By - KSANDK on July 29, 2022
Venture Capital [“VC”] and Private Equity [“PE”] firms have played a significant role in the recent start-up boom that has swept the Indian economy. These investments are made in exchange for a minority position in the investee company in the form of equity shares, convertible preference shares, or debentures. Although they offer investors a share of the company’s profits, minority shareholder risks necessitate the negotiation of investor control and exit rights as part of the contract. Further, the governance structures that accompany VC investment in start-ups raise the risk of a disagreement between the investor and the investee over the business management. Eventually, entrepreneurs and venture capitalists frequently overlook the need for transactional legal documents in their rush to strike the deal.
Several control rights are required to manage the disputes which arise due to transactional disputes. They can be in the form of:
They allow investors to participate in the firm’s governance without becoming official members. This is governed by the company law and contract law under the company’s articles of association & shareholder agreements, as explored below.
The Articles of Association [“AoA”] of a privately held or publicly traded company describe and outline shareholders’ rights and duties. These are critical to the firm’s survival and status because they are part of its constitutional articles. Sections 7 and 14 of the Indian Companies Act 2013 [“ICA”] require the disclosure of these articles. Further, corporations may insert other clauses in the articles that are relevant to their day-to-day management. As a result, corporations can include particular shareholder rights in their articles of incorporation.
The investor seeks board nomination rights, which allow them to pick directors, quorum requirements for the attendance of an investor representative at board and shareholder meetings, and veto power on specified reserved items in a privately negotiated Shareholder’s Agreement [“SHA”].
An investor seeks to obtain the following rights under the SHA:
Private equity investors have certain nominations for the board of directors, depending on the percentage of the company’s shares covered by deadlock rules. Meetings at the board, shareholder, and committee levels must be attended by a nominated director of a private equity investment.
Affirmative voting rights are sometimes compared to private equity investor veto rights since they require the corporation to get the investor’s prior written consent before making certain decisions at board, shareholder, and board committee meetings.
The SHA creates a protective shield for contingencies to ensure that funds are used appropriately towards a predetermined business plan.
Matters requiring a majority vote in favor of the resolution are important to the company’s basis and may have far-reaching implications.
However, some concerns are judged more urgent than those that necessitate a special resolution and necessitate the approval of a specific shareholder or shareholder group. Reserved, veto, positive vote and consent rights are of particular interest to the investor. These are terms in an SHA that require the approval and execution of all or a subset of partners to be approved and executed. As a result, by requiring that any modification to the Articles be approved by the investor, the rights granted to certain shareholders as described in the Articles can be protected from changes.
Decisions involving the preservation of investor rights invariably include an examination of the distinction between the transferability of shares in private and public firms. This is due to the Securities Contract Regulation Act 1956 [“SCRA”].
Under Dahiben Umedbhai Patel v. Norman James Hamilton, [1] it was held that the provisions of the SCRA do not apply to private companies because their securities lack the “character of liquidity” and are not “marketable securities” under Section 2(h)(i) of the SCRA. In Bhagwati Developers Private Limited, [2] the court affirmed that the SCRA’s definition of “security” did not encompass securities issued by private businesses. It further stated that the SCRA requirements apply to the shares of a public unlisted firm.
Exit rights are among the most important strategic rights for investors. These rights, known as “put options” and “call options,” are incorporated into contracts as “options” and are just contractual agreements. A put option is an investor’s right to sell their shares at a certain price if a certain event occurs. The Reserve Bank of India forbids the inclusion of an optionality clause in an agreement between an Indian firm and a foreign investor that guarantees the foreign investor a return upon exit since it would violate the Foreign Exchange Management Act of 1999. However, the insertion of such phrases in other contracts is not prohibited by Indian law.
Under the ICA, a company is controlled by its Memorandum of Association [“MOA”] and AoA. As a result, the company is made a party to SHA so that its provisions are enforceable against it, and provisions of the SHA are included in the AOA to protect the rights of PE investors.
In PE contracts, enforceability difficulties frequently arise during the PE investor’s exit phase. A PE investor must develop a clear exit strategy before investing. Exiting a non-profitable business, ending an investment after achieving the intended level of earnings, and quitting a losing company should all be part of an exit strategy.
V.B. Rangaraj vs. V.B. Gopalakrishnan and Ors. [3] addressed the need for investor rights and protection, and it established the rule that, regardless of what is stated in the SHA, any restriction sought to be enforced on share transfers will only be recognized if it is duly included in the AoA. However, restrictions on the transfer of shares or their absence had a point of assessment before the AoA, namely the type of corporation being invested in. A public corporation’s shares are freely transferable, whereas a private company is obligated by law as per Section 2(68) of the ICA to limit the transferability of its shares. As a result, when the AoA and the SHA clash, the AoA will take precedence.
The historical prevalence of family-owned businesses in India, along with the tough legal compliance environment has pushed PE investors to seek minority stakes in Indian investees. PEs have resorted to using SHAs, which include governance and investor protection features, to compensate for their minority position. These tactics are intended to give a foundation for minimizing founder opportunism while also protecting investor wealth. Furthermore, due to the nature of a VC investment being largely speculative and risky due to factors such as market uncertainty, a lack of sufficient data on performance and profitability, and information asymmetry on both sides, they prefer to avoid majority participation and instead secure the benefit of protective provisions for themselves.
Indian regulations aim to create a business climate based on accountability, openness, and trust for the benefit of investors. The way the Indian judiciary handles lawsuits for the preservation of investors’ rights reveals that the rights of private equity investors are effectively safeguarded in India. The interests of the PE investor must be clearly described during the design and negotiation of the transaction paperwork, taking into mind the terms’ capacity to be legally enforced.
If you want to read more about how to navigate the start-up industry, you can check out our other posts on a quick overview of how to register your company, the purpose and components of a founder's agreement, or the basics of seed funding in India on our blog.
