Startups are companies in their early stages of functioning and operations. They generally start with high costs but limited revenue and investments which are generated by various sources. As these startups are working in a more organic, rather than well settled form they tend to face obstacles in various stages of their operations. The startup founders might have anticipated the problems that might occur to them, they might still be unsure on how to tackle such obstacles. Here in this article we’re not gonna talk about complicated instruments like credit default swaps. We’re going to talk about instruments that startups can use to help them take off the ground.
The different types of security instruments a startup can use are:
Equity shares
These are known as shares of common stock in the US and ordinary shares in the UK. This is what startup companies will issue right after the formation, usually to the founders or “promoters”. I say usually, because in the US, it’s not mandatory for you to issue shares at the time of formation, although people usually do.
It’s a high risk – high reward security. If you hold these shares, you’re going to lose out if the startup goes down the drain since everyone else will be paid out before you. But if the startup goes public, you’re going to make money because you will be able to sell these at much higher than what you would have paid for them. It also serves as an indicator of the value of the startup company.
Unlike many other securities, these can continue to be held for an infinite period of time in the same form as these are issued. When you talk about listing, you’re usually talking about listing your equity shares, because preference shares / debt is listed under very specific regulations.
The holders of these shares get to vote on everything in the company, except in certain cases. But usually, they have full voting rights.
Equity shares with differential voting rights
There are quite a few US companies having ‘Class B Common Stock’ or common stock which do not have voting rights, but surprisingly, this is not that common in India.
The intention for ‘Class B Common Stock’ is very clear – it’s intended to be given to employees or advisors. The founders of a startup want to give an upside in the value of the stock to such people, but not the ability to gather together and stall management decisions. These can also be used for purely financial investors, who are not really interested in the management of the company, but want to gain capital appreciation.
In India however, in most cases, you see employee stock options being given to the employees – these shares have the same voting rights as other equity shares. That’s why most stock option pools will not exceed 10% in total. Financial investors will mostly be investing in CCPS – compulsorily convertible preference shares.
While we talk about non-voting shares, there can also be shares which have superior voting rights than the others, however this is rare. But basically, the intention is to vary voting, dividend or liquidation preference rights based on the types of people to whom the shares are issued and their objectives.
Preference shares
The preference shares in India are also known as preference shares in the UK and preferred stock in the US.
Now preference shares in India mandatorily have to be one of the two – redeemable or convertible. You cannot keep preference shares in the same form for more than 20 years. You have to either redeem them i.e. return the money taken against these shares or you have to convert them into equity shares.
Let’s discuss these Preference Shares in detail:
- Redeemable preference shares
Redeemable preference shares are closer to debt, but are not debt. These are not very popular in the business startup model. These also get dividends, not interest, so it’s basically an unattractive form of debt for an investor. Though for the founder this might be the best way to get funds because it’s like getting a long term unsecured interest free loan without any kind of dilution. The only place where they are more used are in cases where the investors are personally interested in the founders.
To an investor, these would usually not make sense because there’s no capital appreciation – the amount is to be repaid. Dividend is not the same as interest – it’s only given from distributable profits, so you may or may not get it. And these are unsecured instruments – so there’s no security and if the company splits, the creditors are paid before the preference shareholders.
- Convertible preference shares
These can be either optionally convertible or compulsorily convertible Preference Shares.
Optionally convertible preference shares would be something that investors would prefer, for the reason that it gives them some period to wait and watch and convert if they think fit and get the shares redeemed otherwise. For obvious reasons, optionally convertible shares are also optionally redeemable. So if the startup is on a growth trajectory, the investor will convert, and if things are not working out, they will choose to get the amount back, thus avoiding the loss.
But unfortunately, there is a problem with these. If you need to sell these to a non-resident, because of the possibility of redemption, it will be considered a partially debt instrument and thus be covered within the ECB guidelines. For instruments to escape ECB guidelines and fall within the FDI route, they need to be compulsorily convertible.
And because investors want to keep all routes of exit open, compulsorily convertible preference shares (CCPS) are used in most transactions. At some point of time, these would have to be converted into equity. For protecting exits, some investors may ask for the converted equity shares to be bought by the promoters at a certain IRR (Internal Rate of Return) – this depends on how badly the founders need the money and how strong their traction with the customers is.
SAFEs and iSAFEs (Indian Simple Agreement for future equity)
There are investors who have the appetite to put funds in high risk – high return securities, and there are startups who want no-strings-attached funds – no security, no interest, no repayment and no dilution at the time of receipt of funds. SAFEs or Simple Agreements for Future Equity are made for these people.
Simply explained, SAFEs result in the investors “giving” out the funds to startups in their initial stages, with a good conversion rate if and when the startup is able to secure further funding in a valuation round. The investors benefit from a discount to the valuation or conversion at a valuation cap which is lower than the actual. But there is hardly any downside protection, except that the SAFE funds are to be returned prior to the founders. This is why SAFEs are for accredited investors, those who wouldn’t be badly affected if the funds were totally lost. There’s just one agreement entered into and that’s all that’s needed for the funds to be transferred.
In India though, it’s not possible for people to simply “give” the funds. That would become an unsecured loan and by definition, a “deposit” under the Companies Act. That’s why startups have to issue CCPS – compulsorily convertible preference shares as iSAFEs. You can then convert the CCPS based on a discount to valuation or a valuation cap, in a similar manner as the SAFE. The thing is that in India, unfortunately, it hardly remains “simple” given that you still have to create share subscription and shareholders agreements and comply with rights issues or private placement requirements.
The convertible note is something that would give a little bit of protection to the investors in case the business of the company touches the ground.
Convertible note
A convertible note is, as the name states, a hybrid instrument. It’s in the form of debt for a limited period (most convertible notes have had a maturity period of 24 months). If an ‘equity financing‘ i.e. an investment at a valuation round happens in that time, the convertible note gets converted for principal plus interest amount. If the equity financing does not occur, the convertible note amount is required to be repaid.
The benefit to an investor is that it’s debt i.e. it’s repayable before equity in the case the business of the company does not pick up. If the business does pick up and someone is willing to invest in the company at valuation, the note will get converted into equity, so the investor will also get the benefit of the possible appreciation in equity at a later date.
For India, convertible notes are not included within the definition of “deposits” and are also permitted to be issued under the FDI policy, giving double benefits. But the problem is that there is a minimum amount of INR25 lakhs required to be invested in a single tranche to escape the definition of deposits. So if an individual NRI investor is looking to invest 10-15 lakhs, that can’t be through a convertible note.
Convertible debentures
Debentures have been around for a while, and typically these were used as a secured loan, except that the lenders had fractionalized entitlements. But in an era of startups having no assets but IP (Intellectual Property), the idea of security falls away and therefore, convertible debentures are the ones that are used more by startups. Though there may be certain circumstances where secured and non-convertible debentures are preferred.
As we already know, unsecured non-convertible debentures will simply become ‘deposits’ under the Companies Act and therefore, these are avoided.
Similar to preference shares, convertible debentures can be optionally convertible or compulsorily convertible. Optionally convertible debentures are also repayable, bringing them within the purview of deposits (except where the lenders are companies) and so, though Lenders always prefer an option, mostly compulsorily convertible debentures (CCDs) are used in practice.
These can also be used like an iSAFE i.e. where they will convert at a valuation cap predicted to be lower than the actual valuation. And they will convert at the principal plus an interest amount. There can be a variety of structures used based on the lender and the startup.
Non-convertible debentures
Non-convertible debentures are proper debt instruments.
What is it that you would be most interested in if you were a lender?
You will be interested in repayment. You don’t want to go to the point where there is a repayment default and you have to take over the security and liquidate it to make good of the default. You would rather prefer that the loan gets repaid properly and on time. Therefore, lenders would first consider what is the means through which the loan is going to be repaid.
Also, time-matching can be done when it comes to your sources of funds and application of funds. Considering these aspects, secured debentures are largely used as sources of funding in real estate. High-ticket secured debentures are issued by developers and the property being developed is the security being offered.
The sale of units in the scheme is the means of repayment and the term of the debentures will match perfectly with when the scheme is expected to be completed and the funds repaid.
Sweat equity
Ideally, the intention to issue Sweat Equity is to do away with the cliff and vesting requirements applicable to employee stock options and reward someone instantly for past efforts or intellectual property.
Let’s say you have a startup and few employees worked with you from the beginning, because they believed in your idea, at much lower than market salary. Now if you grant stock options to them, under the Companies Act, these can only vest after a year. But what about the work they have already done for you?
This would be a fit case for sweat equity, where you can grant shares at much lower than the market value and reward them for their work. But unfortunately Sweat Equity shares kind of become unworkable because of their requirements.
Why do Sweat Equity shares become unworkable because of their requirements?
You are saddled with the requirement to get two kinds of valuations done – one for the shares and another for the intellectual property and that too, by registered valuers. You would rather give them ESOPs (for which no valuation is mandatorily required) and have more options vest right after the cliff of one year. This is why they are not as popular as ESOPs.
ESOPs (Employee Stock Option Plan)
ESOPs are one of the most common tools sought out by founders to ensure an ownership feeling among the employees and to increase retention.
ESOPs are recognized and regulated by the Companies Act, 2013. Hence if you are looking to grant ESOPs under the framework of this Act, then your business has to be in the form of a private limited company. Also, within this Act, it can only be granted to employees and directors. So if you’re looking to grant equity interests to advisors, you have to structure it a bit differently.
Your most important decisions are as regards the pool, the eligibility criteria, how you are structuring the vesting, the exercise price and planning for the exits of the employees.
For obvious reasons, when employees are allotted the shares, the shareholding of the existing shareholders will be diluted, so you need to get your existing shareholders to approve the installation of an ESOP plan. Your investors need to be aligned too.
Can you have flexible vesting schedules? Yes. Can you have multiple plans in place? Also yes.
If you’re looking to explore these options and find the best fit for your startup, please don’t hesitate to contact us for personalised advice and support.