Legal Foundations of Start-up Incorporation and Compliance

Partnership Firm

A partnership firm is the simplest form of business entity, requiring a minimum of two members (individuals or corporate entities). It is formed by executing a partnership deed – a written agreement that typically includes:

• Name of the firm and place of business
• Objects (business to be undertaken)
• Capital contribution of each partner
• Profit‑sharing ratio
• Dispute resolution clause

Registration of the partnership deed with the respective Registrar of Firms (state‑level) is optional. It becomes mandatory only when immovable property is involved. An unregistered partnership firm suffers two major disadvantages:

• It cannot sue third parties in case of disputes.
• It cannot apply for DPIIT start‑up registration.

Key takeaways

• Minimum 2 members (individuals or corporates).
• Partnership deed governs terms; registration with state Registrar is optional.
• Unregistered firm: no legal standing to sue third parties and ineligible for DPIIT start‑up benefits.
• Registration is compulsory if the firm holds immovable property.

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Limited Liability Partnership (LLP)

A Limited Liability Partnership (LLP) is a hybrid structure combining features of a partnership and a company. Liability of partners is limited to their capital contribution.

Formation process

1. Pre‑incorporation discussion – Partners decide on capital, profit‑sharing ratio (can differ from capital ratio), place of business, objectives, and registered office.
2. Name reservation – File form RUN‑LLP with the Ministry of Corporate Affairs (MCA). Two name choices can be submitted; one will be approved if it does not resemble an existing LLP or registered trademark.
3. Incorporation documents – After name approval (valid for 90 days), file form FiLLiP with:
   • ID and address proofs of partners and designated partners
   • Registered office documents and proofs
   • Subscription document (consent of partners to form the LLP)
   • Certification by a practicing professional (CA, CS, or advocate)
4. Certificate of Incorporation – Issued by MCA upon processing FiLLiP.
5. LLP agreement – Must be filed in form 3 within 30 days of incorporation.

Key takeaways

• Hybrid entity: limited liability of partners + partnership flexibility.
• Name via RUN‑LLP (valid 90 days); incorporation via FiLLiP.
• Mandatory: file LLP agreement (form 3) within 30 days.
• Certification by a professional is required.

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Private Limited Company & One Person Company (OPC)

Private Limited Company

The process mirrors the LLP structure but with distinct forms and prerequisites.

1. Pre‑incorporation discussion – Founders decide initial capital, first directors, state of business, and objectives. A Founders’ Document (optional but advisable as good governance) may capture these agreements.
2. Name reservation – File Spice Plus Part A. The name is approved if it does not resemble an existing company or registered trademark. Name availability lasts 20 days (extendable up to 60 days by paying a fee).
3. Prerequisites (explained in detail below):
   • Digital Signature Certificate (DSC)
   • Director Identification Number (DIN)
   • Identified registered office
   • Charter documents: Memorandum of Association (MOA) and Articles of Association (AOA)
4. Incorporation forms – File Spice Plus Part B together with Spice Plus Agile Pro (linked form). Contains:
   • Shareholder and director details, ID/address proofs
   • Registered office details and proofs
   • MOA & AOA
   • Declarations (non‑disqualification, truth of information)
5. Output – Certificate of Incorporation plus automatic generation of PAN, TAN, ESIC, EPF, and bank account. Professional tax and shops & establishment registration are integrated only for certain states.

One Person Company (OPC)

The process is largely the same as for a private limited company, with these differences:

• Only one member (the sole shareholder) who must nominate a person to succeed them (ensures perpetual succession).
• Can be incorporated only by an Indian citizen or an NRI.
• Cannot be formed for: non‑banking financial services (NBFC), not‑for‑profit activities, or as a Section 8 company.

Key takeaways

• Private company: name via Spice Plus Part A (20‑day window, extendable); incorporation via Spice Plus Part B + Agile Pro.
• Automatic registrations: PAN, TAN, ESIC, EPF, bank account upon incorporation.
• OPC: single member + nominee; only Indian citizen/NRI; prohibited for NBFC/NPO/Section 8.
• Founders’ Document is advisable but not mandatory.

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Prerequisites and Documentation for Incorporation of a Company and LLP

Digital Signature Certificate (DSC)

• Required for all online filings with MCA (under IT Act).
• Application online using ID/address proofs and OTP verification of email/phone.
• Validity: 1–3 years; stored in a password‑protected USB token.

Director Identification Number (DIN) / Designated Partner Identification Number (DPIN)

• An 8‑digit unique number allotted to each director (DIN) or designated partner (DPIN).
• Can be obtained at incorporation (for up to 3 directors/designated partners) or post‑incorporation via Form DIR 3.
• Once allotted, it is lifetime; must be renewed every 3 years by June 30.

Registered Office

• Companies Act, 2013 mandates every company to have a physical space capable of receiving communications at all times.
• Options: residential house (may attract commercial tax), apartment (if by‑laws permit), or coworking space. Virtual offices are strictly not allowed.
• Name board must display: company name, address, CIN, GST number, website, email – in English and local language.
• Proofs: utility bill (≤2 months old) showing the address, plus No Objection Certificate (NOC) from the owner.
• Registered office can be intimated at incorporation or within 30 days via Form INC 22.

Proofs for Directors / Shareholders

Charter Documents: MOA vs AOA

Share Capital

• Authorized share capital: the maximum amount of share capital the company is allowed to raise.
• Paid‑up share capital: the actual capital invested by shareholders.
• Both limits can be increased by following prescribed procedures.

Declarations and Certification

• Declarators (directors and shareholders) must confirm:
  • They are not disqualified or ineligible to form the company.
  • All information and proofs submitted are true and correct.
  • The company will not accept deposits from the public except as permitted under the Companies Act, 2013 or RBI regulations.
• Certification by a practicing professional (CA, CS, or advocate) is required on the incorporation forms.

Exam tip Remember: Aadhaar is not accepted as ID proof for incorporation filings. Virtual offices are prohibited; only physical, identifiable spaces qualify.

Key takeaways

• DSC is mandatory for online filings; stored in a USB token.
• DIN/DPIN is lifetime but must be renewed every 3 years by June 30.
• Registered office must be a physical space; virtual offices banned.
• MOA = objectives + clauses; AOA = internal management rules.
• Authorized capital = maximum; paid‑up capital = actual.
• All incorporations require professional certification and specific declarations.

Post-Incorporation Compliance

Within 30 days of incorporation, the board must hold its first meeting. A bank account must be opened, and the subscribers to the Memorandum of Association (the initial founders) transfer their agreed capital contributions.

Once funds are received, the company allots shares to the founders and must file Form INC-20A (Declaration of Commencement of Business). Until this form is filed, the company cannot start any business – borrowing is also prohibited.

After filing INC-20A, share certificates must be issued to the subscribers within 60 days from incorporation. The Statutory Register of Members must be updated.

Appointment of Auditors

The first auditors must be appointed within 30 days of incorporation. Once the board approves the appointment, Form ADT-1 must be filed with the Ministry of Corporate Affairs (MCA) within 15 days of appointment (overall within 50 days of incorporation).

Board Authorization for Business Registrations

The board may authorize one director to apply for various business registrations needed for operations (some may be state-specific).

Exam tip: Form INC-20A is a hard deadline – no business activity (including borrowing) is permitted before filing. Share certificates must be issued within 60 days, not 30.

Key takeaways

• First board meeting: within 30 days of incorporation.
• File INC-20A to start business; borrowing also prohibited until filed.
• Issue share certificates within 60 days; update Register of Members.
• First auditors appointed within 30 days; file ADT-1 within 15 days of appointment.
• Board can authorize a director to handle other registrations.

Start-up Registration

Registration with the DPIIT (Department for Promotion of Industry and Internal Trade) is not mandatory but unlocks several benefits.

Eligibility

Loss of Recognition

A start-up loses its recognition if:

• Formed by splitting an existing enterprise (demerger/merger).
• Gets acquired and becomes a subsidiary, associate, or joint venture of another entity.
• Formed with similar line of business, same place of business, and at least one common designated partner/director.

Benefits of Start-up Registration

General

• Access to DPIIT and state government schemes.

Labour Laws

• Relaxation in inspections; compliance can be met via self-certification instead of inspection.

Intellectual Property

• Reduced application fee for patents.
• Fast-track processing of patents.

Companies Act, 2013

• Can issue convertible notes (hybrid debt/equity) – flexible fundraising.
• Can grant ESOPs to promoter directors (otherwise not allowed).
• Can raise any amount of deposits from shareholders without limits.

Foreign Exchange Management Act (FEMA)

• Can issue convertible notes to non-residents.
• Can borrow external commercial borrowings (ECB) from outside India with fewer restrictions.
• Can pledge intellectual property as security against borrowings (otherwise not permitted).

Income Tax Act

• Carry forward of losses even on change in ownership.
• Tax holidays – subject to Inter-Ministerial Board approval.

Application Process

1. Register on the DPIIT portal (completely online).
2. Update the business profile.
3. Upload a pitch deck proving innovation/improvement, along with company details.
4. DPIIT issues the start-up certificate.
5. Optionally, register on the state-specific start-up portal for state-level benefits.

Key takeaways

• Any entity except sole proprietorship, with turnover ≤₹100 crore and innovation focus, can register.
• Registration valid 10 years; lost on acquisition, merger/split, or duplication.
• Benefits span labour, IP, company law, FEMA, and income tax.
• Process is online via DPIIT portal; state portal can be used separately.

MSME Registration

Registration as a Micro, Small & Medium Enterprise (MSME) is available for entities in manufacturing, trading, and services. Classification depends on investment in plant & machinery and annual turnover – both thresholds must be satisfied.

Registration Process

• Completely online on the UDYAM registration portal.
• Fill basic details of the entrepreneur, authorised signatory (for company/LLP), and category.
• UDYAM certificate is sent by email.
• One-time registration – no renewal, free of cost.

Benefits

• Access to schemes of the MSME Ministry.
• Loans at reduced interest rates.
• Subsidies for patent and trademark registration, and for product standardisation/licensing.
• Mandatory payment of dues: Law requires that dues to Micro & Small Enterprises (MSEs) be paid within 45 days from the date of delivery/service. Corporates with overdue payments beyond 45 days must report to the ministry via Form MSME-1.

Exam tip: The 45-day payment rule applies only to MSEs (micro and small), not medium. Form MSME-1 is the compliance tool for larger companies.

Key takeaways

• MSME categories: micro (2.5 cr / 10 cr), small (25 cr / 100 cr), medium (125 cr / 500 cr).
• Registration on UDYAM portal, one-time, free.
• Benefits: cheaper loans, IP subsidies, access to schemes.
• Dues to MSEs must be paid within 45 days; non-compliance reported via Form MSME-1.

Other Commonly Applicable Registrations

Some registrations are integrated with the incorporation process; others must be applied for separately.

Integrated (mandatory or optional during incorporation)

Additional Registrations (post-incorporation)

Key takeaways

• Bank, ESIC, EPFO are mandatory and integrated in incorporation forms.
• GST, Shops & Establishment, Professional Tax may be integrated for some states or optional.
• Trademark, Factories Act, IEC, POSH, and state-specific registrations must be applied separately as per business activity.
• POSH registration on SHe-Box is mandatory for all employers.

Governance Hierarchy of a Company

The shareholders are the supreme governing body. They delegate powers to the board of directors through charter documents or as enabled by the Act. The board in turn authorises the Managing Director (MD) or CEO for day-to-day operations. CXOs (e.g., Chief Technology Officer, Chief Financial Officer) handle specific functional areas. Powers and compliance responsibilities are bifurcated: certain matters require shareholder approval, others only board approval.

Company Compliances

Compliances under the Companies Act are of two types:

• Annual (routine) compliances – recurring every year.
• Event-based compliances – triggered by specific corporate actions.

Annual Compliances for a Company

Current-law note: Filing requirements and deadlines change. Use this table for the course framework and confirm current dates and applicability on the MCA portal or with a qualified professional.

Event-Based Compliances for a Company

Triggered by specific actions, each requiring internal approvals (board and sometimes shareholders) and filing of forms with MCA. Examples:

• Change of statutory auditors – board approval → shareholder approval → MCA forms.
• Change in share capital – e.g., raising funds; requires board approval, shareholder approval, valuation report, and multiple forms.

LLP Compliances

Compliances for an LLP are less extensive than for a company.

Annual Compliances for an LLP

Event-Based Compliances for an LLP

Staying Compliant

• Ignorance of law is no excuse – directors and designated partners are expected to know applicable laws.
• Consult professionals – company secretaries, chartered accountants, lawyers – because it is impractical to know all laws.
• Penal consequences for violations affect future fundraising and overall credibility.

Exam tip: “If you think compliance is costly, try non-compliance.” Expect questions on the distinction between annual vs. event-based compliances and the specific forms (e.g., MSME, DPT-3, AOC-4, MGT-7, PAS-6) and their due dates.

Key takeaways

• Governance: Shareholders → Board → MD/CEO → CXOs; powers and compliance duties flow down.
• Company annual compliances include 4 board meetings, AGM, director disclosures, Form MSME (half-yearly), Form DPT-3 (June), AOC-4 (30 days post-AGM), MGT-7 (60 days post-AGM), DIR-3 KYC, and PAS-6 (half-yearly for dematerialisation).
• Event-based compliances for companies arise from changes in auditors, share capital, etc.
• LLP compliances are lighter: annual return (May), financial statements (October), and event-based forms for partner changes (Form 3/4) and registered office changes (Form 15).
• Compliance is critical – non-compliance carries penalties and damages credibility; always seek professional advice.

Start-up Funding Stages and Lifecycle Overview

Understanding funding stages is essential because start-ups, as private limited companies, rely heavily on external capital throughout their lifecycle. Each stage corresponds to a specific maturity level of the venture and attracts different types of investors.

The Funding Lifecycle (Pre-seed through Exit)

The following table summarises the standard nomenclature, the venture’s development milestone at each stage, and typical sources of capital.

Exam tip: The naming convention (Seed, Series A, B, C …) is the most‑tested detail. Know which investor type matches each stage: angels → seed, venture funds → Series A, private equity → later rounds.

Why an exit is necessary. Founders and all investors (angels, venture funds, private equity) need an “upside” – a return on their capital and effort. The exit event (sale or IPO) provides that return.

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Sources of Funding: Equity, Debt, and Grants

Equity Capital

Equity capital is permanent capital – it stays in the company until dissolution. Equity shareholders are the highest‑risk takers but also receive the highest potential rewards.

Contractual clauses. In shareholder and subscription agreements, preference shareholders often receive additional rights (through contract) that effectively give them voting and other privileges beyond what the Companies Act provides.

Debt Capital

Debt capital is a liability – the company must repay the amount, either in cash or by issuing equivalent shares. Common sources include:

• Borrowings from directors and relatives
• Borrowings from shareholders
• Inter‑corporate borrowings (from another company)
• Borrowings from banks, financial institutions, and private equity firms
• Convertible notes – an instrument available only to start-ups (debt that converts to equity upon a future trigger)
• Convertible debentures – debt that can be converted into equity shares

Grants

Grants are not a typical primary funding source but provide a pipeline of non‑dilutive capital, especially during R&D and product development. Sources include:

• Corporates (corporate social responsibility / innovation programmes)
• Government ministries (e.g., education, defence, semiconductors, health, AI – increasingly active in the start‑up space)
• R&D institutions
• Incubators (often channel government funds)
• Impact investors – investors who prioritise social impact alongside returns, typical for for‑profit social enterprises

Exam tip: Grants are non‑dilutive, but each source has specific application criteria and compliance obligations. Know the typical grant channels (government → incubator → start-up) and the role of impact investors.

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Key Takeaways

• Start‑up funding follows a staged lifecycle: pre‑seed → seed → Series A/B/C… → acquisition or IPO.
• Equity capital is permanent; equity shares carry full voting rights, preference shares carry priority in dividends and winding‑up.
• Debt capital includes borrowings from directors, banks, and convertible instruments (convertible note is start‑up‑specific).
• Grants come from corporates, ministries, R&D institutions, incubators, and impact investors – useful in early R&D stages.
• Every investor ultimately needs an exit (sale or IPO) to realise returns.

Borrowing Compliance and Legal Framework for Start-up Funding

Borrowing (debt capital) is a key funding source alongside share capital, grants, and other equity. The Companies Act 2013 sets guardrails — limits, approvals, and reporting — that every private limited company must follow. The core question: from whom can you borrow, under what conditions, and what happens if you ignore the rules?

Sources of borrowing – permitted lenders

Limits and exemptions

• Shareholder‑borrowing cap: For a private limited company, total borrowings from shareholders cannot exceed 100% of the aggregate of:

  • Paid‑up share capital
  • Free reserves (accumulated profits, not earmarked)
  • Securities premium (excess over nominal value paid by investors)

  Example: If paid‑up capital = ₹5 lakh, free reserves = ₹2 lakh, securities premium = ₹10 lakh, the limit is ₹17 lakh. Any loan from shareholders beyond that requires special exemption.

• DPIIT‑registered start‑up advantage: The 100% cap does not apply for the first 5 years from incorporation. This allows raising more debt from shareholders without breaching the limit — a critical relief for early‑stage ventures.

• Director borrowing: No monetary limit. However, the director must provide a declaration that the loan amount comes from their own funds (not borrowed from third parties), to prevent money laundering.

Compliance requirements – the checklist

1. Board approval at a formal meeting (resolution recorded) for all borrowings.
2. Shareholder approval (by ordinary or special resolution) when borrowing from shareholders or exceeding limits.
3. Director’s declaration (if lending as director) – stating own funds, not routed.
4. Loan agreement (preferred for director loans) detailing interest, tenure, repayment, and conversion possibility – tabled at board meeting.
5. Annual filing of Form DPT‑3 with the Registrar of Companies (ROC) – reports all deposits (including exempted ones) taken during the year.

Critical traps – “strict no” items

• Friends and family as lenders: Unless they belong to an exempted deposit category (e.g., certain relatives, other permitted classes), receiving a loan from a friend or family member is not allowed. A casual GPay or credit‑card swipe to cover expenses is considered a borrowing and can be a breach with serious consequences. Instead, raise funds from them via equity (share capital).
• Advances against supply kept unadjusted beyond 11 months become a “deposit” under the law – a violation.
• Non‑adherence to any limit or approval procedure becomes a red flag during investor due diligence and regulatory scrutiny.

Exam tip: The single most testable point is the 100% cap on shareholder borrowings and the DPIIT start‑up exemption (5 years). Also remember that director loans have no cap but require a declaration and board approval.

Key takeaways

• Borrowing from shareholders is capped at 100% of paid‑up capital + free reserves + securities premium; DPIIT start‑ups exempt for 5 years.
• Directors can lend unlimited amounts with board approval and a declaration of own funds.
• Friends and family are not permitted lenders for debt; use equity instead.
• Advances against supply must be adjusted within 11 months to avoid becoming a deposit.
• Annual DPT‑3 filing with ROC is mandatory for all deposits (including exempted ones).
• Non‑compliance is a red flag; board and shareholder approvals are required.

Rights Issue – Process, Compliance and Shareholder Decisions

A rights issue is a method of raising fresh capital by offering additional shares to existing equity shareholders in proportion to their current holdings. The core intuition: every shareholder has a fundamental right to maintain their percentage ownership in the company. Without a rights issue, new investors dilute that percentage. A rights issue preserves that right – the company must first offer new shares to existing shareholders before seeking outside capital.

Process Timeline

Shareholder’s Three Options

1. Accept the offer – remit the money to the company’s bank account.
2. Decline (wholly or partly) – not participate.
3. Renounce – transfer the right to subscribe to another person (in their favour).

Exam tip: Silence is not acceptance. If no response is received within the offer period, the offer is deemed declined. Companies in a hurry often overlook this – planning the timeline is critical.

Additional Compliance if Non‑Resident Shareholders

• If any existing shareholder is a non‑resident, the company must also comply with FEMA (Foreign Exchange Management Act).
• Inform the Reserve Bank of India (RBI) about the investment, confirming that both Companies Act and FEMA rules have been followed.

Key takeaways

• Rights issue is a governance right – prevents dilution for existing equity shareholders.
• Offer must be proportionate to each shareholder’s existing stake.
• Offer period: 7–30 days (can be shortened with consent).
• Shareholder options: accept, decline, renounce; silence = decline.
• Allotment within 60 days of receipt of money; PAS‑3 filing within 30 days; stamped certificates within 2 months.
• No government approval needed for resident shareholders; FEMA applies for non‑residents.

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Preferential Allotment and Private Placement

When existing shareholders cannot or will not fully subscribe to a rights issue (or the company needs to bring in new investors), the company raises funds from a select group of identified investors. This method is called preferential allotment or private placement. For a private limited company, issuing shares to the general public is prohibited; outside capital must be raised through this regulated channel.

Instruments Used

• Equity shares
• Compulsory Convertible Preference Shares (CCPS)
• Compulsory Convertible Debentures (CCD) – a debt instrument that must convert to equity.

Pre‑Investment Compliance – Three Critical Checks

Process Overview

The company identifies the investors (could be a subset of existing shareholders or entirely new ones). The board approves the offer. Money flows into the escrow account. After allotment, similar post‑allotment compliance (PAS‑3, share certificates) applies, but the rules are more stringent than for a rights issue.

Exam tip: The valuation report has a 90‑day validity. Planning the fundraise within that window is essential; otherwise, a new valuation is needed. Also, the separate bank account is a unique requirement for private placement – do not confuse with rights issue.

Key takeaways

• Preferential allotment / private placement is for raising funds beyond the existing shareholder circle.
• Instruments: equity, CCPS, CCD.
• Pre‑checks: Authorized Share Capital sufficiency, separate escrow account, valuation report (valid 90 days).
• Non‑resident investors require a merchant banker report and FEMA compliance.
• Rules are stricter than for a rights issue – non‑compliance can block future funding rounds.

Private Placement – Process and Compliance Framework

Private placement is a method of raising funds by issuing securities (e.g., CCPS, CCD, optionally convertible debentures) to a select group of identified investors without a public offering. The process is highly procedural and prescriptive; any deviation can lead to severe penalties.

The sequential compliance journey

Step-by-step compliance details

1. Board meeting – The board (decision-making authority) must formally approve the issue of securities. This includes identifying the investors (after informal/formal discussions and term sheets), deciding the type of security (CCPS, CCD, etc.), and calling a general meeting.

2. General meeting and special resolution – Shareholders have a fundamental right to know about new investors, their rights, and the resulting dilution. A special resolution (75% majority) is required for private placement. Ordinary resolutions (simple majority) are insufficient.

3. Filing MGT-14 – Within 30 days of passing the resolution, the company must file form MGT-14 with the Registrar of Companies (ROC). This makes the decision public and ensures transparency.

4. Offer letter (PAS-4) – A formal private placement offer letter must be issued to each identified investor by name. The prescribed format (PAS-4) includes financials, projections, business plans, identified investors, valuer details, offer timeline, and the designated bank account. It acts as a mini-investment memorandum.

5. Investor application and remittance – Investors submit their investment application and transfer the money exclusively to the designated bank account (a special account opened for this purpose). The offer letter must be issued before the money is received.

Exam tip: A common unintentional non-compliance is an investor transferring money before the offer letter is issued. The startup, not the investor, faces the penalty — the ROC can issue a notice or the non-compliance is flagged as a red flag during due diligence in the next funding round. Penalties are high and prescribed.

6. Board allotment – Within 60 days of receiving the money, the board must approve the allotment of securities.

7. Filing PAS-3 – Within 15 days of allotment, the company must file form PAS-3 with the ROC. Only after this filing can the startup use the money from the designated bank account for business purposes.

8. Post-compliance – Update statutory registers, issue stamp duty and share certificates. If there are non-resident investors, additional FEMA compliance is required via reporting to the Reserve Bank of India portal.

Exam tip: The entire sequence is linear and time-bound. Startups often need funds urgently (e.g., to pay salaries or file patents) but cannot shortcut the process. Funding must be planned well in advance.

Practical implications

• The process ensures transparency through approvals and public filings (ROC).
• Non-compliance is strictly penalized; each deviation has a prescribed penalty.
• The same private placement method can also be used for rights issues (to existing shareholders) with a similar compliance framework.

Key takeaways

• Private placement requires a board meeting → special resolution (75%) → MGT-14 (30 days) → PAS-4 offer letter → designated bank account → allotment (60 days) → PAS-3 (15 days) → funds usable.
• The offer letter must be issued by name to each investor before they transfer money.
• Funds cannot be used until PAS-3 is filed with the ROC.
• Non-compliances are penalties-heavy and often discovered during later due diligence.
• Planning the funding timeline is critical; the process cannot be done in 15 days.

Convertible Notes for Start-ups

A convertible note (CN) is a hybrid financial instrument – debt that carries an option to convert into equity at a future round. Intuitively: an investor lends money now and later either gets repaid or becomes a shareholder, usually converting. It was introduced in India alongside the Start-up India initiative (2016) and is available only to DPIIT-registered start-ups.

Key features

Exam tip: The ₹25 lakh minimum ticket size is a hard requirement. A start-up cannot issue convertible notes if it raises smaller amounts from multiple investors – the same investor (institution, corporate, or individual) must commit at least ₹25 lakh.

Why start-ups prefer it in early stages

• Low compliance burden – no valuation report needed (valuation is deferred to conversion).
• Simple process – board resolution + ordinary resolution (special resolution not required).
• Fast fundraising – ideal for bridge rounds, pre-Series A rounds.
• Fewer investor management headaches – dealing with many small investors is unwieldy; CN encourages larger tickets.

Issuance process (sequential)

1. Board resolution – approve raising capital via CN and draft the CN agreement.
2. Ordinary resolution at general meeting – shareholders approve the issuance.
3. File MGT-14 with the Registrar of Companies.
4. Issue CN certificate – stamped document (convertible note certificate).
5. If the investor is a non-resident – also report to the Reserve Bank of India (FEMA compliance).

No separate placement memorandum, no separate bank account requirement, and no valuation report (because shares are not issued until conversion).

How conversion works

At the next qualified round of funding, the CN holder exercises conversion at a pre-negotiated discount rate. The terms are documented in the CN agreement. If the start‑up is liquidated before conversion, the CN holder is entitled to repayment (as a debt instrument).

Key takeaways

• Convertible notes are only for DPIIT-registered start-ups.
• Minimum ticket size: ₹25 lakh per investor – non-negotiable.
• Tenure: 10 years; can be converted or repaid.
• Compliance: board resolution + ordinary resolution + MGT-14.
• No valuation report required at issuance – a major simplification over equity rounds.

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Due Diligence in Start-up Funding

Due diligence (DD) is a comprehensive investigation performed by investors before committing money – a health check of the start‑up’s financial, legal, and operational condition. It uncovers risks hidden behind the founder’s pitch deck.

Why is DD essential?

• Understand the real financial condition – books of accounts, not PPTs.
• Verify intellectual property (IP) – patents, trademarks, copyrights (often the core of start‑up valuation).
• Detect hidden or fraudulent transactions – intentional or unintentional errors.
• Assess compliance levels under all applicable laws (Companies Act, FEMA, labour laws, tax laws, IP laws, IT Act, DPDP Act, sector‑specific laws).
• Identify tax dues – income tax, GST, professional tax, ESI, PF, and any disputes.
• Review contractual obligations – customer contracts, warranties, delivery timelines, insurance, vendor agreements, employment contracts (promised incentives).

The DD process in the funding timeline

Key stakeholders

• Investor’s DD team – lawyers, company secretaries, chartered accountants.
• Start‑up’s internal team – founder(s) in early stage; later CFO, senior HR, etc.
• External advisors – valuers, legal counsel.
• Regulators – if findings require adjudication.

What DD examines

Outcomes of the DD report

• Findings – some are critical (red flags), some are minor.
• Action plan – rectifications (pay penalties, file late returns, regularise non‑compliances).
• Incorporation into legal documents – the DD findings directly shape the share subscription agreement (SSA) and shareholders agreement (SHA).

Two key concepts emerge from DD findings:

Conditions Precedent (CP) – actions that must be completed before the investment closes (e.g., pay overdue taxes, file missing annual returns). Conditions Subsequent (CS) – actions required after funding (e.g., obtain insurance for directors, complete a pending adjudication).

DD findings also become the basis for representations and warranties given by the company (e.g., “the company is validly incorporated and has complied with all laws”) and indemnification clauses protecting investors if those representations prove false.

Exam tip: Due diligence is not optional – it is a pre-investment requirement that affects the final terms of funding. Never underestimate the work needed to prepare a clean data room.

Key takeaways

• Due diligence is the diagnostic phase before investment closes.
• Covers financial, legal, IP, tax, contracts, and governance.
• A data room (virtual or physical) is created with all required documents.
• DD findings lead to conditions precedent/subsequent, representations, and indemnification.
• The level of DD stringency increases from angel to Series A/B/C rounds.

The Cost of Non-Compliance: Case Studies

The due diligence process uncovers critical failures that can delay, devalue, or deny investment. Two real cases illustrate the pattern.

Case 1: GCL Technologies (2014–15)

• Sector: Medical R&D, raised ₹25 lakhs from a VC fund.
• Core failure: No corporate records maintained for 4–5 years since incorporation (2011). No board meeting minutes, annual compliance filings, or shareholder registers.
• Red flags:
  • Promoter infused ₹80 lakhs as loan from time to time, but the borrowing was never approved in a board meeting (mandatory under the Companies Act).
  • No clarity on repayment or conversion to equity – impossible to retroactively regularise without approvals.
  • Some statutory forms not filed.
• Outcome: Investor’s legal team strongly recommended adjudication/compounding – paying fines. This cost 6–7 months of time and additional cost to the promoter and company, diverting attention from business.
• Additional issue: Unregistered IP – a competitor could register first, destroying valuation in an IP-driven business.

Case 2: Medical Defence Company (recent)

• Core failure: Share certificates not issued within 60 days of allotment – a fundamental board duty. Stamp duty delayed.
• Auditor appointment failures:
  • Not appointed within 30 days of incorporation.
  • Under the Companies Act 2013, auditor tenure is 5 years; only appointed for 1 year – cannot be corrected.
• Loans from directors: ₹4 crores infused over time, not reported to the Registrar (directors confused loan vs. share capital, no professional guidance).
• Loan to a subsidiary without special resolution.
• No proper records since 2022 despite an investment commitment publicly announced.
• Outcome: Required almost a year to rectify records and pay fines – avoidable by real-time compliance.

Exam tip: “It’s my own money” is no excuse. Any director’s loan must be approved by board resolution, documented, and filed. Backdating is impossible in the digital era.

Common Red Flags and Their Consequences

Due Diligence Outcomes: Business Impact

Non-compliances found during DD ripple outward even if the investment proceeds.

• Public audit report: Statutory auditors must report non-payment of taxes, unapproved loans, etc. The audit report is filed with the balance sheet – publicly available. This impairs the company’s credibility with customers, government tenders, and future investors.
• Loss of directorship: Directors who fail to file annual returns for their companies become disqualified. The first question any new director must answer: “I am not disqualified by law.” A negligent director can lose all directorships.
• Valuation negotiation: Investors aggregate all red flags from financial, legal, labour, and IP due diligence. Even a great product can see valuation slashed.
• Denial or delay of investment: Investors may walk away entirely. Start-ups that depend on external funds for growth then stall or shut down.
• Penalties non-deductible: Fines for non-compliance are not allowable as business expenditure. The company pays tax on the penalty amount – a double financial hit.

Exam tip: Non-compliance penalties are not tax-deductible. A ₹10 lakh fine effectively costs ₹13–14 lakh after tax.

Conditions Precedent, Closing Actions, and Conditions Subsequent

Funding agreements divide the investment process into three sequential parts.

Conditions Precedent (before money flows)

Typical items required before the investor releases funds:

Closing Actions

Once conditions precedent are met:

1. Investor receives disclosure letter and certificate of warranties.
2. Investor transfers funds to company’s bank account (per offer letter).
3. Board records the receipt and approves allotment of shares.
4. Shareholders’ meeting approves updated Articles of Association.

Conditions Subsequent (after funds received)

• Issue and deliver share certificates (within 60 days of allotment).
• File non-resident investor information with RBI (if applicable).
• Employment agreement: Promoters/co-founders must execute an updated employment agreement as per investor format – they will continue as CEO, CTO, etc. Investors require continuity of key management.
• Rectify any outstanding DD findings (e.g., finalise IP registration, clear auditor appointment).

Exam tip: The employment agreement is often overlooked but is a critical condition subsequent. Without it, investors can block further tranches or even rescind the deal.

Post-Investment Management: Continuous Fundraising

Receiving funding is not the finish line – it is the start of the next cycle. Start-up fundraising is a treadmill: planning for the next round begins the moment the current round closes.

• Fund deployment: Money must be used strictly for the purposes stated in the offer letter. Misuse destroys credibility and future fundraising.
• Investor management: Ongoing communication, reporting, and relationship maintenance until the investor achieves a satisfactory exit.
• Timeline: Plan the next round 18 months in advance. From identification to negotiation, DD, and documentation, the process is time-bound (legal deadlines + business urgency).
• Multi-stakeholder coordination: Lawyers, auditors, regulatory bodies, and existing shareholders must be aligned continuously.

Key Takeaways

• Due diligence uncovers non-compliances that can be fixed only at significant time and cost – and sometimes cannot be fixed.
• Red flags (missing records, improper loans, late share certificates, auditor lapses) directly reduce valuation or kill a deal.
• The funding process is three-part: conditions precedent → closing actions → conditions subsequent. Each must be meticulously handled.
• Non-compliance penalties are not tax-deductible; they incur a double cost.
• Post-investment, start-ups must immediately plan the next funding round and comply with all covenants. Fundraising is a continuous journey, not a destination.

Understanding the Fundamentals of ESOPs

Employee Stock Option Plan (ESOP) — also called a Stock Option Scheme — gives employees the right to purchase a fixed number of shares in the company at a future date for a price set today. It is a non-cash incentive designed to attract and retain talent: instead of paying higher salary today, the company offers a stake in future growth.

Purpose

• Attract talent when cash is scarce — offer equity upside in lieu of market-rate salary.
• Retain early employees and high performers by linking reward to long-term value creation.
• Align employee interests with shareholder value — everyone benefits when the company succeeds.

Eligible & Ineligible Persons

For DPIIT-registered start-ups: the above restrictions are waived for 10 years from incorporation/registration. During this period, ESOPs can be issued to promoter group and directors holding >10%.

Key ESOP Terms

Lifecycle of an ESOP

1. Grant: Company awards options to an employee under the approved ESOP scheme.
2. Vesting: Options become exercisable over time (e.g., 25% per year over 4 years after a 1‑year cliff).
3. Exercise: Employee pays the grant price and converts vested options into shares.
4. Sell: Employee sells the shares (usually after an exit event like acquisition or IPO) to realise gains.

Procedural Compliance (Key Steps)

1. Draft a tailored ESOP scheme with legal and tax advisors.
2. Obtain board approval for the scheme.
3. Obtain shareholder approval via special resolution.
4. File the special resolution with the Registrar of Companies (Form MGT‑14).
5. Grant options under the approved scheme.
6. On exercise, allot shares → paid-up capital increases.
7. For non‑resident employees, file with the Reserve Bank of India (RBI).

Flexibility in Structuring

The ESOP scheme should grant the board operational flexibility. Common vesting patterns:

• Typical: 4‑year vesting, 25% per year after a 1‑year cliff.
• Customisable per employee: e.g., 50% after year 1, then remainder over 2 years; or quarterly vesting.
• Not all employees need be included — the board can selectively grant options.

Exam tip: Do not promise ESOP shares in the employment letter before the scheme is approved. The mandatory 1‑year vesting cliff means an employee cannot convert options into shares earlier than 1 year from grant, regardless of the joining date.

Key Takeaways

• ESOP = right to buy shares at a fixed price in the future; a non-cash incentive for attracting and retaining talent.
• Eligible: permanent employees, directors, and employees/directors of holding/subsidiary. Ineligible: promoters, independent directors, directors with ≥10% equity (exempt for DPIIT start‑ups for 10 years).
• Four lifecycle stages: grant → vest → exercise → sell.
• Compliance: board + shareholder approval (special resolution), filing MGT‑14, allotment on exercise, RBI filings for non‑residents.
• Board retains flexibility to set vesting schedules and selectively grant options.