When Angels Meet Lawyers

Akshat Pande – Founder and Managing Partner, Alpha Partners (Author)

&

Shreya Solenkey – Associate, Alpha Partners (Co-Author)

An investment made by an angel investor, usually before the company has earned any revenue or profits, can be called as an ‘angel investment’. An angel investor is usually an individual with high net worth, who provides financial support for start-ups, small companies or entrepreneurs, usually in return for equity in the company. Such individual investors may either be a friend or family member of the founder, a close business associate or in some cases, the angel investors are organized as a formal group wherein the group founders or leaders guide the individual investors for making investments in startups (such as Inflection Point Ventures “IPV”) etc…

How is an investment made by an angel investor different from any other private investment?

    • Period of investment

Angel investors usually opt for an exit from the investment after 2 ‑3 years either through sale to bigger investors like family offices or VC firms or Sale of business to a strategic acquirer.

    • Level of risk involved

Angel investors usually invest in a business at a time where the revenue flow of a business is uncertain, hence the risk involved is usually high.  Networks like IPV try to manage the risk by conducting rigorous up front due diligence often taking help from industry experts drawn from their diverse membership base.

    • Post investment involvement

Angel investors usually do not engage themselves in the day-to-day activities of the business and therefore are not directly involved in running the business except where the mentorship and guidance is required or expected. If investing through networks like IPV, all angels collectively may demand a Board seat to closely monitor the progress of the start-up.

  • Importance of Legal Due Diligence for Angel Investors

A detailed legal due diligence helps in ascertaining the potential legal risk that may be required to be borne by an angel investor or may have a financial impact on an angel investor or his investment. The scope of legal due diligence in case of angel investment is threefold (i) to identify the legal issues and risks associated with the existing set up of the investee entity and relationship between the founders interse and with the entity; (ii) to identify the legal requirements associated with the prospective business of the investee; and (iii) advise to hedge the angel’s risks that may arise due to the above.

As is clear, the first aspect of the scope of legal due diligence is considerably limited, considering the age of the investee. However, in certain cases, specifically in regulated businesses such as financial services, it is important to check whether the investee has procured necessary licenses, approvals, registrations and are in continued compliance with the regulations. Other than that, the legal due diligence report will cover aspects such as whether the investee entity has been incorporated properly, its constitution documents are in line with its present business plan and are flexible enough to carry out the business proposed to be carried out by the company, whether the founders have a well laid out agreement between themselves to govern the relationship between the founders, level of compliance of the investee, specifically relating to taxes, employment laws, company law and sectoral laws. In certain cases, it is also possible to assess the financial impact of a particular issue so that it helps the investor to negotiate accordingly.

The second aspect of the scope will involve legal risks associated with the future business, if the business plan presented to the angel investors involves pivoting from the existing business model. In general, early-stage companies will have a larger plan and then few diversions which enables them to experiment with their technology or core business to be applied to other types of businesses. For example, an e-commerce company also starting a non-banking financial company to provide short term loans to its vendors for working capital. It is therefore important for the angel investor to understand the legal requirements of such prospective businesses or legal risks associated with the same so that the definitive agreements may have sufficient provisions to cover such risks.

The third and the most important aspect of the due diligence is the direct advise to the angel investor as to how should the definitive agreements hedge the risks of all the issues highlighted above and indicative provisions to be inserted in the agreements.

Further, since angel investments involve a higher risk, the documentation for angel investment is materially different from that which is done for any other type of investment.

All the factors above highlight the need for legal due diligence and consequently need to hire lawyers for angel investments. However, it may not be possible or even economical for each individual angel investor to retain Lawyers for detailed legal due diligence. The advantage of investing through an Angel network like IPV is that angel networks often have top legal firms on their retainer to help them with legal due diligence for all their deals.

It is to be clarified that a legal due diligence will not advise whether or not to invest. It is for the investor to assess the risks and take that decision. However, the due diligence exercise most definitely should highlight all aspects which enable the investor to take an informed decision as well as to negotiate with the investee.

Modes of Investment – Types of Securities

An angel investor may invest in an investee company in any of the following types of securities:

  1. Ordinary Stock or Equity Stocks: This type of security is the main source of finance for any company giving the investors the right to vote, stock profits and claims on assets. Ordinary stockholders do not have any preferential rights with respect to repayment or dividend.
  2. Convertible Preferred Stock: This can be optionally convertible (except in case of non-NRI foreign investors) or compulsorily convertible preferred stock. In case of optionally convertible stocks, the stockholder has the right, on expiry of a particular term of investmentor happening of an event, to either convert or redeem his investment at pre-decided ratio/valuation. Compulsorily convertible stocks are, as the name suggests, required to be compulsorily converted into ordinary stock on completion of a term or happening of an event. Holders of preferred stock have priority over the ordinary stock when it comes to dividends, repayments or liquidation of the company.
  3. Convertible Debentures: This type of security is issued by a company in form of debt against investment and is convertible into ordinary stock at a specified time (no later than 10 years from the date of issuance) either fully or partly. Debt has a much higher level of protection for the investor and the interest paid on the debt is required to be paid by the investee and therefore it ends up being tax-friendly. Issue with debentures is that the servicing of interest is, in most cases, not possible for a startup. Also, in certain cases, the debentures need to be secured by assets of the issuing company, which is also an impossibility with startups and early-stage companies.

Most preferred security for angel investors has been convertible preferred stock, where the conversion ratio is pegged at the valuation to be derived at a future round of investment by an institutional investor such as a VC fund (usually at a discount), more because at the angel investment stage, it is difficult to come out with a realistic investment.

Investment by Non-Resident Indian In India:

Investment on repatriation basis mean an investment, proceeds of which are eligible to be transferred back to the non-resident’s country. Whereas under non‑repatriation basis investment proceeds are not eligible to be transferred back to the non-resident’s country.

Investments by non-resident Indian (‘NRI’) in an Indian company on a non-repatriation basis has been made at par (for most parts) to a domestic investment. Therefore, such an investment made as per Schedule 4 of the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017 (“Regulations”) can be made just like a domestic investment, albeit in compliance with the said schedule. This basically means that the sectoral restrictions, restrictions related to type of securities etc. that are applicable in case of a foreign investment (FDI) transaction are not applicable to the same.

Other than that, NRI’s may make investment on a repatriation basis into Indian companies. However, such investment falls under Schedule 3 of the Regulations and is subject to sectoral caps and conditions prescribed under the Foreign Direct Investment Policy of India. It also requires an investor to invest compulsorily convertible securities and optionally or partly convertible securities are considered debt.

Importance of Founder’s Agreement for Angel Investors:

A founders’ agreement is basically an agreement between the founders of the company providing for inter se rights and obligations of the founders, manner in which and conditions subject to which the shares are held by them in the company, deadlock resolution and consequences of breach, exit or termination. The terms of the agreement are then included in the constitution documents of the company to make it enforceable against the company as well.

It is extremely important for an angel investor that founders of the company in which he is investing must have a founders’ agreement in place. In the event the company does not have a founders’ agreement in place, the same must be done up as a condition precedent to the investment by the angel investor. For a peaceful angel investor, it is important to know that the things between the founders are in black and white and the shares of the founders regulated by an agreement and in case one of the founders leaves or breaches his part of the deal, his shares will end up being consolidated with the surviving founders.

Financial Impact of Legal Irregularities:

An angel investor may also elect to become a director of the company in which he has made an investment. In such a case, it is important to understand the circumstances under which a director can be held liable in case of any legal irregularity. Director’s in most cases are not personally liable for any non-compliance by the company or any transaction undertaken by a director on behalf of the company in his capacity as a director. However, if it can be shown that the director was personally involved in the decision making which leads to the irregularity, breach or a fraud, he may very well be personally liable. In many laws such as employment laws, if a director is named in a regulatory action, in order to absolve him, it has to be specifically proved that a particular non-compliance or irregularity was not undertaken by his consent or connivance.

In our experience, we have seen that the regulatory bodies would typically include names of all directors on board in a regulatory action and it will be for the company or the director concerned to prove that he was not actually personally involved in the activities which lead to the regulatory action. This becomes even more grave when there are penal consequences of a regulatory action or where a criminal offence is made out (actions by Reserve Bank of India (RBI), Economic Offence Wing (EOW), money laundering, cheque bouncing, certain labour laws, legal metrology, food laws etc.).

It is therefore imperative that the investment agreement to be entered into between the angel investor and the investee company consists of adequate protection and indemnities in favour of the angel investor (or nominee) acting as a director of the company. It is also important to require the company to procure adequate insurance so that the indemnity is funded by adequate insurance coverage. Other than financial interest, the angel director should also be protected adequately by the company, should there be a criminal made out against the director and the company.

Conclusion:

It may be difficult for the angels to cross the wall between heaven and hell and meet the lawyers, but it is imperative that the angels see lawyers as their protectors rather than evil beings.

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