SEED FUNDING AND START-UPS

By Chandan Goswami & Aditi Gupta*

A Start-up company means a private company incorporated under the Companies Act, 1956 or 2013 and recognized as a start-up under the notification issued by the DIPP, Ministry of Commerce and Industry. Perceived as being capable of offering abundant opportunities for startups, India can be termed as the “posterchild” of emerging markets for its vast commercial potential. Add to it the 700 (approx) million people born through the late 1980’s to the 2000’s who carry material ambitions with the ability to spend in order to make those goals a reality, India has the potential to offer the best ecosystem to start-ups. From hairpin to airplanes, Indian start-ups can do it all. However, in order to carry out their business, a start-up needs finance.

Finance is the lifeblood of any business. A start-up is mostly the result of a novel idea that is the brainchild of its founder(s) and therefore the initial investment in the business comes either from the founders or from their friends and family. However, once the idea gets manifested into reality, the start-ups require more fund to operate and thus begins the journey of start-up funding. The stages of funding depends on the amount of fund required by any start-up company.

This article delves into the seed funding stage and enlists the most important legal documents a start-up must have up their sleeves when negotiating for funds.

SEED FUNDING AND ITS PROCEDURE

The funding done at the nascent stage is called seed funding and the capital is known as seed capital. It is the initial capital used at the time of starting the business. It is required for market research, product development, and other initial stage operations. It also permits exploration of the business idea by converting it into a viable product or service that further attracts venture capitalists. The paperwork involved in seed funding is relatively less and straightforward, compared to advanced rounds of funding. The interest rates are usually lower and there are mostly no restrictions in the manner of business working as it is still in the nascent stage.

WHERE DOES THE SEED CAPITAL COME FROM

The the seed capital is primarily obtained from –

A. Equity financing which includes Angel Investors, Venture Capitalists and Private Equity firms.

B. Debt financing which means obtaining a loan from banks and NBFCs, external commercial borrowing, credit guarantee trust for Micro and Small Enterprises Scheme (CGTMSE) loan.

C. Initial public offering

D. Non-Conventional methods which includes gathering funds via crowdfunding, incubators and accelerators

IMPORTANT PAPERWORK INVOLVED IN RAISING SEED FUND

A. NON-DISCLOSURE AGREEMENT

This agreement is signed between the start-up owner(s) and the potential investor(s). It is signed to ensure that the seed investor protects the secrecy and confidentiality of the information being shared by the start-up.

B. TERM SHEET

It is a significant document that envelops the deal structure by clearly elucidating the terms of investment including the price per share and Pre-money and Post-money valuation of the company. It is non-binding and the proposed investment is subject to formalization by Share Subscription Agreement and the Shareholders Agreement.

Term Sheet broadly has two provisions- Economic Provisions and Commercial Provisions. The economic provisions govern the commercial part of the term sheet and include price per share, participation by investors amongst other things whereas the Control provisions lay out the powers, rights, and preferences the investors will have over the founders.

C. BUSINESS VALUATION REPORT

It evaluates the Fair Value (valuation) of shares of the Company i.e. the price per equity share of the Company as on the date of Seed Investment. The higher the valuation of the company, the more lucrative it appears to the potential Seed Investor.

D. LETTER OF INTENT

It signifies the interest of the investor in making the proposed investment in the start-up. This investment is subject to the completion of the due diligence process, provision of additional information, and fulfillment of certain conditions precedent by the start-up.

E. DUE DILIGENCE REPORT

The proposed investor conducts the due diligence of the complete business of the start-up. A positive due diligence report further assures the investor about its investment in the start-up.

F. SHARE SUBSCRIPTION AGREEMENT (SSA)

This agreement is entered by and between the start-up and the proposed investor, thereby defining the mechanics of the proposed investment in the start-up. It is a share offer document by the start-up and a promise by the investor to subscribe to the shares of the start-up that binds the parties to the deal and sets out the investment process to be followed

G. SHAREHOLDERS AGREEMENT (SHA)

This agreement is between the investor and the existing shareholders of the start-up thereby defining a common understanding between them concerning the economics of the deal, the extent of control i.e rights and privileges of the incoming investors, duties, and liabilities of the founders, the reserved matters, the terms governing the further fundraising, the Anti-dilution measures and the liquidation preference for the investor(s).

In the next article we will delve deeper into the domain of funding and will discuss the other stages, the various documentation involved in it (long documents and short documents) and the key aspects start-ups should keep in mind while they move ahead in securing funding.

*Aditi Gupta is a final year law student from Institute of Law, Nirma University and has interned with us from January 8th to February 8th 2021.