Fundraising Essentials: A Practical Guide for Indian Startups  

Introduction 

Indian startups secured $9.2 billion in venture capital (VC) funding across 984 deals between January and October 2024, reflecting a 44.4% increase in funding value compared to the previous year. This surge highlights India’s growing role in the global startup ecosystem, contributing 7.1% of global venture capital deal volumes and 4.2% of disclosed funding value during this period. 

While these numbers underscore the opportunities available to Indian startups, they also reveal the critical importance of navigating the fundraising process effectively. Raising capital is not just a financial milestone; it is a defining step toward growth and innovation. It fuels expansion, enables talent acquisition, and supports the realization of bold visions. However, behind every successful deal lies a complex maze of regulatory compliance and procedural requirements. 

In this article, we delve into the intricacies of private placements, a favoured mode of fundraising for startups. While the compliance requirements may seem straightforward, they often involve nuances that are easily overlooked. This guide outlines the critical aspects that every founder must bear in mind to ensure a seamless and compliant fundraising journey. 

What are the modes of raising capital for an Indian startup under Companies Act 2013? 

Startups can raise capital via modes such as (i) Rights Issue, (ii) Private Placement and/or Preferential Allotment.  

1. Rights issue: Pursuant to Section 62 (1) of the Act, Rights issue is a method of raising funds by offering additional shares to existing shareholders, giving them the first right to purchase new shares in proportion to their current holdings. 

2. Private placement: Pursuant to Section 42 of the Act, Private placement is a method of raising capital by offering securities to a select group of investors, such as high-net-worth individuals (HNIs) or institutional investors, instead of the public.  

Preferential allotment: Pursuant to Section 62(1)(c) of the Act [and linked with Section 42], preferential allotment is a method of raising capital by issuing equity shares or convertible securities to a select group of investors, such as venture capitalists or strategic partners, under agreed terms.  

Private placement and preferential allotments are quite similar with a few more specific procedures to be followed in case of preferential allotment. 

Why is Private placement and/or preferential allotment the preferred mode of raising capital? 

The preferred mode of raising capital is Private Placement and preferential allotment over rights issue when institutional investors are involved owing to the following reasons: 

• Broader investor base: Private Placement and Preferential Allotment allow companies to target institutional investors, HNIs, or strategic partners who can bring both capital and strategic value and is not limited only to existing investors. 

• Alignment with investor expectations: Institutional investors prefer the structured nature of Private Placement and Preferential Allotment, which allow them to negotiate terms like preferential rights or board representation. 

• Confidentiality: These methods maintain confidentiality during the fundraising process, as they involve a select group of investors. This is especially important for startups looking to protect sensitive business information or strategic plans. 

What are the key compliance requirements and pitfalls to avoid under the private placement method (Section 42 of the Act) for a company? 

Do’s: Key steps to get it right 

• Get approvals: Procure necessary board and shareholder approvals before initiating the process. A special resolution is required for passing the private placement offer. 

• Maintain proper records: Board must issue a private placement offer letter (PAS-4) to the identified persons with all required details about the securities, including pricing, terms, and rights attached. The company shall maintain a record of offers in Form PAS-5 as mandated by the Act. 

• Open a separate bank account for fundraising: Open a dedicated bank account for receiving subscription money. This account must be used exclusively for fundraising activities and not for operational transactions. The same account can support multiple fundraises, provided operational use is avoided. 

• Make relevant filings early: File necessary forms such as SH-7 (for increasing authorized capital) and MGT-14 (for shareholder approvals) in the early stages. Addressing these filings upfront ensures smoother execution and allows for corrections if issues arise. 

• File PAS-3 in time: Submit PAS-3 (Return of Allotment) with the RoC within 15 days of allotment. Delays can attract penalties and may impact the compliance standing of your company. 

• Issue security certificates or dematerialized securities: Ensure securities are either issued in physical certificate form or dematerialized (demat) form within 60 days of receiving subscription amounts, in compliance with statutory timelines. 

• Refund delayed allotments: If no allotment occurs within 60 days of receiving funds, return the subscription amount to the investors. Any delay in repayment can attract penalties and legal repercussions. 

Don’ts: Pitfalls to avoid 

• No public advertising: Avoid any form of public solicitation or advertisement, as this would contravene the nature of private placement and violate provisions of the Act. 

• Don’t Exceed 200 Investors: The offer cannot be extended to more than 200 investors in a financial year, excluding ESOPs and Qualified Institutional Buyers (QIBs). Breaching this limit may reclassify the transaction and attract penalties. 

• Misuse of Funds: Use the funds raised only for the purposes stated in the offer letter (PAS-4). Any deviation can result in investor disputes and regulatory scrutiny. 

• Avoid usage of funds before filing PAS-3: Funds raised through private placement cannot be utilized until PAS-3 (Return of Allotment) is filed with the Registrar of Companies (RoC). 

• Subscription amounts cannot be in cash: Accept subscription money only through banking channels. Payments in cash are strictly prohibited and can invalidate the private placement process. 

Key Observations from Practice

‍We commonly observe oversights in the following areas: 

• Bank Accounts: Using operational accounts instead of a dedicated capital account for receiving investment funds. 

• Premature Fund Usage: Utilizing funds before filing PAS-3 (Return of Allotment) with the Registrar of Companies. 

In case of non-residents investing, what are the additional compliances that the company is required to do? 

Receiving investments from non-resident investors requires strict adherence to the Foreign Exchange Management Act (“FEMA”), 1999, the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (“NDI Rules”), and, where applicable, the Foreign Exchange Management (Debt Instruments) Rules, 2019 (“DI Rules”). 

The following considerations are crucial: 

Routes of investment: 

• Automatic route: Investments in sectors with no restrictions can proceed without prior government approval. Examples include technology, manufacturing, and retail (up to 100% in some categories). 

• Government route: Prior approval is required for investments in restricted sectors such as defense, telecom, media, and multi-brand retail. Applications are processed through the Foreign Investment Facilitation Portal (FIFP). 

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Sectoral caps and conditions: 

• Ensure adherence to the sector-specific FDI caps and conditions as prescribed by the Department for Promotion of Industry and Internal Trade (DPIIT). 

• Some sectors, such as real estate or multi-brand retail, may require additional approvals, especially under the DI Rules for instruments like non-convertible debentures. 

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Type of instruments and governing laws: 

• Equity instruments: Governed by the NDI Rules, these pertain to equity linked instruments such as equity shares, convertible debentures, convertible notes, and preference shares. 

• Debt instruments: Investments in non-convertible instruments such as non-convertible debentures (NCDs), bonds, External Commercial Borrowings or other debt instruments must comply with the Debt Instruments Rules, which prescribe terms for maturity, interest rates, and end-use restrictions. 

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Pricing Guidelines: 

• Equity instruments must be issued at a price determined through internationally accepted valuation methods, certified by a registered valuer or a SEBI-registered merchant banker. 

• For debt instruments, the pricing and terms must comply with the guidelines specified under the Debt Instruments Rules, including adherence to interest rate ceilings, maturity requirements, and end-use restrictions as prescribed by the RBI 

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Reporting obligations: 

• Advance reporting form: File with the Reserve Bank of India (RBI) within 30 days of receipt of funds. Include details such as the total amount received, purpose, and sectoral compliance. 

• Form FC-GPR: Submit within 30 days of issuing equity instruments to non-resident investors. Attach supporting documents, such as the valuation report, board resolution, and certificate from a company secretary or auditor. 

• Annual return on foreign liabilities and assets (FLA): File by July 15 every year to report foreign investments and liabilities, including equity and debt. 

• Form ECB (if applicable): File within 7 days of signing the loan agreement for external commercial borrowings. Ensure monthly filings of ECB-2 for outstanding amounts. 

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Commonly overlooked aspects to plan ahead for a smooth fundraising closure 

1. Engage the right professionals: Collaborate with experienced professionals, including legal advisors, company secretaries, and valuation experts, to ensure seamless discussions among stakeholders. This helps maintain smooth processes and timely filings, avoiding compliance lapses or penalties. 

2. Finalize the cap table early: Confirm the cap table at the outset to ensure clarity and accuracy for all stakeholders. For rounds involving convertible securities, ensure that the effective conversion price and new round price are determined, and valuation reports are procured accordingly to meet regulatory requirements.  

3. Assess Press note 3 (PN3) for non-residents: Evaluate the applicability of Press Note 3 for non-resident investors, particularly those from jurisdictions under restricted jurisdictions. Obtain the necessary approvals proactively to avoid delays or complications in the investment process. 

4. Initiate dematerialization of securities: Begin the dematerialization process as soon as the term sheet is executed. Early action ensures that equity shares are converted into electronic form in compliance with current regulatory standards, reducing delays during later stages of fundraising. 

5. Maintain valuation report timeliness: Ensure that valuation reports used for projections remain current. The period covered in the reports should not exceed 90 days from the issuance of the offer letter to remain valid and compliant with regulatory requirements. 

6. Share Filing Drafts with Investors for confirmation: Before making regulatory filings for allotments through the MCA and RBI’s FIRMS portal, share drafts with investors and their advisors. Their review can help identify and rectify any oversights, ensuring accuracy and compliance. 

7. Aligning cap table with filings for compliance: Ensure that the cap table submitted in the filings is consistent with the company’s official cap table and accurately classifies securities as equity instruments. It is also advisable to have the AD Bank review the cap table to ensure continuity and minimize the risk of application rejection. 

8. Obtain AD Banker sign-off before regulatory filings: Before submitting filings to regulators such as FC-GPR and FIRMS Portal filings, secure approval from the company's Authorized Dealer (AD) banker. This step helps prevent rejections and ensures all compliance gaps are addressed proactively. 

9. Ensure non-resident KYC compliance: Ensure that the non-residents have completed the KYC process. Non-compliance can lead to delays in fund transfers, regulatory scrutiny, or even rejection of filings. Completing the KYC process proactively helps streamline the investment process and avoids bottlenecks during critical stages of fundraising  

10. Verify ultimate beneficial ownership (UBO) compliance: The company must ensure accurate verification and disclosure of the Ultimate Beneficial Ownership (UBO) of investors, in collaboration with the Authorized Dealer (AD) Banker. The AD Banker may require supporting documents to establish who holds the ultimate control or benefit from the investment. Since thresholds may vary by bank, involving the AD Banker early is essential. 

11. Address stamp duty and securities certificate management: Ensure the requisite stamp duty is paid promptly, and professionals representing the company take responsibility for sending physical share certificates or completing the dematerialization of securities. Proper tracking is essential, as locating these documents later - especially after professional changes - can become challenging for founders. 

12. Ensure grossed-up subscription amount for non-resident investors: Founders should engage with non-resident investors to confirm that the subscription amount is grossed up to account for any charges imposed by the investor's bank. The net amount credited to the company's account must match the subscription amount stated in the documents. This approach ensures the company can issue shares as agreed and avoids the cumbersome process of refunding non-residents, which can lead to delays and additional complexities. 

13. File FC-GPR promptly: When raising funds from non-residents, ensure the FC-GPR form is filed promptly. In case of rejections from the RBI, collaborate with experienced professionals to rectify and refile before the next round. Addressing these issues proactively can prevent compounding penalties or indemnification requests during subsequent fundraising efforts. 

14. Maintain key documents for future rounds: As a founder, ensure that you have the following documents ready - investor agreements (share subscription agreement, shareholder agreement, investment agreement etc), both executed and in word format along with the finalized cap table for the round. These documents can serve as the foundation for future fundraising rounds and help expedite the process during initial stages. 

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