Legal Tips for Indian Startups

Sharda Balaji
 

Sharda is founding partner of NovoJuris Legal, an innovative new-age law firm specializing in corporate, private equity, fund formation, fund investments, technology, cross-border transactions, IP, mediation, and settlements. NovoJuris is consistently ranked top 5 in India's private equity placements and has participated in 360+ transactions representing entrepreneurs, VCs, acquisitions, and exits.

India is gaining the world's attention with the very high number of startups and unicorns. While the government is continuously making strides in ease of doing business in India, there are a lot of things-like regulations-that can derail a good idea from getting to the market. If you're starting a business, then legal advice is certainly advisable, especially from lawyers who understand the path from starting up and scaling up exponentially. As a lawyer who has worked with hundreds of startups, I wanted to provide startup founders with an overview of the legal challenges involved in starting a business so that you can budget your time and resources effectively.

Location, Location, Location

The first thing to consider is, where will you incorporate? With 29 States and seven Union Territories founders would like to optimize for talent, government-friendly policies, networks of entrepreneurs, market demographics, and other factors, your company could have operational offices anywhere in India. But the registered office, that is, the address you provide to the Registrar of Companies (ROC), is the legal address of the company and that address has lots of consequences for the startup. Shifting the registered office from one state to another is a long process, so choose your location wisely.

Upon incorporation, there are many registrations which are mandatory, such as professional tax, goods-and-services tax, and shops and establishment tax for the office location. If the registered office is to be shifted, then all of these registrations will have to be modified to reflect the changed address.

A second consideration about location has to do with whether you anticipate a global presence. Many startups would like to have their holding company in other parts of the world for a variety of reasons, like raising further rounds of capital, being closer to the customer, tapping into larger markets, and having opportunities to merge with an international company or be acquired by or acquire an international company. But Indian regulations make it tough for resident Indian founders to remit capital into such a holding company while still wanting to have a subsidiary in India which would provide software development and other services. The regulatory policies such as Liberalized Remittance Scheme or Overseas Direct Investment are complex to comply with.

It is a tad easier to start the holding company outside India than to start in India first and then flip over the holding structure. So, if you believe that your company will eventually want a global presence, think carefully first about where you locate your initial business.

It is also important to consider the Place of Effective Management (POEM) by considering the location of the founder, where the management and control resides and other parameters, in order to ensure that tax jurisdiction is clear. You can't register your company in a place with liberal tax policies, for example, while actually conducting business from another location. The POEM and legal registration must match.

Need Financing? You Need the Right Structure

After you decide on a location for your startup the next critical decision that will have a big impact on your business is the legal structure you choose for incorporation. All of the typical corporate forms (private limited company, limited liability partnership, or partnership) will work for startups, but if you need to raise capital, the private limited company is the appropriate structure.

If you started your company somewhere else in the world and you wanted to test the waters in India, you wouldn't have to necessarily incorporate but could instead operate as a liaison office or a branch office, with prior permission of Reserve Bank of India. There are very few activities permitted for a liaison or branch office. However, a subsidiary company structure has many benefits. You will note that a venture capitalist would invest into a holding company.

Expanding into India through a subsidiary company structure provides the ability to be funded through equity, debt, or raising invoices for services provided to the parent company. All subsidiary companies are treated as domestic and are taxed accordingly.

There is a great impetus by the government for India funds-funds by and for Indians-and there are several funds being set up in India (SEBI registered Alternative Investment Funds). Yet most venture capital funds have been set up outside India due to tax treaty benefits. If the fund located outside India is investing into startups, the Foreign Direct Investment Policy Circular (FDI Policy) administered by the Department Promotion of Industry and Internal Trade is relevant. FDI Policy is fairly liberalized and many sectors, such as technology, are under the "automatic route." This means there is no prior approval required from the government, but intimation of FDI has to be reported. There are a few sectors which have a sectoral cap on receiving funds or require prior government approval. For example, ecommerce, retail, and trading have several restrictions so founders will have to do research prior to accepting funding.

Another type of funding involves loans. Loans provided by foreign entities are governed by a separate set of regulations, the External Commercial Borrowings.

Employee Stock Options

Most startups provide ESOPs for retention, compensation, reward, and recognition of employees. In India, ESOPs are taxed at the time a person exercises the vested grants based on the fair market value of the shares as perquisite tax. But they are also taxed based on the sale price as capital gains tax. Startups are seeking the government's favor to remove the tax liability at the time of exercise.

One issue involving ESOPs that founders need to be aware of is that an employee who is a promoter or a person belonging to the promoter group, or a director who either himself or through others holds more than 10 percent of the equity shares of the company, are not eligible for ESOPs. This stipulation applies to a person whether or not they hold the shares directly or indirectly. However, startups that are registered under the Startup India Action Plan have the flexibility to participate in ESOPs.

Valuation

Over the past few years, valuation of the investment into companies has been debated widely in India. Before a startup can issue securities in their company, they'll have to obtain a valuation certificate from a chartered accountant or merchant banker. The valuation could be on any internationally accepted principles of valuation such as Discounted Free Cash Flow Method or Net Asset Value Method. The real issue arises if the valuation is in excess of the fair market value. If that happens, then the investor will be taxed, and this is referred to as the "angel tax." The government is trying to address this issue through having the startups registered under the Startup India Action Plan.

Good News for Startups

The Indian government recognizes the regulatory challenges faced by startups and in 2016 launched the Startup India Action Plan, which simplifies many processes. Under the Plan, startups are defined as a private limited company, a partnership firm, or an LLP incorporated or registered in India not prior to 10 years. A startup cannot have annual turnover exceeding INR 100 crores in any preceding financial year. In addition, the Plan applies to those startups working toward innovation, development, deployment, or commercialization of new products, processes, or services driven by technology or intellectual property.

There are many benefits for startups registered under the Plan, which include self-certification for compliances under numerous environmental and labor laws, including:

• Fast-track patent and other intellectual property protection applications, processing, and rebates
• Preferences in public procurement by governmental departments
• Expedited winding up of the company

Registered startups also get an exemption from the angel tax mentioned above.

The ability for a startup to certify for compliances is a huge advantage since India has a vast number of laws related to labor and employment. For example, most companies require a registration certificate under the Shops and Establishments Act or the Factories Act, depending on the nature of work carried out. But each State has its own Shops and Establishment Act which regulates many of the work-related compliances, including:

• Number of paid leaves, sick leaves, and casual leaves
• Number of working days and holidays
• Minimum and maximum number of working hours per day

Obviously, the startup company needs to study the relevant Act before making company policies since all employers must adhere to labor laws.

But that's not all. Every employer is required to adhere to and maintain multiple registers under the following Acts. However, a registered startup will not be subject...