Steps To Avoid Legal Hurdles In Start-Ups

START-UP: LEGAL DEFINITION

The Department of Industrial Promotion and Policy (Ministry of Commerce and Industry) through its Gazette Notification No. G.S.R 364 (E) [hereinafter referred as 'the Notification'] dated 11.04.2018 defined a Startup business as following:

An entity is to be considered a startup as per Rule 1(a)

(i) "a start-up for up to seven years from its date of incorporation/registration if it is incorporated as a Private Limited Company or Registered as a Partnership firm or a Limited Liability Partnership.

(ii) Turnover of the entity for any of the financial years since incorporation/ registration has not exceeded Rs. 25 crore.

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Setting-up of the startup

Incorporation

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Classification of a Registered Company on the basis of liability is mentioned herein below:

Unlimited Liability Companies: In these kinds of companies, the liability of members of the company is unlimited and thus, it can be invoked as per the interest of each member in the company. These sets of companies may or may not have share capital. An unlimited liability company can either be a public company or a private company.

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In unlimited liability companies, the main risk lies with the Directors and shareholders in 'losing everything' at the time of winding up of such a company. It could eventually extend to losing personal assets by the Directors and shareholders to the creditors to pay off their liabilities.

However, there are certain advantages that can be availed by Unlimited liability companies, for example, confidentiality- these set of companies do not have to file annual reports to the Office of Registrar General, although the directors need to prepare the financial statements of the company. Secondly, the information of the company is not available for public records, meaning, the company can operate without disclosing its information while it can always look through the information of its competitors. The other possible advantages are Creditor Confidence and Improved management. This is so because the creditors would have increased faith and trust in the company that it wouldn't take credit more than its payback capacity, moreover, the shareholders would have a keen interest in the management of the company which may stand a chance of dissolution, thereby keeping the company conscious of careful risk management.

In the opinion of the author, this form of company format is not opted by entrepreneurs as this involves a great amount of personal risk, which outweighs the advantages as mentioned above. Additionally, it is not well understood by general public as well as the courts.

Company Limited by Guarantee: Then comes the Company Limited by Guarantee wherein, the liability is limited to an extent or amount as is undertaken by each such member of the company, in accordance with the memorandum, to contribute to the assets of the company in the event when the company is going to wind-up. The members of the guarantee company are placed in the position of guarantors of the company's debts up to agreed amount.

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In these types of company, the status of a company stands as a separate legal entity. The company can buy and sell properties, employ people, borrow money, defend itself in a legal suit in its own capacity, thereby meaning, that the members of company are protected from being held personally liable for debts arising in the business of the company. Mostly this format of companies is opted for by the NPOs, clubs, charity societies etc. because the company itself thereby retains the profits arising out of the business and does not distribute them among the members.

Companies limited by shares: A company that has the liability of its members limited by the memorandum to the amount, if any, unpaid on the shares respectively held by them is termed as a company limited by shares. For example, a shareholder who has paid Rs. 75 on a share of face value Rs. 100 can be called upon to pay the balance of Rs. 25 only. Companies limited by shares are by far the most common and may be either public or private.

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Firstly, in the situation of financial difficulties arising in the company the personal assets and finances of the shareholders are protected. Secondly, no tax is levied on the dividends accrued by the shareholders on their shares. Moreover, these set of companies are only taxed as per profits made by them, thus no higher tax payments like sole traders or partnerships. Thirdly, it's an entity separate from its owners. Fourthly and most importantly, limited liability companies enjoy professional status and reputation as for an impression of reliability. Limited Liability companies therefore are deemed to be one of the most preferable company formats by entrepreneurs.

Therefore, at the outset, a startup is advised to choose among the above provided possible options and the process of incorporation in accordance with the provisions of Companies Act, 2013 should be undertaken. Thus, after the idea of incorporation has been conceived, the startups should make endeavors to form an adequately informative Memorandum of Association [herein after referred to as 'MOA'], providing the complete information related to the objects of business and its activities, which essentially works as a binding force for the area of operation of business. Moreover, another decisive instrument, known as, Article of Association [herein after referred to as 'AOA'] should be put on papers, which contain the regulations related to the business.

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^[7] While setting up a startup for any entrepreneur is a high-risk attempt to ensure that all the business planning, accumulation of human resources and business associations should be made optimum use of, the startups must make it a point to keep themselves abreast of the changing laws and regulations in India.

Recognition

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Certification

^[9] An exemption of 100 percent of profit and gains can be availed by an eligible business by enganing in a qualified business for any consecutive financial year within five years from the year of incorporation.

[10] The application for the same could be made by filling the FORM-I enclosed in the Notification of 11.04.2018. The provision dealing with 80-IAC has been mentioned below in the citation for the perusal of the reader.^[11]

Legal Mistakes commonly made by Startups

There are measures that every start can take to avoid certain risks by taking care of the following points at the nascent stage of incorporation of a startup.

It is suggested that before the entrepreneurs kick start the process of consolidating bigger business plans, they must firstly ensure that attention to smaller, yet important legal aspects is paid. Therefore, the entrepreneurs must choose a correct legal entity for their respecitve startups to avoid paying higher taxes or other legal difficulties that possibly may arise later. Some of the structures are, Registered Company (Public/Private), LLP, Partnership etc.

^[12] It is also very essential for the entrepreneurs to know and understand the contents of each and every contract signed by them. A simple mistake of including the promoter's name along witht the name of the company can also expose the promoter to be personally liable along with the company, even though the company is a limited liability company. Thus, you should draft your contracts to avoid controversies--they should state very clearly who has agreed to what. By this way, potential litigation can be avoided.

[13] Similarly, regularly missing on tax payments and non-professional help with respect to tax related issues often bring heavy discomfort to startups, as only the professionals are aware of the nitty gritty of tax related issues.

^[14] For example, a trademark is a quintessential tool in launching new product segment for brand extension. It is a powerful way to effective penetration into new markets, like Honda saw the opportunity and took advantage by launching motorbikes in the US car based market.

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Legal implications wrt Startups in socio-economic sector

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1. "The net worth of the company should be Rs. 500 crores or more;
2. The annual turnover of the company is Rs. 1000 crores or more;
3. Annual net profits of the company should be at least Rs. 5 crores."
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So, if the startup meets any of the above given conditions, they may be required to create a committee to enforce its CSR mandate.

Legal implications of securing legitimate funds for start-up

Startups are often seen to be securing their funds by either the way of private equity investors or Angel investors. In other cases they also opt for Debt financing, viz., obtaining loans or Commercial borrowings. We shall have a look at the legal requirements to be fulfilled in both the cases hereinbelow.

Private Equity

For a startup, Private Equity [hereinafter referred as PE] is indeed one of the first large investment considerations for any startup. And as a result, convertible instruments are used as most common instruments of securities for PE investment. These securities are essentially of two types, compulsory convertible preference shares and compulsory convertible debentures. Between the investors and startups execution of the below mentioned documents are carried out:

1. Term Sheet/ Letter of Intent/ Memorandum of understanding: These documents provide for the basic commercial understanding between the Investor and the startup.
2. Share Subscription Agreement/ Debenture Subscription Agreement:
• These agreements take care of the number of shares issued in the share capital to the investors or the issuance of number debentures after duly having valued the startup;
• Moreover, these agreements also provide for the conditions to be fulfilled by the investors or the investee after the completion date;
• Sets of representation and warranties and indemnification resulting from due-diligence exercise or otherwise, etc.
3. Shareholders' Agreement dealing with redemption rights on debenture or preference shares, exit options to investors after the lock-in-period etc.
   
   Angel Investor
   Angel investors are those individual persons or industry professionals who invest or fund the venture in return of an equity stake. As per SEBI Regulations, 2012, SEBI has imposed the following restrictions on the Angel funds investing in ventures in India;

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1. "An investee company has to be within 3 years of its incorporation, not listed on the floor of a stock exchange, and should have a turnover of less than Rs. 25 crore and not be promoted by or related to an industrial group (with group turnover exceeding Rs. 300 crore).
2. The deal size is required to be between Rs. 5 lakhs and Rs. 5 crores. Separately, it is required that an investment shall be held for a period of at least 3 years."
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C. Debt Financing

1. Loan from Banks & NBFCs
   Loans from banks and NBFCs help finance the purchase of inventory and equipment, besides securing operating capital and funds for expansion. More importantly, unlike an Investor or angels, which have an equity stake, banks do not seek ownership in your venture. However, there are several drawbacks of such funding option. Not only do you pay interest on loan but it also has to be done on time irrespective of how your business is faring. They require substantial collateral and a good track record, besides the fulfilment of other terms and conditions and a lot of documentation as follows:

1. Application for loan sanction by borrowers;
2. Issue of sanction letter by the Bank;
3. Agreement of Loan;
4. Security/collateral documentation, such as (i) Deed of Mortgage; (ii) Deed of Hypothecation; (iii) Deed of guarantee; (iv) Share pledge agreement; (v) Memorandum of Entry; etc.
1. External Commercial Borrowings
   New ventures can also avail the borrowings by way of bank loans, buyer's credit etc. to finance their business activities as per their requirements. However, such borrowings from ECBs come with certain end use restrictions. For example, these borrowings cannot be used for lending or investment in capital market or for acquiring a company in India. The ECB guidelines are framed by the Reserve Bank of India, hence a strict compliance of the conditions prescribed by these guidelines are warranted.
2. CGTMSE Loans
   New ventures may also procure loans under the Credit Guarantee Trust for Micro and Small Enterprises scheme launched by Ministry of Micro, Small & Medium Enterprises (MSME), Government of India. By the way of this scheme, one can get loans of up to 1 crore without collateral or surety. Any start up can obtain loans from any scheduled commercial banks and specified Regional Rural Banks, NSIC, NEDFi, and SIDBI.

Conclusion

A startup is a serious effort undertaken by any entrepreneur to give shape to his business ideas and bring the same into a functional form. To encourage a smooth and efficient functioning of a startup, the author has tried to give a detailed and concise insight on the subject to help the new ventures surmount the potential hurdles that might arise due to some miniscule mistakes of the ventures at its nascent stage. The need of addressing the issues concerning non-warranted legal problems faced by startups has been long felt. Unwanted litigations or legal hurdles often get the entrepreneurs astray from their primary objective and thus, to avoid these problems to a certain extent, the ventures can always keep a track on the changing legal scenarios vis-à-vis commerce by placing timely reliance upon legislations that may affect their business.

Authored by –

1. Ankit Rajgarhia, Senior Associate
2. Srisatya Mohanty, Associate
3. Priyan Garg, Associate-in-Charge – Knowledge Resource

References

4. Notification of Department of Industrial Policy and Promotion, Ministry of Commerce and Industry dated 11.04.2018.
5. Section 7, The Companies Act 2013.
6. Section 2 (21), The Companies Act 2013.
7. Section 2(22), The Companies Act 2013.
8. Decoding amended Section 80-IAC available at https://taxguru.in/income-tax/decoding-amended-80iac-startup-section-act-1961-commercial-viability-legal-provisions.html
9. Section 80-IAC of the Income-tax Act, in the Explanation below sub-section (4),–– (a) for clause (i), the following clause shall be substituted, namely:–– '(i) "eligible business" means a business carried out by an eligible start up engaged in innovation, development or improvement of products or processes or services or a scalable business model with a high potential of employment generation or wealth creation;'; (b) in clause (ii),–– (i) in sub-clause (a), for the figures "2019", the figures "2021" shall be substituted; (ii) in sub-clause (b), for the words, figures and letters "previous years beginning on or after the 1st day of April, 2016 and ending on the 31st day of March, 2021", the words "seven previous years beginning from the year in which it is incorporated" shall be substituted.
10. Nikita Bhatia, 10 legal mistakes made by startups available at https://yourstory.com/2016/03/legal-mistakes-startups
11. Laura Plimpton, Secrets to a successful business contract, ENTREPRENEUR INDIA available at https://www.entrepreneur.com/article/175364
12. Mendonça S. et al., Trademarks as an Indicator of Innovation and Industrial Change, p.7
13. Section 135, The Companies Act 2013.
14. Draft Amendments to SEBI Regulations, 2012, BOARD MEMORANDUM available at https://www.sebi.gov.in/sebi_data/meetingfiles/apr-2018/1524117274041_1.pdf