap table before the investment is made.

The product of share price and the total number of shares on the cap table after the investment gives the Post-Money Valuation.

ESOP Pool Pre-Money or Post-Money?

The investor usually asks that ESOP pool be created (or increased) Pre-Money. That means, the dilution due to the ESOP pool creation or increase should be entirely taken by the existing shareholders. The share price at which the company issues shares to the investor decreases if ESOP pool is created/increased Pre-Money (see the concept of share price calculation explained above).

On the other hand, if ESOP pool is created/increased Post-Money, investor also gets diluted. Here, the dilution, and the decrease of value taken by the founders and any other pre-existing shareholders (i.e., folks who already owned shares before the investor came in) would be lower, compared to creation/increase of ESOPs on the Pre-Money cap table. ‘Decrease of value’ can be ascertained by looking at the price per share post ESOP creation/increase.

Investors insist on ESOP creation/increase Pre-Money as the need to expand the cap table (in this case, to hire talent) is foreseeable, or even a pre-existing condition of the company.

Useful tip: Increase of shares on the cap table due to increase of ESOP pool doesn’t increase the valuation of the company, unlike an increase of shares resulting from an investment.

Watch this space for the next instalment of Deal Terms Demystified. In the meanwhile, feel free to share this post with your friends and colleagues you feel would find this helpful.

A lot of voices have been raised against an Income Tax Act amendment, which came to be popularly known as the “angel tax”. The Department of Industrial Policy and Promotion (DIPP) issued a notification on April 11, 2018 setting out a framework for start-ups to claim exemption from angel tax (Exemption Notification). The 2012 Union Budget introduced a rule that when an Indian private company receives equity investments from an Indian investor at a premium to the company’s fair value, the premium is taxed as ‘income from other sources’. Angel tax was the result of this rule. This rule was introduced to check illegal money flows disguised as capital investments into nondescript private companies. However, the activity that was affected the most by this rule was angel investments into Indian start-ups by domestic angel investors. It is ironic that the introduction of angel tax coincided with large scale systematic efforts to broad base angel investing. It is also relevant that since the premium to the fair value of the shares is treated as income from other sources the start-up would not be able to adjust the tax against its business losses.

Under the Exemption Notification, if the following criteria are fulfilled in a proposed angel investment, the relevant start-up may apply for an ‘approval’ for exemption from angel tax:

a. The start-up (other than a biotechnology start-up) is a private limited company incorporated not more than seven years back (biotechnology sector start-ups should have been incorporated not more than ten years back).

b. The start-up is working towards innovation, development or improvement of products or processes or services, or if it is a scalable business model with a high potential of employment generation or wealth creation.

c. The annual turnover of the start-up in any financial year (prior to seeking the approval for exemption) has not exceeded Rs. 25 crores.

d. The total paid up share capital and premium after the proposed angel investment does not exceed Ten Crore Rupees.

e. The investor has an average ‘returned income’ of twenty five lakh rupees or more for the preceding three financial years, or has a net worth of two crore rupees or more as on the close of the previous financial year.

f. A merchant banker has issued a report to the start-up specifying the fair market value of the shares of the start-up.

In a proposed angel investment where the above criteria are satisfied, the start-up may make an application, prior to the investment, to the eight member Inter-Ministerial Board seeking tax exemption. The Inter-Ministerial Board is comprised of the Additional Secretary of the Department of Industrial Policy and Promotion, and representatives of the Ministry of Corporate Affairs, Ministry of Electronics and Information Technology, Department of Biotechnology, Department of Science & Technology, Central Board of Direct Taxes, Reserve Bank of India, and the Securities and Exchange Board of India.

The framework under the Exemption Notification has a couple of significant structural challenges which potentially make it a non-starter. To set the context, a conservative estimate is that about 400 angel investments were made in the financial year 2017-2018. Looking at the current Indian start-up funding climate, it is safe to say that the current year would see at least the same number of angel investments (the widely held belief is that angel investment activity would grow appreciably this year). Also, typically early stage start-ups (in which angel investments are made) have a very short capital ‘runway’ and would be dependent on angel investment capital for continuing their operations. Given this, angel investment transactions are executed at a quick pace.

Under the Exemption Notification a start-up receiving angel investment has to make a prior application for exemption from angel tax. The application should include details such as the proposed date of issue of shares to the angel investor(s), number of shares to be issued, price of the shares, etc. Thus, the hundreds of start-ups that receive angel investments would have to apply to the Inter-Ministerial Board once the investment decision has been made and deal terms have been finally agreed upon, but before the actual investment. This requirement of prior approval for tax exemption guarantees delays in the completing an investment, potentially defeating the purpose of the investment. The Inter-Ministerial Board which was originally set up under the start-up India initiative meets once a month. This means two things: (a) start-ups might have to wait for days or weeks before their application is taken up; and (b) every time the Inter-Ministerial Board convenes there would be a significant number of applications which would need to be disposed of, and multiple deferrals of applications appear inevitable. Where the speed of completing the investment is critical, the mechanism proposed under the Exemption Notification unfortunately fails to deliver the intended objective.

It now seems clear that the start-up ecosystem needs to engage further with the government to try and hammer out a workable solution to the angel tax issue.