Archana Rajaram of Mumbai-based Rajaram Legal explains why having sound legal counsel is important for a smooth-sailing startup journey.
The legal realm is not for all, but should be. From raising funds, to giving employee stock options, to everyday business with clients, legal issues are best sorted before they come up. In an interaction with YourStory, Archana Rajaram, Founding Partner of Rajaram Legal, a Mumbai-based law firm for entrepreneurs and investors, speaks on the various legal hurdles that can potentially stump founders.
Rajaram Legal, an independent counsel for funds such as Unilazer Ventures and Matrix Partners, has won the award for Best Startup Law Firm at the IDEX Legal Awards. Archana explains why the legal ramifications of a startup’s operations need to be closely monitored in the edited excerpts below.
YourStory: When is the best time for a startup to engage a legal counsel? What are the common legal hurdles most face, and how does one overcome it?
Archana Rajaram: Ideally, a startup should engage legal counsel right from inception, so it can be advised early on with the right checks and balances. This is especially relevant for regulated sectors such as financial services, insurance etc.
However, legal costs are difficult to manage for a young startup. So, if it’s operating a business that is not regulated, such as a Software-as-a-Service (SaaS) or a tech company, legal counsel can be engaged as the company scales and starts entering into material contracts with customers.
Common hurdles for a startup include raising seed funding, signing up to onerous terms, not following through with filings with various regulators, not filing for intellectual property registrations, or incorrect filings in a founder’s name rather than the company, loans from founders to the company, without following company secretarial compliances etc.
YS: When is the ideal time that a startup should issue employee stock ownership plan (ESOP) to employees?
AR: This is entirely contextual, depending on the requirements of the startup. If it is cash strapped and can’t afford key talent, ESOPs are a great carrot to dangle to get key hires to join at a discount to market salaries.
ESOPs are also a great retention tool. So, even if the company is funded or able to offer market rates, ESOPs—which give employees ownership in the company (albeit nominal)—are a great way to retain employees. Timing to grant ESOPs can vary anywhere between Day 1, if a founder needs to hire senior resources but cannot afford their high salaries, or Year 2 or 3 onwards to keep employees motivated.
YS: Typically, what percentage of capital should a founder distribute among employees as ESOPs?
AR: This is again need-based. A 10-percent ESOP pool is a fairly standard allocation upfront. But, there have been pools anywhere between five and 20 percent. For example, a single founder may need to allocate a fairly high percentage for the CTO and other senior hires. But if one of the founders is the CTO and already has equity, or if the founding team has three-four members who hold equity, then ESOPs would not be for senior hires and may be needed at a later stage.
YS: How are ESOPs of a listed company different from those in a startup in terms of exercise, conversion into shares, their sale or exit?
AR: The key difference is that listed companies have a ready market for their shares. So, as soon as options vest, an employee can exercise and cash out. For an unlisted company, there is no market for shares acquired upon exercise of vested options. Sometimes, an incoming investor may buy out employee shareholders as secondaries happen at a discount, but this is not always the case. Invariably, a company has to wait for its IPO or a strategic sale to realise the benefit of its ESOPs.
YS: What do you suggest to startups as an absolute must when they want to go for a fundraising, in terms of the amount they seek, to the legal points they must keep in mind?
AR: This is a tough one to keep simple. In early-stage funding, founders should look out for ‘reverse vesting’ of their shares. Since many companies get funded even before operations have commenced, essentially on the strength of the founder’s capability, founders need to earn the shares they hold.
It’s important to keep vesting terms fair and the grounds for losing shares as objective as possible (such as fraud, or being charge-sheeted for an offence). They should look out for clauses where they are made personally liable for anything that happens to the company. This will come up in the form of ‘indemnities’, which indemnify the investor for losses suffered by the company.
Since it is the founder managing the company, investors often seek this kind of protection for their investment. But this should be mitigated by limiting and qualifying such liabilities. Investors also seek economic protection – like liquidation preference, anti-dilution, veto rights. There are variations to these, but market practice is starting to conform to 1x straight liquidation preference, broad-based weighted average anti-dilution etc.
YS: Last year saw a growing number of startups raising debt funding in addition to equity funding. What would this mean for them in legal terms in the long and short run? What would you suggest to a startup from a legal standpoint on the pros and cons of both debt and equity?
AR: Venture debt has its clear advantages – no dilution in shareholding, no pledge of shareholding, and a great source for funding. But with venture debt comes collateral – which is all assets of the company. Startups don’t have many assets (save for IP), so not much is at stake.
Venture debt players do take on some veto rights – for example, no fundraising, no change in business, no key hires etc., without consent. Some venture debt players escrow receivables to ensure loan repayment, but most drop this demand in the negotiation process, and only seek it when a default in principal repayment occurs.
The con is the fixed repayment terms. Startups often pivot affecting cash flows and their ability to repay. They also run out of money earlier than anticipated. So, venture debt is best placed post a Series-A or Series-B funding, where the company is not as early stage, and has some predictability and accountability on cash flows to secure loan repayment.
YS: With an evolving startup space in India, both in terms of operations and offerings, and regulations, what has been your biggest challenge, or the most interesting case you have dealt with?
AR: This is an answer only a litigator from a popular TV series can answer with a lot of flavour. As a corporate lawyer left to close 100-page Shareholder Agreements (often spilling over 250 pages), which interesting as it may be to me, may not really qualify as interesting to the world at large!
With that disclaimer, my most interesting case so far has been advising a high growth stage company where one of its investors was about to go bankrupt and intended to initiate an in-specie distribution of its assets to its clients (which means give away its shares in my client to 900+ investors). This would have made my client a public company overnight, and significantly affected its fundraising prospects, let alone the logistical nightmare dealing with so many shareholders. Fortunately, there was an interested buyer who bought out the (about-to-go-bankrupt) investor. But there was a harsh five-day timeline to close the deal (given the imminent bankruptcy), and a lot of intense negotiations with multiple stakeholders to get this done.
YS: What are the top five things that a founder must keep in mind when starting out?
AR: Only one thing – get a good lawyer!