Incubation Agreements
Legal Q&A
Purpose of Agreements
• To set out the terms relating to the
incubation, mentoring and support services to
be provided/being provided to Startups by the
Service Provider (SP)
• To lay down the terms and conditions for a
mutually beneficial arrangement aimed at
growing the Startups into runaway success
stories!
Concerns on the Incubation Services
Agreement (ISA) and the Promoters
Agreement (PA) raised by the startups
Five years is too long without a
provision to terminate.
Especially with a very likely
scenario where founders might
leave for other jobs. [Clause
4.1-ISA and 6.1 of PA]
• Continuance of agreement creates no obligation on its own
irrespective of whether a promoter has left the Startup or not
unless any event that triggers an obligation to the Service
Provider (SP) arises.
• 5 years is a short and reasonable period for the Startup to
achieve success and any of the events triggering a payment
obligation to the SP.
Events that trigger obligation to the
SP under the ISA
• If SP introduces a Potential Customer, an obligation to pay SP 5%
of the Gross Contract Revenue generated from the Potential
Customer for the first 3 years. [Clause 3.1 (a)]
• If an Investor wishes to invest in the Startup (or an entity setup by
the Startup outside India) an obligation to permit SP to exercise its
right to co-invest/invest upto 30% of the total investment proposed.
A 30% discount on the Pre-Money Valuation will be available to SP
for its investment only for one round of investment. [Clause 3.1 (b)]
• If SP introduces a Potential Investor, an obligation to pay SP an
arranger’s fee of 2.5% of the total funding received. [Clause 3.1 (c)]
• If Business, assets, Key Employees and/or the intellectual property
rights of the Startup are sold, transferred etc. and the Startup
receives a consideration for such sale etc. then an obligation to pay
SP 20% of the total consideration. [Clause 3.1 (d)]
Events that trigger obligation to the
SP under the PA
• If the Promoter accepts employment with a
Potential Employer (introduced by the SP), an
obligation to pay SP 10% of the Promoter’s
annual CTC for the first year of employment.
[Clause 2.1]
• If the Startup is acquired by any person or the
business, assets, Key Employees and/or IPR is
sold etc. and Promoter receives any
consideration in this connection, then an
obligation to pay SP 20% of the total
consideration received. [Clause 2.2]
Concerns on the PA
Why is there a clause that says SP has
to be notified of jobs? [Clause 3.1 of
PA]
• This is for information purposes only so that SP is
aware as to whether it needs to charge the
service fee for introduction of the employer (if
applicable) and further for SP to be made aware
that you are no longer working with the Startup.
This does not call for a formal notice. A simple
email or timeline update will do!
Concerns on the PA continued…
There is a legal advice that says 2.1 and 2.2 of
the PA aren't clear enough to be mutually
exclusive. There is a provision for SP to charge
both. 2.1 relates to 10% payable to SP for
person being employed and 2.2 relates to 20%
payable to SP for acqui-hire. Can SP charge for
both?
• The intention is not to charge for both. Clause 2.1 envisages a situation
where SP is acting as a placement agent while Clause 2.2 envisages a
situation where SV gets a share from the consideration received by the
Founders / the Startup on the sale of the Startup / Startup’s business / IP.
They are mutually exclusive.
• However, we are drafting a supplemental agreement to expressly clarify
that if SP charges under 2.2, then it will not charge you under 2.1 as well.
Concerns on the PA continued…
Clauses for Acqui-Hire are doubled in both
agreements. Will the Founders have to pay double?
(Clause 2.1 and 2.2)
• There is no obligation to pay double.
• Under the ISA, the Startup has to pay if it receives
any consideration, while under the PA, the
Promoter has to pay if he/she receives any
consideration. So if bonuses are split between
Promoter & Startup, we receive 20% of the total.
Concerns on the ISA
Partnership Agreement: The tag along,
drag along etc. is too much in SP’s favour.
[Clause 4.1 a) b) c) – IA]
• Tag Along – Standard clause appearing in all Shareholder Agreements to
protect minority shareholders.
• Drag Along – This is to protect your (majority shareholders) interest to
ensure that SP, the minority shareholder, can be called upon to sell its
shares if you are proposing to sell 100% to a third party.
• Anti-dilution – Standard clause in Shareholder Agreements to protect
minority shareholder from losing all its rights through dilution of the
shareholding (e.g. Facebook). This right exists only if SP pays to invest in
the Startup when fresh investment is made to maintain its shareholding.
Investment would be at the same price as the other investors.
Concerns on the ISA continued…
In relation to the tag-along, in case of the startup company’s wishes to sell
shares to third parties, they have to make sure that the third party shall buy
the shares held by SP also. This is practically not possible. For eg, a big
company is interested in buying only a portion of the shares to takeover the
company and instill new management and bring it up on their own approach
the startup promoters only because they see potential but don’t want to
takeover all the shares, according to this agreement that would not be
possible. Just because the promoters cannot convince them to buy the whole
company they lose an opportunity to divest and get returns from their own
company which is ridiculous. [Clause 4.1 (a)]
• Tag along does not increase the number of shares that a potential acquirer
needs to buy or insist that all of the shares held by SP be bought.
• It only requires that the Promoters and SP sell such number of shares that
the acquirer wishes to buy on a proportionate basis.
Concerns on the ISA continued…
In relation to the drag along right, in case the promoters find
the perfect time to divest and exit by giving up the company
for sale, if they don’t convince SP to sell their shares too they
will not be able to exit. But if SP bring an investor favourable
to them to takeover the company and if they hold the
majority shares in the startup by that time (which they most
probably will given the condition they stated in the
consideration clauses) they can force the other shareholders
to sell their shares. [Clause 4.1 (b)]
• Drag-along rights are for the benefit of the Promoter /
majority shareholder and gives you the right to call upon SP
to sell its shares if you are proposing to divest completely.
• The ISA does not give SP the right to acquire majority
shareholding.
Concerns on the ISA continued…
In relation to the tag along right, if Chillr is made a nominee for
investment in the Startup on behalf of SP and Startup is a competitor
of Chillr, can Chillr halt Startups investment in a likely worst possible
scenario? "The Parties agree that the valuation of shares regarding
the aforesaid transaction shall not be prejudicial and detrimental to
the reasonable commercial interests of the Service Provider.“ [Clause
4.1 (a)]
• The Tag along right is to enable the minority shareholder (SP) to
have a right to tag-along and sell its shares in proportion to any sale
of shares by the Promoters.
• In the event the share valuation is not favourable to SP/ the
nominee to ensure a reasonable ROI, SP (or its nominee) may
simply not exercise its tag-along right.
Concerns on the ISA continued…
Co-investment of 30% by SP in proportion to any
investment is a reasonable claim. But the issue of
these securities at a discount of 30% no matter what
securities they are for, is unreasonable and
also against the Companies Act. The maximum
discount that a company can give anyone according to
the Act is 10% be it equity or preference shares or
debentures. [Clause 3.2 (b)]
• Shares can be issued at a discount from the market price. What the
Companies Act, 2013, prohibits is the issue of shares at a discount
on the face value of the shares. The 30% discount on the price at
which the shares that are being issued to the new investor, which in
most cases is several times the face value of the shares, is
permitted by the Act.
• Moreover, the discount is only for one round of investment.
Concerns on the ISA continued…
Any amount an investor brings in, will give SP the right to receive 2.5% of the
amount as commission and this has to be paid in 20 days to SP. This is
unreasonable; what if the investor is giving the money to be particularly
invested in the growth of the company or for its essential functioning? For eg.
if the investor is investing in the company through preference shares and the
money received thereby is invested fully in getting a license? What then? Are
the promoters to pay from their pockets? Another case could be if investment
is in stages to protect investor interest. In that case too the startup will have
to pay them 2.5% on the whole amount of investment which essentially
means we will end up paying from our pockets again. [Clause 3.1 (c)]
• Arranger’s fee is standard market practice for any person (including
investment bankers) arranging funds for an entity.
• It is payable only when SP brings in the investor and is payable only when
the Startup receives any money and can be paid in tranches if the
investment is also only received in tranches.
• In normal investment scenarios, investments are raised keeping in mind
commissions and other payouts that the Startup will have to make.
Concerns on the ISA continued…
In relation to Clause 3.4 the rent /
rates for the premises and services
that may be charged by SP is not
specified. It basically gives SP
unlimited rights to charge any
amount as rent and rates.
• Please note that Clause 3.4 as well as several other clauses apply
only in instances of physical incubation services and shall not apply
to virtual incubation services.
• To be clear, SP is not offering physical incubation services to your
batch.
• We are adding this expressly in the Supplemental Agreement.
Concerns on the ISA continued…
Why do we have to sign 2 agreements? Can't we
sign just one?
• The ISA and PA address two different
scenarios / services and cannot be combined.
Supplemental Agreements Clauses
We propose to have the following clauses in the
Supplemental Agreements to clarify the following:
• That commission is payable only on one year’s
annual CTC if SP helps Promoter find a job
• That the Promoter will not be double charged
under Clauses 2.1 and 2.2 of the PA
• That the various clauses relating to the physical
incubation including collection of rent etc. at a
future date do not apply to virtual incubation
services provided by SP.
THANK YOU