Navigating Transaction Documents
This article is part of a larger series on Deal Closing. Click here to access all our modules.
2.1 Overview
Once a term sheet is signed, the lead investor will engage legal counsel, who will initiate the drafting of “definitive transaction documents”.
Transaction documents embody the commercial arrangement agreed to in the term sheet, are far more detailed (with more legalese), consider the local compliance requirements, and are legally binding. These definitive transaction documents allow you to accept the investment while following the correct regulatory process.
Paperwork & processes differ across countries. A more mature market like the US has publicly available standardized documents. E.g. the SAFE for pre-seed and seed transactions.
The regulatory framework in India is a lot more complicated. There are multiple different instruments and nuances, making the standardization of documentation a confusing and cumbersome process.
However, there has been a consistent effort to standardize and make transactions more efficient across the ecosystem.
At an early stage, 3 different types of documents are commonly used:
We’re going to dive deeper into each of these in the next section(s), and cover what their advantages, norms, and use cases are along with some time spent on declassifying Convertible Debt Instruments, commercial terms, and end with how timelines for all of this works
PS. A special thanks to Shepherd Law for helping out with all the draft documents linked in this playbook 🥰
2.2 Convertible Debt Instruments 🎷
We go over both of these instruments in detail in the following sections.
2.2.1 Convertible Note 💵
A convertible note (CN) is a short-term debt instrument that early stage startups use to raise funds from investors. It allows investors to loan money to a startup and "convert" the loan amount into equity shares of the company in the future, typically at a discounted conversion price.
Key terms associated with Convertible Notes
Discount rate: CN investors get a favorable rate, usually 15-25%, when converting their note into equity shares in the next round. For example, if your next round valuation is $10 million and the convertible note has a 20% discount, the note converts at a valuation of $8 million.
Valuation cap: Puts a ceiling on the maximum valuation that the convertible note will convert at in the next round. This benefits investors.
Valuation floor: Puts a minimum price below which the investor's note will not convert. This protects the entrepreneur.
Conversion period: Converts to equity at the end of the maturity period (typically 18-24 months) or when the price round occurs.
Pros of using Convertible Notes
Deferred valuation: You can delay deciding on a startup valuation, which is difficult in the early stages.
Quick fundraising: Notes have simpler and faster paperwork than priced equity rounds. You can get the money substantially quicker, without lengthy SHAs & SSAs (detailed below).
Rolling close: Allows different investors to fund at different times, still treating all note holders equally. Useful when trying to accumulate small angel cheques; mitigates having to wait for one large lead investor.
For example, Investor A puts $50K on Jan 1st, Investor B puts $30K on Jan 15th. Both can get the same discount and terms when converting to equity later.
Cons of using Convertible Notes
Future limitations: Taking a SAFE or convertible note between rounds can make it hard to create enough of an allocation in the next round to attract a high-quality lead who will price the next round. You can read more about this here.
No investor rights: Noteholders don't yet have shareholder rights like voting rights, board seats etc. until the actual equity conversion happens.
No senior rights: Noteholders convert to plain equity, not preferred equity with liquidation preference common in early stage priced rounds.
Size limitations: Notes generally have a minimum investment size ~$30K (INR 25lakhs). Not for very small angels.
Even if noteholders don't yet have investor rights, startups commonly provide basic information sharing and inspection privileges as a gesture of goodwill to major note investors.
The deferred, uncertain nature of convertible notes does mean investors take higher risk with respect to the governance setup of the organization and the rights given to them. Generally, the discount rate, valuation caps, etc. are favorable enough to make it worthwhile.
In summary, when structured properly and aligned to investor interests, convertible notes allow early-stage startups to kickstart fundraising momentum without struggling over elusive valuations.
2.2.2 Compulsory Convertible Debenture (CCD) / iSAFE 🔐
A compulsory convertible debenture (CCD) is a debt instrument used by early-stage Indian startups to raise investor funding that compulsorily converts into equity shares in the future.
An iSAFE functions similarly but is based on the US SAFE model adapted to India. The terms of a CCD and iSAFE are fairly similar in practice. As a founder, there is little difference between the both and the choice is often determined by the investor’s legal preferences.
Both are simple, standardized agreements allowing founders to efficiently close investment rounds before finalizing on a valuation.
Pros of using CCDs and iSAFEs
Deferred valuation: Avoid painful early stage valuations, perfect for pre-seed/angel deals.
Preferred equity conversion: CCDs can have the option to convert to preferred equity in future rounds unlike notes.
Customizable investor rights: iSAFEs allow founders to offer investors basic rights and protections upfront even before conversion.
Lower minimums: No minimum cheque size requirements make CCDs/iSAFEs accessible to smaller angel investors.
Cons of using CCDs and iSAFEs
Conditional rights: Investors technically don’t have formal rights until actual equity conversion happens. Need good founder-investor rapport.
In summary, CCDs and iSAFEs balance both founder and investor interests on key issues like rights, valuations and risk/return better than traditional convertible notes in most cases. The standardized documents help expedite closures.
2.3 Shareholders Agreement & Share Subscription Agreement 🤝
Shareholder Agreements (SHAs) and Share Subscription Agreements (SSAs) are the definitive equity round transaction documents preferred by institutional investors in India.
While complex and lengthy, they allow investors to get formal shareholder rights and enforce important governance practices in startups they invest in.
Key Terms associated with SSAs and SHAs
Share percentages: The SHA specifies the equity split between founders, employees and investors post-investment.
Shareholder rights: Investors get voting rights, information access, board seats, liquidation preference and other minority protection rights.
Restrictions: On share transfers/new issues to protect shareholding percentages. Enforced through rights of first refusal, co-sale rights and consent requirements.
Exit: Mechanisms like buyback, drag along and tag along rights are covered to allow exit. Mergers and acquisitions related clauses included.
🚨 P.S: These are all terms we have covered in the previous section of this playbook. You can read it here. 🚨
Pros of using SHAs and SSAs
Formal shareholder rights: The most legitimate way for investors to get enforceable rights and control.
Strict governance: Good way to institute financial, operational and management controls suitable for scaled startups.
Credibility & compliance: Essential to attract venture capital, private equity and other institutional monies.
One single source: All investors sign the same document. A single SHA is signed by all shareholders and a single SSA is signed by all the investors that are subscribing to shares.
Cons of using SHAs and SSAs
High legal costs: SHAs and SSAs require extensive customized drafting for each startup, increasing legal fees.
Slower closures: Lengthy documents lead to longer finalization and negotiation cycles between founders and investors.
Inflexibility: Changing business models may need SHA amendments since investor protections are hardcoded early on.
In essence, SHAs and SSAs provide unmatched legitimacy and rigor demanded by institutional investors. But they work best once startups have achieved product-market fit and some scale.
2.4 Commercials Terms 📝
Given our experience in this closing process, we are going to cover the commercial terms below that have not been previously looked into in other sections of this playbook.
Vesting
Founders have a certain number of shares in the company - obviously, they are generally the largest individual shareholders through the first few rounds.
Based on the lock-in period (previously deconstructed) at term sheet stage and the agreed vesting schedule, there will be some portion of shares that are vested for the founder and some that are unvested.
💭A vested share is one that you have fully earned and own outright. Practically, this means that you can sell this share.
An unvested share is one that you own but are yet to earn which happens per the vesting schedule or on the occurrence of an event such as exit. 💭
Here’s a hypothetical 💡
Let's say you have a typical 5-year vesting period, this is what the breakdown of those 5 years could look like, basis the given vesting schedule:
The first year is known as a “cliff” and no shares vest for the founder in this particular one year period
For all the years following the cliff, a certain percentage of shares vest, depending on a pre-agreed vesting schedule
2 schools of thought can be applied when deciding the vesting schedule
Shares vest evenly through the vesting period
Shares are backloaded (more shares vest later) to prevent critical talent from leaving the organisation
Leaver Provisions
In case the founder wants to exit the company before the shares are fully vested, there can be 2 scenarios that play out:
Good leaver
A situation when the investors, remaining co-founders and you mutually consent to the Founder to be exiting the company.
All vested shares plus the shares that would have vested within that year will typically hold fair market value, and it falls on the exiting founder to try and find a buyer for liquidity.
The unvested shares in this situation are bought back by the company at face value, and are usually transferred to the ESOP pool of the Company.
It is important to note that even in a good leaver situation, the voting rights of the founder cease to be in effect once the employment is terminated.
Bad leaver
A situation of disagreement between the founder(s) and the other shareholders on an act or decision that goes against the stipulated responsibilities of the said founder(s); with no resolution in sight.
All vested and unvested shares of the exiting founder will typically be bought back by the company at face value.
While the above is fairly standard, there are different ways that good & bad leaver situations can be tackled and we always recommend that, as the founder, you should have an employment agreement with the company that covers various scenarios and acceptable outcomes, much like you would create with the critical talent that you end up hiring for your firm.
As a supplement, you can also have an agreement between the co-founders that covers various conflict scenarios and how they need to be handled. If such a document isn’t created, the conflict will either be investigated and final say will be decided by the board, or you can choose to hire a third-party expert wherein the final decision provided by them at the time will be applicable.
Affirmative Vote Matters
Affirmative Vote Matters (or Investor Approval Matters) are typically a list of items for which a company will need to take consent from their lead investor prior to actioning. This is a list of 20-odd items (found in our draft SHA- Schedule 6) that effectively relate to the structure of the company; such as financial decisions made over certain thresholds, any key employee changes, any regulatory or IP changes that may be applicable.
All of these might sound daunting but it's important to remember that having these investor approval matters is beneficial to maintain a compliant company. A list of potential AVMs is given in the draft document that's attached and I would encourage you to go through it. Keep in mind that these may alter depending on what level of control your investor might want to have in the company.
Fallaway threshold
The concept of fallaway threshold is not common at an early stage, but is more a commercial concept that can be introduced at seed & future rounds if needed.
Effectively it means that when an investor’s shareholding reduces below a certain percentage, certain rights will not apply to them anymore. For example, if your lead investor holds 10% in the company today, at the time when their shareholding drops below 5% (this is your fallaway threshold), the investor will no longer have the right to be on the board or exercise drag right or have affirmative voting matters etc.
Reps and Warranties
In any transaction, it is typical for the company and the founders to make certain representations.
🚨 A representation is an assertion as to a fact, true on the date the representation is made, that is given to induce another party to enter into a contract or take some other action.🚨
For example- the company has been incorporated rightfully, the company has no debt, the company can enter into such a transaction etc.
🚨 A warranty is a promise of indemnity if the assertion is false.🚨
Your investors are deciding to invest in the company, based on the information and knowledge that you have shared which need to hold true for the deal to stand. Please note, reps are given by the founder(s), and the company as applicable - these are covered in detail in the Share Subscription Agreement.
Indeminity
An indemnity is a contractual obligation of one party to compensate the loss incurred by another party due to the relevant acts of the indemnitor or any other party.
Based on the representations and warranties that a founder and the company give, the concept of Indemnity kicks in which effectively means that your investor is indemnified against if any of these reps and warranties are incorrect.
2.5 Timeline ⏰
Closing the SHA & SSA i.e. aligning on all the commercials before you’re ready to sign can take a fair bit of time and involves a lot of different steps. Let’s break these down:
SHA & SSA v1: Usually the lead investor takes care of all drafting. They send the term sheet to their legal counsel and ask them to draft the SHA & SSA based on those commercials. This takes about a week.
Review of SHA & SSA v1:Once you receive the SHA & SSA from your lead investor, send it to your legal counsel with the signed term sheet as a reference. Ask them to review it purely from a commercial perspective and highlight key points.
Meeting with your legal counsel: Have a meeting with your legal counsel and discuss the important points that you’d want to negotiate with your lead investor. Of course, go through the document once yourself as well so that you understand the basics, and your counsel can guide you on concepts that are unclear.
Share your comments with the lead investor: Drop your comments on specific rights / clauses that you want to negotiate. Clearly mention why the current clause needs to change, what you’re looking for and why. This helps both parties to digest the problem statement, and think through practical solutions that work for you & the investor while protecting interests for both parties. Clarify that these comments are purely commercial and drafting suggestions will be made later.
Discussion with lead investor: The next step is to have a meeting with your lead investor to negotiate the said points. These will primarily be centred on the SHA. It is good practice to respond to mutual comments before hopping on a call. It’s unlikely that you’d be able to close all the points in a single meeting. Both parties will require time to think and reconsider the other’s perspective. When you have multiple meetings, it’s most efficient to maintain a tracker (sample linked here) of points that have been closed and the ones that are pending. Practical mid-point suggestions are usually where you will land, so the goal should be to get to solutions that cater to the interest of both parties as soon as possible.
SHA & SSA v2: Once the commercial understanding has been established and all open points have been closed, the lead investors shall draft the v2 which reflects the changes made after negotiations. Ask the investor to share docs in clean and track versions.
Review of SHA & SSA v2: Go through the v2 documents to ensure that all commercial updates reflect appropriately. Send the list of commercial points negotiated and alignment reached to our lawyer along with the v2 documents. Ask your lawyer to (i) review from a commercial perspective, and (ii) suggest drafting changes as necessary.
Meeting with your legal counsel: The purpose of this meeting is to understand the major drafting changes that have been made by your legal counsel, the rationale behind those and the commercial impact of those changes (if any). Send these across to your lead investor.
SHA & SSA v3: The lead investor will ask their legal counsel to review the drafting changes and either accept or reject those changes as they see fit. They’d send across a version of documents that contain their responses. Here, discuss with your lawyer if you’re okay with the final drafting. If there are any specific points that you feel strongly about, discuss those with your lead investor and clearly communicate your reservations.
Pre-exec version: Fill out the placeholders: Based on final alignment of commercial & drafting changes, the lead investors legal counsel will prepare the SHA & SSA. Throughout the SHA & SSA, there will be certain placeholders that need to be filled out by the promoters (details of promoters, company, round details, other schedules, details of investors). Complete all these details. Now, send out this version to all investors. It is advisable to start work on Conditions Precedent (CPs) in parallel at this stage to ensure there are no delays in your ability to start receiving wires from investors.
Comments from other investors: Other investors might come back with their comments on the documents. It’s fair for them to come back with commercial points (relating to their rights) but it’s best not to entertain drafting changes unless absolutely necessary. Also ask all investors to confirm all placeholder details filled in for them are accurate.
Discussion with other investors: Have discussions with your other investors (back channel with your lead investor if required) to reach alignment on commercials. Mostly, the rights that different investors have are based on their investment amount / shareholding in the company so decide accordingly. It’s possible that lead investor rights and other investor rights might be in conflict in certain cases. As the founder, you should have a strong point of view on what’s fair and be firm on that.
Execution version: Since the lead investor takes care of drafting, communicate the necessary changes that need to be made (if any) pertaining to other investors. Based on all comments & Information received, their counsel will prepare the final execution version of SHA & SSA. Make sure you procure appropriate value stamp papers on or before the execution date stated in the documents.
Send out execution version documents: Send out the execution version documents to all investors. Send the exec version SHA & SSA, and (respective) signature pages separately to each shareholder. Follow up with investors to sign. Once everyone has signed, collate all signed pages, attach them with the main document. This process ends with the company sharing the fully executed SHA & SSA with all investors.
A blanket rule to ensure that this entire closing process is handled efficiently and optimally is by getting a well referenced, practical legal counsel to guide you through terms, and to have an experienced CA/CS which guides you through the entire transaction & closing process.
And that’s it!
Congratulations, you have completed yet another important step in your deal-closing journey! Follow along in our series as we break down more elements. If you found this helpful, please do share it forward and more importantly tag us on social media 🥰
