MONTH : AUGUST 2024

Understanding the Secondary Transfer of Shares

When talking about the startup ecosystem, we usually focus on primary investments. However, as the ecosystem matures, secondary share transfers become important as well. This process allows early investors, employees, or founders to sell their shares without the company going public or raising new capital. This blog will cover what secondary share transfers are, why they happen, the mechanics involved, and the associated benefits and risks.

What is a Secondary Transfer of Shares?

A secondary transfer of shares occurs when existing shareholders in a privately held or unlisted company sell their shares to another party, usually outside of a formal fundraising round. Unlike a primary investment, where the company issues new shares to raise capital, secondary transfers involve the transfer of existing shares from one party to another. These transactions do not inject new capital into the company but instead facilitate liquidity for existing shareholders.

Why Do Secondary Transfers Happen?

There are several reasons why secondary transfers might occur:

1. Liquidity for Early Investors: Early-stage investors such as angel investors or seed-stage firms may be looking for an exit based on their mandates, especially if the company has grown substantially.
2. Exit for Employees and Founders: Over time, employees or even founders might want to liquidate a portion of their shares to fund personal financial planning, diversify their portfolios, or meet other financial needs.
3. Strategic Investor Entry: New investors often drive secondary transactions to enter a company without waiting for the next primary fundraising round. This is especially common among strategic investors who see synergies with the startup's business model or product offerings.
4. Investor Restructuring: Existing investors may also rebalance their portfolios by selling stakes in certain companies and focusing on others with more growth potential.

The Mechanics of Secondary Transfers

Secondary transfers can be complex due to the variety of stakeholders and the regulatory framework involved. Here’s how they generally work:

1. Finding a Buyer: generally involves pitching to another investor, a fund, or a strategic acquirer. Investment bankers, secondary market platforms, or private networks often facilitate this.
2. Valuation Agreement: The valuation in a secondary transfer may differ from the latest primary round valuation due to factors like market conditions, company performance, and investor appetite.
3. Legal and Regulatory Compliance: The transaction must comply with the company's Articles of Association, shareholder agreements, and local regulations. Some agreements may have Right of First Refusal (ROFR) clauses, which give existing investors the first option to buy shares before offering them to external buyers.
4. Due Diligence: The incoming investor will conduct their own due diligence to verify the company’s financial health, growth prospects, and any potential legal or compliance issues.
5. Transfer of Shares: Once the terms are finalized, a shareholders agreement (SHA) is signed, and the shares are transferred to the new investor’s account. Depending on the jurisdiction and company structure, this may require board approval and updates to the company's cap table.

Benefits of Secondary Transfers

1. Provides Liquidity Without Dilution: Since no new shares are issued, there is no dilution of ownership for existing shareholders.
2. Attracts New Investors: Secondary transfers can bring in new investors who may add strategic value, such as industry knowledge, networks, or subsequent funding support.
3. Reduces Investor Pressure: By allowing early investors and employees to realize gains, companies can reduce the pressure for an early exit or IPO.
4. Price Discovery: Secondary transactions can provide a more realistic picture of the company's market value, especially if there hasn't been a recent primary round.

Risks and Challenges

1. Impact on Valuation: If the secondary sale happens at a discount to the latest primary round valuation, it can signal a lack of confidence and affect future fundraising efforts.
2. Governance Issues: Having many small shareholders may complicate governance and decision-making.
3. Regulatory and Compliance Complexity: Different jurisdictions have varying regulations regarding secondary transfers. Non-compliance can lead to legal challenges.
4. Reputational Risk: Large-scale secondary sales by founders or early investors may raise concerns about the company’s growth prospects or internal challenges.

Conclusion

Secondary transfers are becoming increasingly common as startups mature and early investors look for liquidity options. They offer flexibility to investors, founders, and employees while enabling new investors to join promising startups without the company having to raise new capital. However, these transactions come with their own set of challenges and require careful planning and execution.

 Understanding the nuances of secondary share transfers will become crucial for both investors and companies to navigate this complex landscape successfully. For companies, establishing clear policies around secondary transfers and managing shareholder expectations is key to maintaining a healthy balance between growth, liquidity, and investor satisfaction.

An Introduction to Impact Investing

Impact investments refer to investments made in companies, organizations, and funds with the aim of creating social or environmental impact while also obtaining a financial return. Two key aspects of impact investments are intentionality and measurement. The investor should have the intention of achieving both social impact and financial return. While there are established measurement metrics for financial return on investment (ROI), impact investors should also focus on measuring the social impact.

The rationale for impact investing stems from the growing awareness of global challenges such as climate change, poverty, inequality, and lack of access to essential services. Investors, both institutional and individual, are increasingly recognizing the importance of addressing these challenges through their investment choices. Impact investing allows them to align their portfolios with their values, supporting businesses and projects that contribute to solving pressing global issues.

Finding one’s place along the spectrum is a key consideration for any impact investor. At the far left, one motivated primarily by social impact might make a low-interest loan or recoverable grant to a charity. At the other end, a financially driven approach might lead to an equity investment in a public company based on its integration of corporate social responsibility (CSR).

Objectives of Impact Investing

Impact investors typically pursue a variety of objectives, which can be broadly categorized into the following:

1. Environmental Objectives: Investments aimed at addressing environmental challenges such as climate change, deforestation, and pollution. These might include renewable energy projects, sustainable agriculture, and conservation efforts.
2. Social Objectives: Investments focused on improving social outcomes, such as education, healthcare, affordable housing, and access to clean water. These investments often target underserved or marginalized communities.
3. Economic Development Objectives: Investments that promote economic development, particularly in emerging markets. These might include microfinance initiatives, small business development, and infrastructure projects that create jobs and stimulate local economies.
4. Governance Objectives: Investments that enhance corporate governance, transparency, and accountability. This can involve supporting businesses that adhere to high ethical standards and promote diversity, equity, and inclusion within their organizations.

Investment Instruments in Impact Investing

Impact investing can be carried out through various investment instruments, each offering different risk and return profiles. Some of the common instruments include:

1. Equity Investments: Impact investors may take an equity stake in a company or project that aligns with their objectives. This could involve investing in a startup focused on clean energy or a company that provides affordable healthcare solutions.
2. Debt Investments: Investors may provide loans to businesses or projects that have a positive social or environmental impact. For example, green bonds are a popular debt instrument used to finance environmentally friendly projects.
3. Venture Capital/ SociaI impact incubators: Impact-focused venture capital funds invest in early-stage companies with innovative solutions to social and environmental problems. These investments are typically higher risk but have the potential for substantial impact and financial returns.
4. Social Impact Bonds (SIBs): SIBs are a form of pay-for-success financing where private investors fund social programs, and the government repays the investors if the program meets predefined outcomes. SIBs are designed to tackle issues like recidivism, homelessness, and education gaps.
5. Real Assets: These include investments in tangible assets like real estate, infrastructure, or natural resources that have a measurable impact. For instance, investing in affordable housing projects or sustainable timberland can generate both financial returns and social or environmental benefits.

Impact Investing: 4 Common Misconceptions

1.      Impact ventures aren’t profitable: Impact Ventures are defined by a business model where impact is correlated with, and driven by commercial success

2.      Impact is binary: There is a flawed perception of viewing impact as binary—either you are doing good or not. Between these, you can find a broad spectrum, where different types of businesses can have different sorts of impact. 

3.      Impact is intangible & hard to quantify: Data is a critical tool in impact venture building—it not only helps you communicate progress but offers a valuable feedback loop for improvement. You can check out Founders Factory's full Impact Venture Measurement model here.

4.      Impact is a niche of the market: On the contrary, the impact market is experiencing rapid growth, presenting itself as one of the most significant investment opportunities.

Conclusion

Impact investing represents an approach to addressing global challenges while generating financial returns. With a wide array of objectives and investment instruments available, impact investing allows investors to make a difference in the world without sacrificing their financial goals. As the field continues to grow, it offers an exciting opportunity for investors to contribute to a more sustainable future.

Additional sources for reading:

https://confluencephilanthropy.org/Transparency-Is-the-Bedrock-for-Impact-Measurement

https://www.rockpa.org/guide/impact-investing-introduction/

https://thegiin.org/publication/post/about-impact-investing/

https://funds.rbcgam.com/_assets-custom/pdf/RBC-GAM-does-SRI-hurt-investment-returns.pdf

https://www.rockpa.org/wp-content/uploads/2017/10/RPA_PRM_Impact_Investing_Strategy_Action_WEB.pdf 

https://foundersfactory.com/articles/impact-venture-building/

Building a Startup during a Slowdown

Building a startup is challenging in any economic environment, but the dynamics shift considerably during a slowdown. While recessions might seem like the worst possible time to launch a business, history has shown that many successful companies were born in tough economic climates. Let’s explore the pros and cons of starting a venture during a downturn and determining When is a good time for You as a founder to build your startup.

Pros of Building a Startup During a Slowdown

1. Less Competition
   In a slowdown, fewer entrepreneurs leap to start new ventures. This can result in less crowded markets, allowing startups to carve out niches without immediately facing intense competition. There are fewer tourists and less hype.
2. Access to Talent
   Economic downturns often lead to layoffs and hiring freezes at larger companies. This puts a pool of highly skilled and experienced professionals on the market.
3. Focus on Efficiency
   Recessions force startups to operate leanly, which can be a significant advantage in the long run. Founders learn to do more with less, focusing on the essentials and cutting unnecessary costs.
4. Investor Discipline
   Investors become more cautious and discerning. While this might seem a disadvantage, it benefits startups with solid business models. Investors are more likely to back companies with sustainable plans, rather than those riding on hype or speculative trends.
5. Building a loyal consumer base
   If a startup can prove its worth by solving real problems and offering exceptional service. In that case, it can build a loyal customer base that remains with the company even as the cycle turns.

Cons of Building a Startup During a Slowdown

1. Limited Access to Capital
   Investors are more risk-averse, and funding rounds may take longer to close. Startups might have to bootstrap longer or accept less favorable terms than they would during a boom.
2. Reduced Consumer Spending
   Economic downturns lead to reduced consumer confidence and spending. Startups may struggle to attract paying customers, especially if their product or service is considered non-essential. This can lead to slower growth and longer timelines for profitability.
3. Operational Challenges
   Recessions can disrupt supply chains, increase costs, and create operational hurdles. Startups may face difficulties in sourcing materials, manufacturing products, or delivering services, particularly if they rely on global suppliers.
4. Mental Strain
   The stress of navigating a startup through a recession can take a toll on founders and their teams. The constant pressure to survive in a tough environment, combined with personal financial risks, can lead to burnout and mental health challenges.

Is this a good time for you to start a company?- Some Qs to ask yourself before starting out!

• Are the problems you are most interested in “of the moment?” Do you want to quickly jump into AI, web3, or some other cutting-edge tech?
• Do you enjoy being “in the scene”  — or are you more of a heads-down grinder? Is it fun to build hype, and tap into the excitement of an ecosystem?
• Is your strategy more high-growth, high-burn — particularly if your industry/product dictates it — or do you prefer the idea of working through a highly capital-efficient idea over the years?
• If you knew that you were going to build something that might take 10+ years, versus a 2-3 year flip to an acquirer, would that change your mind on the area?

 Conclusion

Ultimately, the success of a startup hinges less on the economic environment and more on the ability of its founders to adapt, stay resilient, and execute a clear vision. Regardless of the economic climate, a strong business model, a deep understanding of customer needs, and the ability to pivot when necessary will always be key drivers of success.

What was the Angel Tax?

The Angel Tax came into play if the total investment value exceeds the company's FMV or Fair Market Value. Investment greater than FMV is categorized as "income from other sources", and the tax imposed on it is called angel tax. The tax was first introduced in the 2012 Union Budget by then finance minister Pranab Mukherjee to arrest the laundering of funds.

This was a unique tax as it converted Capital receipts to Income and taxed Founders and Investors. It adversely impacted the Indian start-up ecosystem by diminishing investors' ability to take commercial risks.

For example, if a company's fair value is Rs 1 crore and it raises Rs 1.5 crore from angel investors, the excess amount of Rs 50 lakh is subject to this tax. Tax authorities considered the premium paid by investors as income, taxable at around 31 percent.

Methods of ascertaining FMV:

The issue with these approaches is that they do not apply to Early-stage companies. This led to friction for Founders & Investors as they struggled to complete formalities and even faced litigation in some cases.
We have spoken about why Valuing early-stage startups is difficult here..

The sequence of events:

2012:

The Angel Tax was introduced as part of the Finance Act of 2012. Placed under the Income Tax Act of 1961, the rationale was to curb money laundering and Tax evasion using Private market investments.

From 2016 to 2018, Angel Funds significantly dried up and the number came down by more than 40%.

2019:

After startups made numerous pleas, the Indian Government implemented some relaxations in the 2019 Union budget. In this budget, the government stated that if the startup is registered under the DPIIT or Department for Promotion of Industry and Internal Trade, it would not be subject to such tax. But these relaxations were still subject to fairly strict guidelines such as:

·        After issuing the shares, the startup's maximum paid-up capital and share premium should not exceed Rs 25 crore.

·        As per Rule 11 UA (2)(b) of the Income Tax Act of 1961, it is imperative for the merchant banker to evaluate the fair market value of the startup.

·        These relaxations did not help reduce frictions regarding reporting or legal tasks & hence was not a welcome move.

2024:

Even after numerous incentives, the complaints regarding Angel Tax were never resolved. As a result, the Union Government took the significant step of eliminating the concept of 'Angel Tax' in the 2024-25 Budget.

What changes with the Abolishment of Angel Tax?

·        Simplification of the Fund-raising process with reduced bureaucracy

·        Encouraging Foreign investment as well due to reduced scope of Tax litigation

·        The fiscal discipline demonstrated by startups after the funding winter has made the Indian eco-system more attractive for Investors

Conclusion:

The removal of the Angel Tax is a welcome move for the start-up ecosystem. Due to the reduced tax and regulatory hurdles, we can expect a more dynamic landscape for investments in India.

The provisions through which angel tax is imposed will cease to be in force from April 1, 2025. 

Considerations on Raising a Round from Existing Investors

Raising a round from existing investors is a strategic decision that requires careful consideration from both investors and founders. While it may seem like a straightforward process, it involves managing trust, expectations, and alignment of interests for both parties involved. In this blog, we will explore the key considerations from both perspectives.

Founders' Perspective

1. Alignment of Interests
   Existing investors have already demonstrated trust in the founders and their vision. Raising another round from them can strengthen this relationship. However, founders must ensure that the investors' interests remain aligned with the company's long-term goals. Misalignment can lead to conflicts and hinder the company's progress.
2. Efficiency and Speed
   Raising funds from existing investors can often be quicker and more efficient than courting new investors. The existing investors are already familiar with the company's operations, and team, which can save time in due diligence and negotiations, allowing the founders to focus more on building the business.
3. Valuation Considerations
   Existing investors may have a different perspective on valuation compared to new investors. Founders must carefully negotiate terms that are fair and reflective of the company's current state while considering potential dilution.
4. Control and Governance
   Additional funding from existing investors may come with changes in governance, such as board seats or veto rights. Founders should evaluate how these changes might impact their decision-making power and the overall control of the company.
5. Signalling to the Market
   Raising a round from existing investors can signal confidence in the company's future prospects. However, if not done transparently, it might raise questions about the company's ability to attract new investors. Founders should communicate the rationale behind the decision clearly to avoid negative perceptions.

Investors' Perspective

1. Assessing the Progress and Milestones
   Existing investors will assess the company's progress since the last funding round. This includes evaluating the achievement of key milestones, such as product development, customer acquisition, and revenue growth.
2. Understanding the Funding Needs
   Investors need to understand the company's funding needs and how the new capital will be utilized. This includes evaluating the burn rate, runway, and specific goals the company aims to achieve with the additional funds.
3. True Price Discovery
   Negotiating a Valuation that aligns with the company's growth potential and investors' return expectations is crucial. Existing Investors must also be aware of not having a Fair market value for the internal round and proceed accordingly.
4. Risk Assessment
   Investors will consider factors such as market conditions, competitive landscape, regulatory environment, and the company's execution capabilities. They need to determine if the wish to double down on their earlier thesis.

Conclusion

Founders must ensure that the terms are fair and that the partnership remains aligned with the company's long-term vision. Investors, on the other hand, must assess the company's progress, risks, and strategic fit within their portfolio. By addressing these considerations thoughtfully, both parties can work together to drive the company's success and maximize returns.