Understanding the Shifting Landscape of Fundraising Negotiations in India with Mehak Khanna from Khaitan & Khaitan

[00:00:00] Mehak: I think it's always that tussle that goes on between equity and debt and probably, you know, for them, it's very important to come up with the right balance of equity and debt when they're looking at fundraising. Enforcement of contracts, that is something where there has been an improvement. We are seeing, uh, that the Indian judicial system is improving.

[00:00:20] Mehak: They're reacting faster. They're giving away remedies. So, yes, it's, uh, definitely become better in the last 10 years. I feel that more than the post factual remedies, it's important to put in, uh, checks and balances and processes. Please so that these instances can be avoided. And for that is it is absolutely important to have, you know, internal teams, internal control teams, internal audit teams within the companies.

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[00:00:54] Rahul: Welcome back to Understanding VC. I'm your host Rahul. Understanding VC is a perpetual MBA on a single [00:01:00] subject, venture capital. Today, I'll be having an in depth conversation on how fundraising negotiations in India are constantly evolving in response to various economic, regulatory, and technology trends with Mehak Khanna.

[00:01:12] Rahul: Mehak is a partner at Kehtan Kehtan, where she leads the corporate and commercial practice, providing legal advice and solutions to clients across various sectors and geographies. Now let's talk to her.

[00:01:23] Rahul: Hi Meheg. Thank you so much for joining me today.

[00:01:26] Mehak: Hi Rahul, it's a pleasure to be here and having this conversation with you. Looking forward to having a great discussion.

[00:01:33] Rahul: Yeah. So, I was having a conversation with the VC here, who's looking to invest in a startup in India. and I think they were looking to invest in a convertible note, instrument. And, uh, he was telling me that it's apparently illegal to do that for a startup. Is that true?

[00:01:50] Mehak: the startups are, allowed to issue convertible notes. In fact, uh, convertible notes as a concept is very much a part of, the Indian [00:02:00] companies act 2013. And a convertible note essentially is an instrument that evidences receipt of money initially as a debt, which is either repayable at the option of the holder or later on it gets converted into certain number of equity shares that the startup company has specified.

[00:02:17] Mehak: So, this is, the context in which convertible notes, are issued. And of course, there are certain, other, uh, compliances that need to be done and those are mentioned, in the law and, specifically the rules, made under the Companies Act. So, yeah, there is, this sort of a framework that exists, and is no longer illegal for certain types of startups, to raise, money through convertible notes.

[00:02:42] Rahul: Yeah. But is there a specific condition, where this is not possible or like.

[00:02:50] Mehak: So this is possible for startups, the way they are, defined. And, you know, this is, essentially for certain [00:03:00] companies, that have been in the business for, I think minimum of 10 years. And, these are the companies that of course need to, Comply with certain requirements, when, you know, these convertible notes are being issued and those requirements in terms of the terms and conditions, how it needs to be executed, what are the meetings that need to be held, what are the board approval procedures?

[00:03:22] Mehak: What are the shareholder approval procedures? What are the other filing procedures with the registrar of companies? I mean, there are rules that prescribe for all of that, that these companies need to comply with. So there is this, uh, whole, set up and process around issuance of, these convertible nodes.

[00:03:40] Rahul: You said the company needs to be in business for 10 years?

[00:03:44] Mehak: Yes. I mean, not exceeding 10 years. Yeah. So period of, not exceeding 10 years, yes, from the date of incorporation. So that is when a company is treated to be a startup under the Indian laws. And of course, You know, the annual [00:04:00] turnover of such an entity for the preceding financial year since incorporation should not exceed 100 crores INR.

[00:04:08] Mehak: The business model, of course, has to be towards development or improvement of a product or service. It should have scalable business and this entity should not have been formed by splitting up or reconstructing an existing business. So these are essentially the few requirements for a company to qualify as a startup under the Indian context.

[00:04:29] Rahul: Yeah. The, the general outlook of a lot of investors, when it comes to investing in India is that it's difficult, uh, there are a lot of regulations, plus it's, it's very difficult to take on money, and, the regulations keep changing. things like that, right? Like, but over the years, at least if you look at the last 15 years, has things improved in your opinion?

[00:04:54] Mehak: see, I think very honestly, the answer is yes and no. On some fronts, things [00:05:00] have improved as far as the Indian regulatory context is concerned. That has made it probably. a little simpler for the founders to conduct their businesses. So there is some part of the ease of doing business story in India that has worked in the context of setting up of the company, getting the initial licenses, Pantan, getting the initial labor approvals, getting the ground running.

[00:05:26] Mehak: So there has been some improvement on that front. But, if you look at the fundraise aspect, if you look at the foreign direct investment laws, the foreign exchange laws, in terms of the obligations, especially on the money that is coming out of India, if you look at the valuation requirements, if you look at the tax requirements, if you look at the recent addition of angel tax in India, all of that has certainly not made things easier for the investors and, you know, Then, of course, consequently not made it easier for the founders as well [00:06:00] in terms of the fundraise.

[00:06:02] Mehak: So I think there are a lot of issues where the Indian government authorities would need to relook in terms of how they can smoothen this particular process and how they can uncomplicate some of the regulations and make it easier, especially in terms of the foreign fundraise. with the Indian founders.

[00:06:24] Rahul: Yeah. And, could you explain, uh, angel tax, because angel investing has also become a thing in the last 15 years on top of this whole startup thing, right? Yeah.

[00:06:38] Mehak: I mean, angel investments, I think, have become a very big part of the Indian startup ecosystem. that's probably, I think, one of the most important and one of the initial routes for funding that the founders resort to. And, also I think in terms of the Indian setup, With the networking and with [00:07:00] the connections and with the friends and family support, it's also not very difficult to generate angel funding.

[00:07:06] Mehak: So I think that also plays a part in the growth of angel funding and the growth of angel networks in India that sort of support startups and startup founders. So I think all of these factors combined. Have resulted in angel funding being an integral part of the startup ecosystem.

[00:07:28] Rahul: but again, angel tax, what is that? And then that's not really helpful to make angel investing any easier, right?

[00:07:37] Mehak: Yeah, I mean, see, of course, there are a lot of deliberations that are taking place on the recent angel tax and why just the angel tax, I think, or in the startup hemisphere in India, the way taxation is proceeding. Even if you look at the 28 percent gaming GST tax, that, the Indian [00:08:00] government has imposed on, gaming startups, with all of these recent changes in additions, I think this is of course, making it even more difficult for the founders.

[00:08:11] Mehak: And of course the investors to be able to navigate this particular space because, Any amount of tax, which is levied. It is, uh, eventually going to be adjusted through the valuation and the sale considerations. We know that, you know, investors of course, are not going to entirely, um, bear the brunt of it.

[00:08:33] Mehak: And, uh, it is something that is going to come up within the negotiations as well. And, uh, somewhere, the valuations are going to be impacted. And of course, the entire startup community as a whole would, bear the brunt of it. I mean, of course, it's, definitely, not a good story in terms of, the startup sector to have all of these issues, which I think, the startups have raised with the government [00:09:00] authorities as well and they are discussing.

[00:09:02] Mehak: And, yeah, so probably, you know, this is, an area where, I think, So a lot of work is going to be required in terms of the startup founders working with the government on the consultation front to see what can be done to sort of, you know, deal with these recent tax issues.

[00:09:24] Rahul: It's the complete opposite in a lot of countries like, in the UK, I think, a lot of people make angel investment because it helps them with taxes. so I think. Everybody invests, not really for financial returns, but for tax benefits. there, there might be second order, consequences for that in the sense like a lot of people who are not really professional comes in and invest and creates another set of issues.

[00:09:49] Rahul: But still, that is more helpful than taxing, especially, this sort of investment that can make a big difference. And these experiments that [00:10:00] turn into large corporations and very few of them turn into those, right? Yeah. Why is that? Like, why are we not moving in that direction?

[00:10:09] Mehak: see, I think very honestly, um, Considering we are talking about GST and angel tax, I mean, if you look at the concept of angel tax, I mean, it, it essentially says that, the government will want to tax the excess consideration that are received by the unlisted companies, with respect to the shares that are issued by them over and above the fair market value.

[00:10:31] Mehak: So I think where they are coming from is that, from a government standpoint, they probably want a piece of that pie. And, uh, if there is any valuation that goes above the fair market value, then that is where the tax comes. And even if you look at the GST gaming tax, again, the concept is to have probably, you know, a pie of the gaming share because it is a high valuation, high revenue based sector.

[00:10:59] Mehak: So [00:11:00] I think, you know, being a developing country, uh, looking at the economic considerations, the government, of course, is, um, Making its tax policy accordingly, but at some stage, for, uh, India to sort of, you know, shift its gears and convert its journey from developing to develop these issues would also need to be taken care of.

[00:11:24] Mehak: And it is very important to give comfort to businesses, to companies that they can run their businesses without, you know. The tax terrorism and tax excesses being there. And I think that is something that, probably as a country, uh, you know, one would need to look into at a policy level.

[00:11:46] Rahul: Yeah. And regulatory changes, uh, also in the FinTech is not really helpful, right?

[00:11:55] Mehak: Yeah. See, I think, uh, so [00:12:00] tech and fintech again, it's such a growing field in India. So if you look at the perspective of the regulators, let's pick up with tech specifically. And the regulator, which is the Reserve Bank of India. So for the Reserve Bank of India, it is very important for them to regulate the sector from a customer standpoint to protect the interest of the customers, and hence with the, you know, progressive technology, whatever issues have come up that have impacted the customers, whether that's on the KYC front or you know, on the frauds that have been committed onto the customers or whether money has been taken.

[00:12:38] Mehak: you know, the customer money has been measured. So on all, all of those fronts and more, the RPI is extremely keen to play it safe, and that is where they're tightening the news on the regulations. That is where we are seeing the regulations on, um, the data front, on the outsourcing front on, um, you know, the lending apps front [00:13:00] on the payment aggregator fund.

[00:13:02] Mehak: We are seeing the regulations being titled. so there is. A reason why they're doing that and why is that reason is absolutely justified because it's ultimately the regulator playing catch up with the instances that are happening with the advent of technology to protect the customer interest. I think somewhat it's also important to balance it with the business interest.

[00:13:24] Mehak: Similarly, if you look at the recent data protection regulation that has been, you know, um, notified for implementation in India. Uh, the D-P-D-P-A, it is a huge landmark for a country like India to recognize, protection of personal data as a significant right, and to implement it on the lines of, um, GDPR.

[00:13:48] Mehak: And it's a significant step, I think, businesses and, uh, you know, common people. Everyone is appreciating the initiative and the efforts that the government has put in [00:14:00] to get this, uh, law. Past, but having said that, at some point in time, the government wouldn't have to look into the business cost implications of implementing this law, especially at the startup level.

[00:14:15] Mehak: And while they have mentioned in the law itself that they may consider giving exemptions, especially to startups, they've not really, um, sort of come up with a policy on what those exemptions would be, whether they'll give it to certain. Sectors at the startup level or not, or what is going to be the criteria.

[00:14:35] Mehak: So it's probably a wait and watch game at this point in time. And one would really need to see what comes out of it. but yes, at some point in time, it is going to be a huge, huge, cost implication onto the startups. And probably there needs to be, you know, some sort of a balance in maintaining the legal compliances and enforcing.

[00:14:57] Mehak: The privacy rights of individuals [00:15:00] versus, you know, sort of imposing additional compliance costs on startups, um, that they might not be able to

[00:15:07] Rahul: all these things is very challenging, for both parties, for investors and, founders. in, so, in the US, AngelList has played a big role, in terms of, like, making a lot of these things easier, right, in terms of infrastructure.

[00:15:20] Rahul: So, there's AngelList in India as well, and there's also Let's Venture, if I'm not wrong. have they been able to, make things easier? Like... Those crowd platforms, connecting investors, uh, and founders, especially at early stage.

[00:15:37] Mehak: not really, I think, these, crowdfunding platforms in terms of, the Indian context are not way up and running. Also, I think in terms of, the Indian, startup founders, I think for them, it's more important to sort of navigate these, issues and come [00:16:00] up with a realistic valuation and come up with certain terms when giving their proposal to the investors so that, you know, they're able to.

[00:16:11] Mehak: Close it at a realistic expectation of the investors. And by that, I mean that when the founders know that there is an increased compliance cost right now, they know that no investor is going to invest without doing a detailed due diligence. They also know that there may be certain tax implications arising out of the transaction.

[00:16:34] Mehak: And they should, you know, accordingly then tweak the proposal and come up with something that is more palatable for the investors, for this space. I think that is something, they are doing at their end and they should continue doing because it's very important for, you know, for the founders to have a realistic approach and to also correct.

[00:16:56] Mehak: their expectations, correct the valuation and to go with [00:17:00] something that is again, you know, like I said, more palatable for the investors because these issues eventually, like I said, will impact the valuation at some stage, it is going to impact the entire process because it's not easy navigating through these issues, especially, you know, when, uh, it's not like, there's a lot of support From the government authorities, uh, there are not a lot of those third party platforms.

[00:17:28] Mehak: So the way we see in us, there are, um, not very many, crowdfunding platforms. So in terms of navigating this space, it's still a very old school space where the founders need to do the major share of the work at their end. They need to have their house in order. They need to prepare for what is coming as far as the transaction is concerned.

[00:17:51] Mehak: And then, of course, go to the professional investors, approach them through either investment bankers or through, you know, other third party consultants, [00:18:00] and then take their proposal, which, you know, expectedly should be, realistic in nature so that they're able to close the deal and get the funds at the earliest.

[00:18:09] Rahul: Yeah. Oh, what about other like, global trends? Like, ESG is, uh, trend, across the world. And then Has that affected fundraising? If yes, in what ways? And also events like pandemic That just happened

[00:18:29] Mehak: So I think definitely, I mean, pandemic, of course, has given both founders and investors some space to think about how they need to go about, the fundraise, how they need to go about the expansion, whether they need to focus on cash burn or not, um, how much do they need to go on an overdrive to raise funds, so on and so forth.

[00:18:55] Mehak: So I think there has been. A lot of, correction in the practices, [00:19:00] also the funding winter post the pandemic has sort of brought in a base correction, in the way, you know, the startup founders were at least valuing their businesses pre pandemic and the way they are doing it post pandemic, there is a certain difference.

[00:19:17] Mehak: so I think, it has brought in some sense of a reality check as far as the startup founders. are concerned. And, there has been this particular, uh, valuation correction as well. And if we look at ESG, yes, ESG has become a very important factor. especially in the last five, six years, more so in the Indian startup ecosystem context, especially, with the recent instances of, You know, few startups not, being absolutely compliant and, you know, some startups also getting into arrangements, that was not on an arm's length basis.

[00:19:59] Mehak: And a couple of [00:20:00] startups also getting involved in alleged embezzlement. I think all of that has again brought in the focus back on ESG, not only as a theoretical concept, but also practically for the investors. to be able to compel the founders to do an ESG check, to do an ESG due diligence before the transaction takes place and before the startups can raise funds.

[00:20:26] Mehak: And this is something that, the startup founders have accepted as well. I think, um, Especially on the manufacturing side, uh, the startup founders know that there is going to be a thorough ESG check. There is going to be a check of labor compliances, environmental compliances, governance aspects, the social side as well.

[00:20:47] Mehak: And it is extremely important to be able to meet the minimum compliance criteria that is laid down under the Indian laws and also meet the criteria that the foreign investors may have [00:21:00] from. their, uh, working and internal compliance standpoint. So I think this is something that is, been made very clear through the investors conduct and the promoters have sort of accepted it, as well, because we're seeing that in practice, detailed, uh, ESG due diligences are being done, and, uh, if there are issues, then, the investors are asking for specific indemnities.

[00:21:24] Mehak: They're asking, You know, for issues to be resolved, they're asking for, uncapped,indemnities to deal with these issues, so on and so forth. So this is an issue,you know, that, is being looked into detail, uh, by the investors.

[00:21:40] Rahul: Okay Indemnity when you say is basically They investors having protection on you know, when things go wrong, that's simply right to explain that

[00:21:52] Mehak: So indemnity see, in ity is something, you're right, that that is something that gives protection to the investors.[00:22:00] but invest, I mean, from an investor standpoint and from a founder standpoint, indemnity is also something which is very crucial in the negotiation domain because ultimately, um, any and all issues, that may arise, whether they are big or small and any sort of dispute that arises in future would need to go through the indemnity process.

[00:22:25] Mehak: And, to put things in context, uh, you know, in terms of, how investors, would want the warranties, the promoter warranties to be categorized, they of course have their set of fundamental warranties. They have the tax warranties, they have the business warranties, they have the environmental warranties, and then they have.

[00:22:44] Mehak: Um, certain indemnities against those, they have the liability caps against those. They want, you know, especially on the fundamental liability front, and, on the tax liability front, they want to be absolutely protected [00:23:00] and that is why they ask for, um, you know, uncapped liabilities as well. Also on to the front of, specific indemnities.

[00:23:10] Mehak: If during the due diligence process, there are certain compliance issues that have been identified. And if there are certain ESG issues that have been identified, the investors these days are very clear that they want a specific indemnity, which is not subject to the general indemnity caps and restrictions, which is, you know, paid right from the first dollar.

[00:23:34] Mehak: And, they're very clear that they want more specific indemnities and, they want the promoters to give those specific indemnities. And, that is how the negotiations go. And, yeah, it's, it's, it's something which is increasingly, becoming more palatable for the founders as well, because they are, you know, agreeing to give these kinds of indemnities.

[00:23:55] Rahul: So, generally, in, when you look at the terms of fundraising, is it [00:24:00] becoming more founder friendly or investor friendly?

[00:24:03] Mehak: So, I think, um, I think both. Let me tell you why I say that. I think from the fundraising side, it's become promoter friendly. It's become easier for the promoters to raise funds. There are a lot of options for, you know, the founders to be able to raise their funds. They are able to raise funds to equity instrument.

[00:24:26] Mehak: They're able to raise funds to that instrument. They're able to raise funds to Banks and financial institutions, of course. so there are a lot of, avenues that are open. Also in terms of the types of instruments. For founders, they increasingly have more options in terms of the instruments that they want to issue.

[00:24:45] Mehak: So, they can issue, equity instruments, they can issue preference shares, they can issue, debentures, they can issue convertible notes, there are a lot of options for them to be able to raise funds. So, in that context, I feel that the founders, of [00:25:00] course, have it much easier than their predecessors in terms of fund raise.

[00:25:04] Mehak: but if you look at the investor side, if we look at, the kind of, rights that the investors. So, if you look at, the have been asking for, I feel that has definitely become investment friendly. And of course, you know, any issues of fraud embezzlement or any startup bust up issues, of course, don't help the founders cause.

[00:25:24] Mehak: And that is something that, of course, gives more leverage to the investors in terms of asking for certain rights. And those rights are not just restricted to, you know, the exit rights or preemptive rights or the normal anti dilutions or the indemnities that I spoke about. Those rights go, to sort of even earmarking the promoter's securities, keeping the promoter's securities locked in an escrow account.

[00:25:50] Mehak: Also putting certain anti fraud clawback provisions to be able to clawback the founder's shareholding in case, you know, any issues [00:26:00] of fraud, embezzlement or misconduct were to crop up. So I think in that sense, the investors, are in a position where at least, In the Indian ecosystem, they can ask for all of these, rights and also get them.

[00:26:14] Mehak: So, I think, in that sense, they're, of course, better placed.

[00:26:18]

[00:26:19] Rahul: Yeah, so, uh, can we, um, go deep on both, right? Like, you mentioned about, that different instruments by which, founders can raise funds. what is the difference between note and debentures you mentioned? That, that was one thing I wanted to ask. And also there, there are these factoring, financial transactions, right?

[00:26:40] Rahul: I think a lot of SaaS companies, there are these, this is an option for a lot of SaaS companies, and also maybe a tech companies that I can think of. So yeah, if you could explain, the, the, the different instruments and details, that would be really helpful.

[00:26:55] Mehak: Sure. So, I think in terms of the instruments, of course, on the [00:27:00] capital side, we have the equity shares and the preference shares. and, You know, which is known as the common capital and the preferred capital and

[00:27:09] Rahul: and the, the founders usually have the common.

[00:27:11] Mehak: So, this is, one way of, raising, capital.

[00:27:18] Mehak: Then of course we have the debt side. On the debt side, we have, the debt instruments. Those are, you know, one is of course the convertible note that I spoke about initially that only certain categories of companies can issue. And, then there are the benchers, dementias are, dead instruments. and, they are the instruments that can also be converted into equity.

[00:27:43] Mehak: So, Founders in their companies have an option to raise funds through mandatorily convertible debentures or through optionally convertible debentures, which after a period of time and subject to certain conditions can get converted into equity. [00:28:00] And that is also something that they look at while raising funds.

[00:28:04] Mehak: And you're right, you know, a lot of edtech startups, a lot of SaaS startups are looking at a combination of equity stock, which is your common stock and debentures. Uh, to be able to raise funds. And I think, this also comes from, the background of, where the startup is in terms of its growth journey and how much funding it needs.

[00:28:28] Mehak: of course, from an equity and debt standpoint, it's always that debate that, the startup founders, don't want a lot of debt to be appearing on their balance sheets and for all the right reasons. But also they're always in that fix that they don't want to dilute, their equity stake in the company.

[00:28:46] Mehak: So I think it's always that tussle that goes on between equity and debt. And probably, you know, for them, it's very important to come up with the right balance of equity and debt when they're looking at fundraisers.

[00:28:58] Rahul: Yeah, [00:29:00] but I did not still understand the difference between note and debentures, okay.

[00:29:04] Mehak: Yeah. So, see, I think with, the notes, it's, let me put it this way. It's, very few companies that can issue it. In terms of, who can issue, like I mentioned, startup companies can issue it. The ventures is a far more, you know, it, it's an instrument which is, commonly used by all the companies.

[00:29:25] Mehak: It can be issued by any company. And, this is far more commercially acceptable as well because it doesn't, have the restrictions of the convertible node. but it is something that, as a debt instrument can be issued by almost any company in India. ,

[00:29:43] Mehak: And, and, and this is also something which is, an acceptable form of fundraise from a foreign exchange law standpoint.

[00:29:49] Rahul: Yeah. So, how is factoring different from other data instruments? .

[00:29:54] Mehak: So, When we talk about factoring, factoring is basically a type of financing concept in [00:30:00] which a business sells its account receivables to a third party to meet its short term liquidity needs. I mean, it's essentially a transaction between two parties where the factor would pay the amount due on the invoices minus its commission of fees.

[00:30:14] Mehak: Now, this is very different from a debt instrument. because a debt instrument, like I mentioned, it's a loan instrument and, usually it's not backed by any collateral and, normally, you know, it has a term of greater than, 10 years and, uh, this is something, which is, uh, a common way of, fund raise for, uh, a lot of companies, especially in India.

[00:30:40] Rahul: Yeah. I think for SAS companies. this is, I've seen a lot of, startups that does this, uh,

[00:30:47] Mehak: Yeah.

[00:30:47] Rahul: they can improve their cashflow by, getting, raising financing like this. Yeah. So in terms of, terms that helps the investors, right? what are some of [00:31:00] those, terms that founders are happy to accept, but is more investor friendly.

[00:31:06] Mehak: Okay, so I think, Founder lock in of securities is one, which is extremely investor friendly. so this means, that, the founder's securities are going to be locked up where they are not able to transfer the securities for a certain time period. And, that is also required from an investor's standpoint, so that, the founders can give.

[00:31:29] Mehak: that much time, to the company that they've set up and so that they're absolutely involved in the day to day functioning of the company.

[00:31:37] Mehak: So this is something, that the founders readily accept. And the second,

[00:31:42] Rahul: years, right?

[00:31:43] Mehak: yes, it's typically four years. In fact, we've also seen this concept of, uh, locking being extended to earmarking of securities.

[00:31:54] Mehak: Now. So what we are seeing is that the founders, shares are being earmarked and [00:32:00] kept in an escrow. And this is to prevent a situation where, you know, the founders end up transferring their shares in breach of the transaction documents. And the investors in that situation are only left with a post facto remedy.

[00:32:18] Mehak: Uh, because, if the shares have been transferred, uh, the investors can't do much. So to prevent that sort of a scenario, they are also looking at escrow, mechanisms where, the founders can, sort of deposit and earmark their, securities. So this is something that we've seen happen very recently, and, some of the investors are, getting the founders to agree to this as well.

[00:32:44] Mehak: The second concept I think is indemnities that I spoke about, especially, those related to the breach of fundamental warranties and tax warranties and, the other category of indemnities based on the specific issues that the investors [00:33:00] discovered during their due diligence, in ESG diligence processes.

[00:33:04] Mehak: So that is also something which is absolutely important. The third, I think is, the preemptive, and the anti-dilution rights. Uh, so, you know, anti-dilution, especially whenever, there is a future down round in the company to protect, the price, and the valuation at which the investors have invested.

[00:33:23] Mehak: They ask for anti-dilution as well. And, the founders, are okay to give it. And, um, I think the other side of rights, which are extremely important. Are the exit rights, because it is extremely important for the investors to make their money and exit the company. And, from a founder's standpoint, it is important to be able to give various options, either in the form of buyback or IPO.

[00:33:51] Mehak: If not that then strategic sale or secondary transactions, but somehow arrange for the exit of the investors as in when they need to exit the company.[00:34:00]

[00:34:00] Rahul: yeah. So, um, recently in India, there's been a lot of, uh, governance sort of issues, right? So is there a change, in terms of fundraising, adjusting to those? instances, as in like, reacting to those instances.

[00:34:22] Mehak: I think so. Yes. I mean, there have been recent instances that have not been in good taste. There have been instances of, um, startup founders being embroiled in disputes with investors. There have been, allegations against the founders for fraud and embezzlement. And there have been certain evident, financial and other compliance issues.

[00:34:46] Mehak: with some startups. So I think all of these issues have made the investors very, uh, there have been discussions between the founders and the investors on how to navigate it. But I think what this has done is [00:35:00] this is again, got the spotlight into how much and what can the investors eventually control. Of course, there have been discussions that the startup founders need to have, you know, their house in order.

[00:35:13] Mehak: They need to. comply with certain, governance regulations. They need to, of course, comply with the financial regulations, and they need to agree to certain clauses in the documents to be able to protect the company's interest and the investor's interest and other stakeholders interest as well.

[00:35:30] Mehak: but despite all of this, there's a very real risk. Of commercially navigating on how much control can the investors have over the founders who are responsible for day to day functioning. Because it is eventually the founders on which the investors are betting on. And I think, um, while, you know, one can of course, speak about all of these issues, and one can try to find a fine balance.

[00:35:58] Mehak: to be able to structure the [00:36:00] documentations to deal with these issues or rather prevent these issues going forward, but there's also a very real discussion that needs to happen on ground, between the investors and the founders on how to navigate this at a commercial and a practical level, because ultimately it's the founders who are running the ship.

[00:36:22] Rahul: Yeah. So, what are founders doing, especially on compliance? yeah, like improving the compliance side of things.

[00:36:31] Mehak: I think for one, they're, putting a lot of, policies and processes in place. They're setting up, uh, separate compliance departments. They're getting, you know, separate, internal, auditors. They're getting internal risk controllers. They're getting, independent directors, they're forming independent committees to look into these issues.

[00:36:52] Mehak: And, they're also looking at, You know, third party external advice from, um, [00:37:00] you know, former, investors from our fund heads, um, former senior officials in the government, former banking officials to ask them what more can they do to navigate this space in terms of, compliance issues and in terms of investor tussles.

[00:37:18] Rahul: Yeah. So, what are the specific compliance sort of, I don't know whether to call it verticals. So, there is tax, there is... With the data thing, data compliance, employment,

[00:37:32] Mehak: I. Yeah, so I think one of course is ESG. ESG compliance is important. The other one is you rightly mentioned is tax compliance. The third one is financial compliances. You know, um, your business, finance side, your audit processes, so on and so forth.

[00:37:54] Mehak: The fourth, or rather the fifth category is going to be, um, you know, the [00:38:00] Compliances pertaining to, your, um, miscellaneous issues, uh, like data, it could be the ID side,

[00:38:09] Rahul: Yeah.

[00:38:10] Mehak: ID as well, IPR, all of these compliances on the miscellaneous side.

[00:38:15] Mehak: So all of, this is going to be categorized as one bucket depending upon, the nature of the business the company is in. And, again, you know, it's important from a founder's standpoint as well to be able to categorize some of these compliances as, absolutely high risk, medium risk and low risk. I think it's important to know what are the kind of, non compliances, uh, that can result in, uh, potentially higher penalties or probably criminal prosecutions.

[00:38:48] Mehak: And then to focus on the. Um, mid risk compliances that will result probably in some monetary penalties, but maybe not prosecution, but they [00:39:00] can still result in a loss of reputation and then certain role low risk compliances, which from a monetary standpoint or brand reputation standpoint are not going to cause a lot of damage.

[00:39:13] Mehak: So I think it's important for every founder to sit with their advisors to do this exercise to be. able to sort of, uh, have this, uh, tracker and analysis ready on what are the high risk, mid risk, and low risk compliances. So that they can work towards it and accordingly allocate cost towards it, because very realistically, a lot of times it's about, the allocation of cost and resources, which is an impediment.

[00:39:41] Mehak: In complying, you know, with various, rules and regulations, though of course not an excuse, but it's important to be able to allocate, the resources and the cost in a manner that at least the high risk and the mid risk, uh, compliances, uh, get done at [00:40:00] the

[00:40:01] Rahul: to keep updated of all the compliance in India, it's itself is like a huge task, right?

[00:40:08] Mehak: No, absolutely. In fact, I recently had a founder telling me that, you know, on an average, it looks like, In the entire journey of a company, there are around 4, 000 to 5, 000 laws applicable. I mean, how are we even supposed to practically navigate that? and, on a lighter note, yes, they're like, you know, we should probably just leave our normal jobs and, uh, leave the business and should just focus on compliance with rules and regulations.

[00:40:33] Mehak: Because it looks like, that is something that we need to pick up as a priority. Though it's impossible with the number of, uh, Laws and rules and regulations that are there. So, yeah, I mean that is something which is definitely An issue in the Indian context, but again, I think one just needs to figure out a way to navigate it in the best possible manner

[00:40:53] Rahul: Yeah. Uh, so, and what about these, employment, labor sort of compliance in terms of like your [00:41:00] team, uh, your employees side of thing, and also, with your customers and, uh, partners and suppliers, et cetera. What about compliances, uh, in both these two aspects and also, enforcement of any contracts is, is not really possible, right, in India, or like, it's more like law doesn't really help with.

[00:41:24] Mehak: Yeah, I mean see very honestly I think On the question pertaining to enforcement of contracts that is something where there has been an improvement honestly on You know, on recoveries, to be done under the contracts or to be able to enforce contractual rights. We are seeing, that, the Indian judicial system is improving, they're reacting faster, they're giving, away remedies.

[00:41:52] Mehak: So yes, it's, definitely become better in the last 10 years. on to your other question on what are the [00:42:00] level of compliances that are required for employees and, you know, for customers, vendors, suppliers in the other bucket. So let's come on to the employees and workers. I think again, navigating through the gamut of employment and labor laws in India, it's quite complicated, especially if one is running a manufacturing setup.

[00:42:23] Mehak: You have the Industrial Disputes Act, there's a Factories Act, there are Standing Orders, there are Payment of Wages Act, Minimum Wages Act, Payment of Bonus Act, uh, ESI, EPF, so on and so forth gradually. There are just way too many laws to navigate, but it is extremely important to do the compliances under each of these laws.

[00:42:43] Mehak: also in the, you know, on the white, color side, uh, With, the office, employees, uh, again, there are laws pertaining to, shops and establishments, gratuity, uh, minimum wages, so on and so forth. So it's extremely important [00:43:00] for businesses to have, You know their HR teams and their labor law advisors absolutely on their toes so that all of these laws and filings and You know can be complied with and multiple compliances can be done So I think from a government standpoint.

[00:43:20] Mehak: They are trying to Streamline the labor law compliances. In fact, there are four labor codes in the OFIC And, uh, one would see them, hopefully getting implemented in the next, 2 3 years. So that is something that the government is trying to do. They're trying to replace all the labor laws and just consolidate everything in the form of four labor codes.

[00:43:46] Mehak: So that is something which is, you know, in the pipeline. Now as far as the laws, uh, and the compliances pertaining to customers and, uh, vendors and suppliers are concerned, Uh, again, you know, [00:44:00] I feel, that is an area where, it is more governed by contracts. I mean, unless there's a specific law, I mean, unless there's a specific law dealing with it.

[00:44:10] Mehak: for example, if there's a data protection act, that is applicable, if, the company is storing the personal data of customers or third party vendors, then of course that is a compliance under that law that the company would need to do. Similarly, if, the company is, in FinTech business and it is, dealing with vendors, which are, also in that space, then it would need to comply with the RBI regulations.

[00:44:34] Mehak: Also, you know, if, the company is dealing with vendors which are small and medium sized enterprises, then there are laws applicable to the SMEs and, one will need to comply with those laws. So I think with the customers and third party vendors, it mostly depends. On the kind of business activity that is being carried out in the kind of transaction that are being done.

[00:44:57] Mehak: Also, I think that, companies [00:45:00] these days are quite cognizant of the fact that they need to have their contracts with their employees, customers, vendors, suppliers, absolutely watertight. so that, you know, there's no issue going forward and they are. Absolutely, you know, putting in the time and effort in getting those contract templates, right?

[00:45:23] Mehak: So whether that's on the employee side or whether that's on the customer side in the form of, uh, customer teas and teas, or whether that's, with the contracts, that the companies are signing with their vendors and suppliers. They are absolutely making sure that the contracts are detailed. They have all the legal provisions.

[00:45:39] Mehak: They have all the commercial, uh, points outlined, the entire scope of work detailed. So that there is as little confusion and interpretation issue going forward as possible.

[00:45:50] Rahul: Yeah. I mean, in my experience, at least, I don't think it's great to say this, but then, there is absolutely still no enforcement of any contracts, right? [00:46:00] Even if there is any enforcement, it's like physical force enforcement rather than by law.

[00:46:05] Mehak: see, in terms of enforcement, I think it's definitely getting better. I mean, if you're talking about the Indian context, things are improving. if we were to look at, the kind of, inspections, for example, that the labor inspectors are doing. For the enforcement of the labor laws, the inspections have increased, the kind of notices that the labor departments are sending, all of that has increased, um, and they're doing it on a more regular basis, they're more in touch with the companies to figure out what all compliances have been done from the last time when they send the notice, so on and so forth.

[00:46:38] Mehak: So I believe there is improvement also if we look at the taxes side, for example, the tax department, uh, you know, Their whole method has changed in the last few years. The way they're sending out notices, the way they're keeping a tab on the kind of transactions that the companies are entering into, the kind of cases and instances that they are [00:47:00] reopening and re analyzing.

[00:47:01] Mehak: So I think all of that is changing. So yes, I think in terms of the implementation, things are changing. Of course, uh, there is a long way to go, but, yeah, things are improving at the ground level.

[00:47:13] Rahul: Yeah. And, um, can we also talk about the liabilities side of things? Um, so you mentioned investors, even for investors, no matter what, what terms, they put in, there is still a limitation on, um, the control that they can have. So, what are investors doing in terms to limit their liability? And also of course, the founders.

[00:47:36] Mehak: in terms of, of course, I mean, from the founders side, the founders, um, try to negotiate for the liability caps, uh, for the indemnities that they give to the investors, at the transaction value. they also try, to whatever extent they can, not have any investor interference, either through veto rights.

[00:47:58] Mehak: Or through, [00:48:00] information rights or through approval of business plans. So they're trying not to have investor interference in day-to-day affairs. That is something that they're trying, um, from a founder standpoint, they're also trying, that, you know, in terms of, the exit rights, they can extend the exit rights to as much time as, you know, they need to get the business up and running.

[00:48:26] Mehak: So whether that's four years, five years, six years, they of course, try to have as many mechanisms in place so that, from their end, they don't breach, um, you know, the, uh, right that, they've given to the investors to exit the company. So, um, you know, these are some of, the rights that, at least from a practical standpoint, the founders try to negotiate and navigate from an investor standpoint again.

[00:48:54] Mehak: While they can't absolutely control the business operations, but we're seeing that the investors [00:49:00] increasingly are retaining the right to appoint a director to the board or to appoint an observer to the board to keep a tab on, what all has transpired in the board meetings, what is happening at the operational level in the company.

[00:49:14] Mehak: They're also, retaining the right to be able to appoint professionals, CEO, CEO. Of their choice in the company in case the promoters or, or, or the founders sort of end up, defaulting. So that is something they're increasingly doing, and this is something that we are seeing that, uh, the founders are also accepting.

[00:49:32] Mehak: so, you know, the right to appoint, a professional, uh, like um, ACEO or ACEO is an important right, and of course it needs to be exercised sparingly, but that is something that the investors are absolutely insisting on.

[00:49:46] Rahul: Yeah, so in case of founder fraud, uh, there's been a number of cases, in the recent past in India, um, what can investors do and has there been any changes in [00:50:00] terms of like, checks and balances put in place to make sure that there is not much, of those cases, at least in the future.

[00:50:08] Mehak: I mean, from an investor standpoint, to be able to have the checks and balances is very important for them to, you know, put in a mechanism of having a compliance committee or a compliance, board and having a compliance officer in the transaction document. That's something very important from their standpoint.

[00:50:27] Mehak: What they're also insisting on is not just an initial, uh, compliance or an ESG due diligence, but to have all of these, compliance in ESG and financial due diligences being done on a quarterly or a biannually basis so that the founders can present them with the updates and, the status of where they stand as far as the compliances are concerned.

[00:50:49] Mehak: From an investor standpoint, I think they're also insisting. For, post, fraud or post embezzlement remedies in the form of, uh, you know, founder [00:51:00] clawback, I mean, where, the shares and the securities of the founders can be clawed back or transferred to the other end investor. They're also insisting on clauses where, the founders would be compelled to leave the company, at least, in the operational capacity and, the fact that they can be replaced.

[00:51:20] Mehak: by certain other professionals. So those are the kind of clauses and provisions that the investors are insisting on apart from the others that I discussed during the course of my conversation in the form of indemnities and so on and so forth.

[00:51:36] Rahul: What can investors do?

[00:51:41] Mehak: See, I think, I mean, in case of embezzlement, it's also very important to get the internal processes right. I mean, of course, once it has happened. Then it's a question of proving it and having the auditors do an audit, prove that there was an embezzlement and then proceed with the criminal remedies, [00:52:00] criminal prosecutions as well.

[00:52:02] Mehak: And of course, proceed with the remedies to get the money back or, you know, proceed with civil remedies that is. but I feel that more than the post factor remedies, it's important to put in, checks and balances and processes in place so that these instances can be avoided. And for that, is it, it is absolutely important to have, you know, internal, teams, internal control teams, internal audit teams within the companies.

[00:52:30] Mehak: To have compliance officers who sort of, uh, you know, keep a tab of all of these issues on a day to day basis and they update the board and the investors if anything goes wrong. I think that's, the more, real way to keep a track of things and, to sort of prevent things from going out of control.

[00:52:51] Rahul: And, um, from the founder perspective, you know, you, you've sent me the notes on this thing and, and it, it talks about [00:53:00] insurance that investors can consider. there is already limited liability for a private company, right? So what is the clear use case of insurance? What are the scenarios where insurance, for directors, uh, will help in terms of, personal liability sort of risk.

[00:53:19] Mehak: Yeah, so in terms of the personal liability, so, um, see what happens is of course, in a limited liability company, we know that, the liability of, the shareholders is limited. But having said that, it is very important. For, directors and officers, especially those important, you know, appointed by the investors to have the directors and officers liability insurance so that tomorrow if something goes wrong in the company, you know, either because of the founders or otherwise, then at least the investor representatives are the one who are protected through this insurance.

[00:53:59] Mehak: Because, [00:54:00] while, you know, they would want to appoint their directors and officers and observers in the company to ensure that everything is going fine, they would not want to be in a position where they are held personally liable when they're not in the driving seat. So that is where DNO insurances really help.

[00:54:19] Mehak: And that is also a trend which has been there worldwide, but it is also picking up in India where, um, Investor representatives insist on, DNO insurances?

[00:54:31] Rahul: Yeah. is there one sort of trend, that is happening right now? which is like a positive signal in terms of like, you know, the right sort of checks and balances are being put in place, but it's also making it easier for. the, the, every party involved in, in terms of founders and investors, uh, to run businesses in India.

[00:54:52] Rahul: Is there something that is like a positive sign?

[00:54:55] Mehak: I think, I mean it's, it, it, it, it was always happening, but I [00:55:00] think it's definitely, you know, got more traction in the last few years and that is, I think, the process of due diligence and having all the compliances in place. So that is something that, the founders and the company are giving a lot of, importance to.

[00:55:16] Mehak: And that's a good trend. though, you know, that is something that of course entails a cost and resources, like we discussed, but it is something that is going to eventually help the founder navigate a lot of issues when they enter into transactions, with, uh, potential investors and, keeping the compliance, Ground clean, is something which is an added responsibility in addition to running the business.

[00:55:42] Mehak: But I think if the founders can get it right, they would end up saving themselves from a lot of other worries in the future.

[00:55:48] Rahul: Yeah. Yeah. This was great. thank you so much for taking the time to do this.

[00:55:54] Mehak: Thank you so much. It was my pleasure, and I hope that, you know, our [00:56:00] audiences, would be able to get an inkling of the current trends, in the startup, sector. And, you know, in case, there are any questions, that anyone would have, I would be happy to answer that as well.