What are the Tax and Legal aspect of Fund Raising

Tax and Legal Funding

There is a lot of confusion among Startups around Fund Raise. Be it around ways to negotiate with investors or decoding the complex framework of Business Valuation or for that matter understanding the complexities around Term Sheet. To answer all these questions and to bring in some clarity to the entire  mechanism I decided to take Taxmantra Advantage Webinar Series – The Art of Fundraising Series, where I discuss three important aspect of the the process ie how to get ready for fund raise, tax and legal aspect of fund raising, decoding business valuation for startups with Mr Alok Patnia (Managing Partner, Taxmantra Global).

In this article we shall try to cover the important points of the second session of the Webinar series ie What are the Tax and Legal aspect of Fund Raising. Over here we discuss issue pertaining to the difference between Term Sheet and SHA, Anti Dilution Rights of the Investor , Angel Tax, details on Drag Along and Tag Along Rights and various things around it.

Tax and Legal Funding


Q1- What is the difference between Term Sheet and SHA?

Ans-  Term sheet is an interest to invest. It includes terms on which the investor is ready to invest in your company. It is not legally binding on the parties. Term sheet is valid for a particular time. Whereas, Shareholder’s agreement or SHA is the final term that has been agreed between the parties and once you sign the SHA it is legally bound by all the parties. Basically, Term sheet is made at the start of the investment process and SHA is made at the end of the process.


Q2- What is the different type of investment instrument?

Ans- There are four types of investment instruments, those are:-

  • Equity shares
  • CCPS(Compulsory Convertible Preference share)
  • CCD(Compulsory Convertible Debentures)
  • Debt:- where some part is inequity and some part is in debentures
  • Cumulative or discounted debentures


Q3- What are the reserve matters?

Ans- Reserve matters are a set of conditions or rules which are laid down in the shareholder’s agreement through which the company is navigated on day to day basis. It means that the investor will lay down certain things wherein the company will require to acquire the permission of the investor before proceeding with the activity, this may include further raising of the fund, a director change, or changing the main object of the company, or giving an ESOP and many more activities which require the permission of the investors.


Q4- What are the Drag Along and Tag-Along Rights?

Ans- Drag along right is a right that enables a Investor shareholder to force a Promoter to join in the sale of a company. The Investor doing the dragging must give the Founders the same price, terms, and conditions as any other seller. Though this clause was intended to be used in good faith, however, a check should be conducted and all such clauses should be modified to protect the interest of the founders.

The tag-along right is a right state that when the founders sell their shareholding; the investors will also get an exit. Also referred to as the “co-sale rights”, this clause was generally brought in to protect the rights of the minority shareholders. 

One can read my article “What does Tag-along and Drag-along rights mean in Term Sheet Agreement?” to know more on this.


Q5- What is the Anti Dilution Rights of the Investor?

Ans-  The anti-dilution right is often used by the investors to protect their rights at times of future rounds of funding. Full-ratchet anti-dilution protection allows an investor to keep his percentage ownership remain the same as the initial investment.


Q6- Please throw some light on ESOP and how does it work?

Ans- Employee Stock Ownership Plans (ESOPs) are basic rights given to employees of a company for buying shares of the company at a fixed price on the date of the grant. ESOPs can be in the form of Stock Option Plans, Phantom Equity Plans, and Stock Purchase Plans.

A company grants an employee the option to buy a certain number of shares in the company at a fixed price after a certain number of years (option period). Before the employee can exercise the option he is usually required to complete the vesting period which typically means that he has to continue to work for the Company for a minimum number of years before part or all of the options can be exercised.


Q7- How is Funding Taxed and how is ESOP Taxed?

Ans-  According to the law if a company is raising funds at a premium than the company needs to pay a tax of 30% on the premium amount. But if you are a stirtup and you have a DIPP certificate and filed the form 56 then there will be no tax levied on you. 

ESOP Taxation

There are two stages of taxability in the hands of the employee which is as below:

The first stage is when the options are exercised by the employee. The benefit, which is the difference between the fair market value (“FMV”) of the shares on the date of which the option is exercised and the amount at which the options were granted to the employee, is treated as a prerequisite as per Income Tax Act, 1961 (the “Act’).

The second stage is when the shares are sold or transferred by the employee in which case the difference between the sale consideration and the FMV of the shares would be treated as capital gains and will be subject to capital gains tax.


Q8- If a Foreign VC Invest, how should his Investment tax?

Ans.  There is no taxation for the startup but the individual investor shall be taxed according to their individual rate; however they being a Foreign VC will get exemption from Angel Tax. However, they need to do RBI Compliance in this regards.


Q9- If an Angel investor wants to invest in the company how shall he be taxed during his investment and his exit?

Ans-  If an investor is exiting than the investors will be taxed at an individual rate and there is no tax rate for the startup in which they have invested.


(Write up on two other subjects of the series will be uploaded soon. In case you have any specific requirement on fund raise you can visit our page Global Fund-raise and Due Diligence or write to info@taxmantra.com and we shall get back to you accordingly)

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