The rapid expansion of start-ups in India has garnered support and assistance from the Indian government as well as several commercial and industrial sectors. In the interest of fostering the expansion of the Indian economy, entrepreneurs have been offered a variety of inducements and advantages to encourage the establishment of new businesses. Financing and funding may become a struggle for entrepreneurs and it holds the key to the development and success of any start-up.

When a business is in its infancy, the financing comes almost exclusively from internal members such as the founders or friends and relatives. This kind of funding, known as “Bootstrapping” helps transform a concept into a product, which in turn attracts further investors. When a business reaches this point, it is common for the founders to seek investments from outside sources, most often via the participation of private individuals (sometimes, high net worth individuals) known as “Angel Investors”. This contributes to the startup achieving a particular level of success and maintaining a degree of consistency. From this point onwards, it is more common for startups to seek funding via venture capitalists or private equity.

All of the above investments may be accomplished using a variety of strategies and financial instruments, some of which are covered in this article.

What Is An Investment Instrument?

Investment instruments or financing instruments, in all their technicality, refer to the documents or contracts which are used as means to acquire capital (equity or debt). It is always a binding legal agreement involving a monetary value between the startup and investors. The nature of capital infused may either be in a mode of debt financing or equity financing. These financial instruments may further be divided according to an asset class, depending on whether they are debt-based or equity-based.

What Is Debt Financing?

Debt financing is the acquisition of a financial loan or a bond to obtain funding for a business. The reasons for obtaining debt financing may range from a strategic decision to anything including obtaining additional working capital, avoiding equity dilution, buying assets, and/or acquiring other entities. A startup may obtain short-term debt financing to obtain working capital, whereas a long-term debt financing model is mostly used to acquire assets or finance projects. In the case of debt financing, the startup having entered the shoes of a borrower, incurs a legal obligation to pay back the funds along with some accruing interest to the investors/financers. Options under debt financing includes i) Bank loan ii) Bond issues iii) Family and credit card loans. Debt financing is famously treated as a conventional way of raising funds for a startup. Irrespective of its advantages over equity financing, the last decade in India has witnessed, a sharp rise in equity financing modes.

What Is Equity Financing?

Equity financing refers to the sale of company shares in order to raise capital. Investors who purchase the shares also purchase certain ownership rights in the company depending on the mode of equity financing used and the investment value. Contrary to debt financing, the returns on investments are not guaranteed and absolute in equity financing. The returns, if any, depends on the growth and profits made by the startup. The founders are not burdened to return the investment amount to the investors. As and when the business grows, the value of the company shares grows and as a result of which, the investors realise their investment amount with good returns.

While many traditional investors understand only the direct equity model, wherein the investor purchases the equity shares of a company and reaps the fruits of that share by selling the share for profits. Over the years, equity financing has come up with various hybrid models of equity, debt, equity and debt together. These hybrid instruments are being used to strike a balance between the needs of both new business owners and investors. These hybrid options are good because owning equity shares doesn’t guarantee a certain return on investment and doesn’t give the investors any special rights or preferences. Further, by giving out hybrid securities, the founders can keep control over how the business is run and what decisions are made.

In light of the above, we now move on to discuss popular financing instruments which startups and investors can use and utilise in the fundraising process.

1.     Compulsorily Convertible Debentures (CCDs)

CCDs are hybrid securities as they are issued as debts but are compulsorily converted to equity shares of the issuing companies. Unlike Convertible Notes, CCDs can be issued by any private limited company. Section 71(1) of the Companies Act, 2013 authorizes a company to issue CCDs. Considering the nature of these hybrid securities the Hon’ble Supreme Court in the case of Narendra Kumar Maheshwari v. Union of India held that “any instrument which is compulsorily convertible into shares is ultimately regarded as equity and not as a loan or debt”. On the other hand, according to the RBI Guidelines, they are treated as equity for all financial statements and records but not as Share Capital of the Company. Thus, it can be deduced that they provide security to investors in the nature of debentures, and are ultimately rendered as shares, upon their conversion. According to the Companies (Acceptance of Deposit) Rules, 2014, they can be issued provided they are converted to shares within 10 years of issue. Valuation is not required if you plan to convert the CCDs at future valuation. However, in case you have predetermined the conversion ratio then valuation report is required from a registered valuer.

Key Features

• It fully, compulsorily and mandatorily converts into equity shares.
• It does not dilute the ownership of existing shareholders.
• It does not carry any voting rights.
• Interest is paid to the investors until the conversion happens.
• Dividends are not payable until the conversion happens.
• It can be issued to both domestic and foreign investors.

Definitive Documentation

• Term Sheet
• CCD Agreement

2.     Compulsory Convertible Preference Shares (CCPS)

CCPS offers fixed dividends in priority and compulsorily converted into equity shares at a predetermined event, not more than 20 years. These are the preferred choice and most favoured amongst investors mainly for two reasons, i.e., the dividend is first paid to preference shareholders, senior to equity or common shareholders and they are also given priority in the event of liquidation.

An early CCPS investor possesses more rights than other investors investing in a higher valuation. It also gives investors anti-dilution rights which allows them to maintain their stake in the company and have a say if their stake gets diluted in future.

The issue of CCPS is governed by the provisions of Section 42, section 55, and section 62 of the Companies Act, 2013 to be read with Companies (Prospectus and Allotment of Securities) Rules, 2014 and Companies (Share Capital and Debentures) Rules, 2014. CCPS, like convertible debentures, is known for an enormous load of compliance requirements and paperwork that is required, namely the demand for a valuation certificate.

Key Features

• It fully, compulsorily and mandatorily converts into equity shares.
• The conversion may be linked to the performance of the company and if the target is not met, the investors can increase their stake in the company.
• It does not dilute the founder’s equity shareholding.
• Authorised capital of the company must have classified preference shares before the issue of CCPS.
• It can be issued to both domestic and foreign investors.
• Dividends are fixed and are paid to the investors in priority to the equity shareholders of the company.

Definitive Documentation

• Term Sheet
• Share Subscription Agreement
• Shareholder’s Agreement
• Disclosures/Side Letters

3.     Convertible Notes (CN)

CN are issued as a ‘debt instrument’ in the form of a loan. It can be issued only by a DPIIT registered and recognised startup company. These are issued initially as a debt, which is repayable at the option of the CN-holder. These may also be converted into equity shares of the company, within a period not exceeding five years from the date of issue of the CN. While the basic concept of a convertible note is the same as that of a CCD, this instrument has proved to be less broad and user-friendly owing to the lack of numerous compliance requirements. The issue of CN is governed by the provisions of the Companies Act, 2013 to be read with Companies (Acceptance of Deposit) Rules, 2014.

Key Features

• It optionally converts into equity shares at the discretion of the investor.
• The age of the company shall not be more than 10 years.
• The company’s annual turnover shall not exceed INR 100cr for any of the financial years.
• Minimum investment amount shall be INR 25 Lakhs from the investor.
• No company valuation is required.
• No control or voting rights are given to investors.
• It does not dilute the ownership of existing shareholders.
• Dividends are not payable until the conversion happens.
• Interest is paid to the investors until the conversion happens.
• It can be issued to both domestic and foreign investors.

Definitive Documentation

• Term Sheet
• Convertible Note Agreement

4.     Simple Agreement for Future Equity (SAFE)

SAFE is usually termed as an equity derivative contract which converts the initial capital invested into the future stock of the company, based on contractual terms and conditions. Startups may prefer SAFE notes because, unlike CNs, they are not debt and therefore do not accrue interest (though for Indian legal compliance purposes, SAFE notes carry a non- cumulative dividend @ 0.0001% and are shown as CCPS). Instead of having terms and schedules, they are based on certain contingent events, the happening or non-happening of which determines the interest of the investor to either: (i) reclaim the invested principal amount or (ii) Convert the capital into stocks/shares of the company. Since it is merely a contract, it will be governed under Section 32 of the Indian Contract Act, 1872 namely contingent contracts. Therefore, the agreement can only be enforced if the contingent event takes place. Furthermore, since it is a contract and not a security, it is fully regulated by the parties (investor and startups). This allows them to customize the clauses as per their situation, financial capabilities and proposed business model, thus striking a balance in the interest of both. However, they are not an immediate share in the company, but merely a promise. This provides no rights to the investor till the actual conversion of the capital takes place. Further, the investor has no rights in the business assets of the venture in case of liquidation as opposed to CCPS, and no fixed dividend or interest as in the case of CCD or a CN. Since SAFE agreements don’t have any interest or maturity date, they cannot be classified as a ‘debt’. Likewise, due to the absence of dividends and other shareholder rights, it cannot be termed as ‘equity’ either.  India Simple Agreement for Future Equity (“iSAFE”) is a standardised template-driven agreement that is gaining popularity due to its ease and efficiency. It is a hybrid of all the instruments mentioned above as it is neither a debt nor an equity but it is regulated by the CA, 2013 as a CCPS (in addition to the Contract Act). It is convertible on the occurrence of specified events.

Key Features

• It converts into equity shares of the company as per the terms and conditions agreed.
• There is no maturity date or compulsory period of conversion.
• It carries no interest or dividend rights.
• No control or voting rights are given to investors.
• It does not dilute the ownership of existing shareholders.
• Dividends are not payable until the conversion happens.
• It can be issued to both domestic and foreign investors

Definitive Documentation

• SAFE note
• Shareholder’s and Share Subscription Agreement (at the time of issue)

5.     Community Stock Option Pool (CSOP)

CSOPs are options which have the same financial rights as equity shares but no voting rights. It is purely a contractual agreement entered into between the startup and the investor for benefitting the investor from the financial benefits linked to the equity issued by the company. CSOPs are redeemed via cash buyouts or converted into equity on the happening of future events like a complete secondary buyout, merger and acquisition or IPO. Furthermore, since it is a contract and not a security, it is fully regulated by the parties (investor and startups). This allows them to customize the clauses as per their situation, financial capabilities and proposed business model, thus striking a balance in the interest of both. However, they are not an immediate share in the company, but merely a promise.

Key Features

• It may convert into equity shares of the company as per the terms and conditions agreed.
• Linked to the performance of the company.
• Paid either in cash or converted into equity.
• There is no maturity date or compulsory period of conversion.
• It carries no interest or dividend rights.
• No control or voting rights are given to investors.
• It does not dilute the ownership of existing shareholders.
• Dividends are not payable until the conversion happens.
• It can be issued to both domestic and foreign investors.

Definitive Documentation

• CSOP Plan
• CSOP Agreement

6.     Stock Appreciation Rights (“SARs”)

A SAR or Phantom Shares is generally defined as the right to receive the benefit of the increase or appreciation in the value of a company stock and it has been specifically defined by SEBI under Regulation 2 (1) (zf) of SEBI (Share Based Employee Benefits) Regulations, 2014 (“SBEB Regulations”) as a right to a SAR grantee entitling him to receive appreciation for a specified number of shares of the company where the settlement of such appreciation may be made by way of cash payment or shares of the company. A SAR is normally paid in cash, although it could also be settled in the equivalent value of stock. Alternatively, it could also be settled in a combination of cash and stock both. While the issue of SARs by listed companies is regulated by SEBI under SBEB Regulations, the issuance of SARs in unlisted companies is largely unregulated. The Companies Act, 2013 does not prescribe any procedure for grant of SARs or settlement of SARs.

Key Features

• It may convert into equity shares of the company as per the terms and conditions agreed.
• Linked to the performance of the company.
• Paid either in cash or converted into equity or both.
• There is no maturity date or compulsory period of conversion.
• It carries no interest or dividend rights.
• No control or voting rights are given to investors.
• It does not dilute the ownership of existing shareholders.
• Dividends are not payable until the conversion happens.
• It can be issued to both domestic and foreign investors.

Definitive Documentation

• SAR Agreement