Why due diligence is conducted for startups in India?
Investment in a startup business could be risky and thus, venture capitalists and angel investors appoint startup consultants having the relevant expertise in the area to conduct startup due diligence before making such an investment. A potential investor in startup companies should gain a holistic understanding of the startup business they are investing in and performing a startup due diligence furthers the cause.
Startup Due Diligence is most often performed by potential startup investors before making the decision of capital entry into a startup business. During this process, the financial, commercial, legal, tax and compliance conditions of the startup are thoroughly analyzed based on historical data in order to objectively assess the operational situation of the company in the near future. This allows the startup investors to estimate the potential risks, SWOT directly or indirectly affecting the value of the target company. Due diligence immediately precedes the negotiation stage, after which the startup due diligence report prepared by the startup consultants is reviewed by the investors and the shareholder’s subscription agreement (SSA) is signed if everything goes smoothly.
Most common due diligence mistakes in 2024
Here are a few common mistakes we have observed after working on startup due diligence for multiple startup business:
A. Legal Due Diligence Mistakes:
Legal due diligence is an essential aspect of the entire due diligence process, especially in the context of procurement. It looks for and assesses any legal risks related to the target company or sector that is being purchased. Contract compliance, litigation risk, intellectual property rights, and many more subjects are covered by legal due diligence. Legal due diligence focuses on a number of things, one of which is government rule and regulatory compliance. This kind of due diligence comprises reviewing all essential documents to ensure that the target firm has complied with all applicable national and international regulations in its operations. The purchasing company may be subject to significant liabilities if they don’t comply. The following factors are involved in Legal due diligence –
- Inconsistent terms in agreements – Plainly, if a contract term means one thing when it is considered on its own and means something very different when it is considered in the light of a printed term in a set of standard conditions, that is likely to shed considerable light on that issue. When two clauses conflict and one of them is a conventional term of one party and the other is the result of bespoke drafting, the bespoke drafting will usually take precedence. If a contract calls for something to be produced in line with a prescribed design and to satisfy specified standards, the parties must share the risk if the prescribed design falls short of the prescribed standards.
- Agreements Inadequacy – Employee stock options are a common topic on investor due diligence questionnaires that founders get. Investors should be wary if you claim to have given your key staff options and have represented this in the cap table, but there are no stock option agreements or plans in place. It is quite probable that investors will request that the founders address this issue as quickly as possible. The solution to avoid the above scenario is to maintain current option valuation. External parties perform this appraisal for any noteworthy occasions, such as the opening of new investment rounds. Initially, your staff members might be curious about the true worth of their options-based shares at any given moment. Secondly, upon employing staff in the nation where your business is registered , they will be required to notify local tax authorities of any appreciation in the value of their shares. The importance of having an updated firm value increases with your organization’s worldwide reach and workforce diversity.
- Stamp duty not paid on agreements – Like income tax and sales tax that the government collects, stamp duty is a tax that needs to be paid in full and on schedule. Penalties are incurred for payment delays. An instrument or document that has paid stamp duty is regarded as legitimate and lawful, and as such, it has evidential value and may be used as proof in court. The court will not accept instruments or papers that are not properly stamped as evidence. A penalty of 2% per month will be applied to the outstanding stamp duty balance if it is not paid on time.
- Equity promises without documentation – Written documentation in the form of a signed binding pledge card or other written correspondence would typically provide sufficient evidence of a promise. Three primary forms of equity are granted to employees by startups: The right to purchase or sell a specific number of founders’ shares at a fixed price is known as a stock option. Between the vesting date—which occurs after an employee has earned stock options—and the expiration date, the employee may exercise this right. This is the most typical kind of equity that entrepreneurs decide to provide their staff members.The right to purchase or sell a specific number of business shares at a fixed price is known as a stock warrant. Although warrants often have longer expiry dates than stock options, they can also only be exercised between the vesting and expiration periods.The ownership of a certain number of shares is known as a stock grant. No vesting is present. The main problem that occurs in startups are that they promise equity without doing proper documentation.
- Inadequate IPR protection – During the frantic process of developing new products, it is not uncommon for entrepreneurs to forget to sign the appropriate contracts with all of the consultants and contractors they have recruited. Investors will always ask about the agreements for the transfer of intellectual property of all the product’s components—codebase, designs, texts, etc. during the due diligence process. It’s suspicious if these agreements weren’t in place. Investor ownership would be at danger in the event that any former workers or contractors choose to sue the business.
B. Financial Due Diligence Mistakes:
Financial due diligence is one of the most important things in the current society. Before completing any deal, firms should be informed about the risks, stability, and financial information. Financial due diligence is carried out extensively to guarantee the correctness of all the financial details included in the confidential information memorandum (CIM). For example, financial statements, company predictions, and projections may be considered in a financial audit.
- Irregularities in filing returns – Due diligence on taxes refers to a comprehensive examination of all possible taxes that might be imposed on a particular firm and all taxing authorities that could have a strong enough connection to hold it accountable for paying those taxes. Buyers in a deal typically use tax due diligence to identify any significant tax obligations that could be a concern. Tax due diligence is more concerned with greater financial statistics than the preparation of yearly income tax returns, which may concentrate on little inconsistencies or errors (e.g., whether a rejected meal and entertainment deduction should have been Rs10,000 instead of Rs5,000). These numbers have the ability to influence a buyer’s negotiating position or choice to proceed with a deal. If the contract only relates to a portion of the shares, the threshold for what is deemed substantial may change based on the entire value of the transaction or the goal.
- Book of accounts not updated on a regular basis – Every registered person is required by the Goods and Services Tax Law to keep accurate and truthful books of accounts and records. If the same is not maintained, the defaulter may face penalties and maybe have their items seized. If, as per section 35(1), books of accounts are not kept up to date, the appropriate official would ascertain the tax owed on unaccounted goods and services in accordance with section 73 or section 74 requirements. Furthermore, failure to preserve or maintain the books of accounts may result in a penalty higher than INR 10,000 or the relevant amount of tax, per penalty section 122(1)(xvi). The Central items and Services Tax Act, 2017’s Section 130 permits the seizure of items and the imposition of fines. Therefore, in accordance with section 130(1)(ii), if the defaulter fails to account for any items for which they are required to pay tax, they will be subject to the seizure of their goods and a penalty under section 122.The investor wouldn’t want to invest in any startup where the books of accounts aren’t maintained which would attract unnecessary penalties and fines.
- Adhoc accounting treatments – Ad hoc journal entries are those impromptu changes to the books of accounts that are made in order to preserve financial correctness. These entries are essential for maintaining accuracy and providing a genuine and impartial picture of the organisation, whether they are made to account for unique or unusual transactions, repair errors, or make necessary modifications outside of the regular accounting cycle. A realistic and fair image of the financials requires, in accordance with basic accounting rules, the creation of provisions for incurred costs under the mercantile system of accounting. As a result, all companies that use the mercantile accounting system must make year-end provisions for the costs incurred related to services rendered through March 31 of the next fiscal year. When the actual invoice is received in a later month or months, the allowance for expenditures is almost always reversed. ITAT Delhi ruled that it is irrational and subject to be removed to prohibit ad hoc spending as a proportion of gross profit in the absence of particular findings.
- Statutory payments not made – Statutory payments are those that, according to applicable law, must be given to government authorities. Almost all countries have statutory deductions from pay. The law mandates these deductions. Different nations have different kinds of statutory deductions, but common ones are income tax, social security tax, government payments to health insurance plans, unemployment insurance, pensions, and provident funds, as well as required union dues. Statutory deductions lower employees’ take-home income, which lowers their ability to maintain a reasonable standard of living. As a result, living wage calculations must account for statutory deductions. As an employer, there are several statutory payments that you may need to pay your employees. Normally, employers may recoup 92% of this, but small businesses may be able to recover 103% of it.
- No compliance for foreign payments – Simply put, foreign payments, also known as cross-border payments, is sending or receiving payments from one country to another. This might be done as a bank or supplier payment, and it often entails a foreign exchange, or FX, of two distinct currencies. Every Indian Resident company that has made a Foreign Direct Investment (FDI) in the preceding year, including the current year, must submit the Foreign Liabilities and Assets (FLA) Return. All borrowers must report all External Commercial Borrowing transactions to the RBI through an AD Category – I Bank every month in the Form ‘ECB 2 Return’. When an Indian business obtains foreign investment and allots shares in response, it must register the allocation with the RBI. Within 30 days following allotment, the corporation must provide the details of the allotment to the RBI in Form FC-GPR (Foreign Currency – Gross Provisional Return).Form ODI must be submitted by an Indian resident who invests overseas. Within 30 days of receiving them, share certificates or any other documentation proving involvement in a foreign joint venture or wholly owned subsidiary must be turned in to the authorized AD. The maximum fine for non-compliance of foreign payments is two lakh rupees, or three times the amount that was violated. For every day after the first that the violation persists, the fine may be as much as Rs 5,000. Therefore, all businesses and Indian citizens who conduct business abroad must make sure that the FEMA regulations are followed.
- TDS non compliances – TDS means Tax Deducted at Source. The goal of the TDS idea was to collect taxes right at the source of income. According to this idea, a person (deductor) who owes another person (deductee) a payment of a certain kind is required to deduct tax at the source and send it to the Central Government. Based on Form 26AS or a TDS certificate that the deductor issues, the deductee whose income tax has been withheld at source is entitled to a credit of the amount withheld. The assessee should pay ₹ 200 per day as a penalty under U/S 234E if he does not file the TDS return within the allotted period. However, the penalty may not be greater than the TDS amount that must be paid. Furthermore, if the assessee provides false information or neglects to file the return within the allotted time frame, he may be penalised between ₹ 10,000 and ₹ 1 lakh under U/S 271H. This penalty will also be applied to the penalty specified in U.S. 234E.
Under certain circumstances, the following can be done to avoid the penalty U/S 271H:
- Send the central government the tax that was withheld at the source.
- If the government is owed money, pay the late penalties and interest.
- Submit the TDS return no later than
C. Compliance Due Diligence:
The process of carrying out a comprehensive examination, audit, or study of a business’s compliance with governmental and non-governmental regulatory organizations is known as compliance due diligence. It basically aims to determine if a business is abiding by the regulations. The possibility that some businesses have discovered ways to get around certain laws is one of the problems that compliance due diligence looks for.
- Failure to maintain minutes and update statutory registers – In accordance with the terms of the Companies Act of 2013, statutory registers are registers that are kept at the company’s registered office and contain particular details of the directors, shareholders, deposits, loans, and guarantees, among other things. The Companies Act of 2013 and the associated regulations outlined in the Companies (Management and Administration) Rules of 2014, together with other applicable requirements, necessitate the maintenance of statutory registers. A corporation must keep the stated statutory registers that are appropriate to them based on their business and activities, even if there are additional registers that must also be kept up to date in accordance with the terms of the Companies Act 2013.Since the corporations Act of 2013 requires the upkeep of the statutory register, any violation of these provisions and regulations carries serious consequences for both the corporations and the defaulting executives of the firm. Keep the necessary statutory registers up to date for the sake of good company governance and to prevent such fines. Penalties under sub-section (5) of section 88 of the Companies Act 2013 stipulate that a company will be fined three lakh rupees and that each officer of the company in default will be fined fifty thousand rupees if it fails to maintain a register of its members, debenture holders, or other security holders, or if it fails to maintain them in accordance with the provisions of sub-section (1) or sub-section (2).
- Missing share certificates – A share certificate is a written document that is legally proof of ownership of the number of shares stated on it, and it is issued and formally signed by authorised signatories on behalf of a firm. A share certificate is issued to a shareholder as proof of purchase and as proof of ownership of a certain number of the company’s shares. Subsection 4 of Section 56 of the Companies Act 2013 states that all companies are required to submit the certificates of any securities that are assigned, transferred, or communicated, unless prohibited by any legislation or by an order from a court, tribunal, or other authority.-(a) For those who subscribe to the company’s memorandum and articles of association, within two months of the date of formation; (b) For any shares that are allotted, within two months of the date of allocation;(c) Within a month of the date on which the firm received the transfer instrument under sub-section (1), or, in the event that a transfer or transmission of securities, the notification of transmission under sub-section (2); (d) In the event that any Debentures are allocated, during a six-month period from the date of allocation. The above section’s proviso stipulates that: (i) in cases where securities are handled by a depository, the company must notify the depository of the specifics of the securities’ allocation as soon as they are made; and (ii) additionally, that certificates of all securities shall be delivered to subscribers by a Specified IFSC public company within sixty days of its incorporation, allotment, transfer, or transmission, and by a Specified IFSC private company within the same sixty-day period. Section 56 of the Companies Act of 2013 contains the punitive penalty pertaining to non-compliance or default, specifically in sub-section (6). Subsection (6) of section 56 of the Companies Act states that in the event that any of the provisions of sub-sections (1) to (5) are not followed, a penalty of fifty thousand rupees will be imposed on the business and each officer involved.
- Lack of govt registrations – When business owners get due diligence questionnaires from investors, data protection will undoubtedly be on the list of topics covered. They want to make sure you have all the procedures and guidelines needed to safeguard the information of your clients and abide by international data protection laws like the CCPA and GDPR. This is particularly true if your firm plans to sell its products in the European Union. You’ll be operating in the EU by default if you’re aiming for a worldwide market.: By implementing appropriate rules and procedures, you may reduce the likelihood of data breaches and improve your ability to collaborate with B2B clients. Investors will also place a high value on your company’s and your business model’s compliance with all applicable laws in the operational jurisdictions. Your startup’s business license and good standing might be suspended if it does not have the necessary permissions. If you work in banking, healthcare, or other delicate industries, this is very likely to happen. Regarding the KYC and AML policies and procedures, they will assist you in adhering to sanctions legislation, anti-corruption laws, and anti-bribery laws. If these protocols are followed, prospective investors and major partners will instantly verify that your firm isn’t included in any harmful databases.
Indian startups must navigate a complex legal and financial landscape, and failing to conduct thorough due diligence can have severe consequences. Here are critical areas to avoid common pitfalls.
- Contract Confusion: Ensure all agreements have consistent terms, are comprehensive, and bear proper stamp duty. Verbal equity promises can lead to disputes; formalize them! Avoid simply copying old agreements – tailor them to each scenario.
- IP Inattention: Inadequately protecting intellectual property leaves your core assets vulnerable. Secure proper registrations and maintain confidentiality agreements.
- Accounting Ambiguity: Maintain updated and accurate books of accounts, avoiding ad hoc treatments. Regularly file tax returns and comply with statutory payments. Address foreign exchange regulations and TDS (Tax Deducted at Source) requirements diligently.
- Paperwork Paralysis: Don’t neglect record-keeping! Maintain meeting minutes, statutory registers, and share certificates. File all necessary statutory forms and obtain government registrations to operate smoothly.
By addressing these due diligence gaps, Indian startups can mitigate risks, ensure compliance, and pave the way for sustainable growth. Remember, due diligence is an investment, not a cost.
FAQs on Due Diligence Mistakes by Indian Startups
Q. Can inconsistent terms in agreements raise red flags?
Yes, inconsistency between agreements (like founders’, investor, or employment) can signal confusion and potential disputes.
Q. Why are inadequate agreements risky?
Vague or incomplete agreements lack clarity and leave room for misinterpretation, leading to conflicts.
Q. Does skipping stamp duty on agreements have consequences?
Absolutely. Unpaid stamp duty renders agreements invalid and unenforceable in court.
Q. Can verbal equity promises create trouble?
Absolutely. Undocumented equity promises lack legal weight and can lead to ownership disputes.
Q. Is copying standard agreements always safe?
Not necessarily. Reproduced agreements might miss crucial details specific to your startup, creating legal gaps.
Q. Do I need strong intellectual property (IP) protection?
Yes. Inadequate IP protection exposes your innovations to misuse and weakens your competitive edge.
Q. What happens if I miss tax return filing deadlines?
Irregularities in filing returns signal mismanagement and raise concerns about potential tax liabilities.
Q. Can outdated accounts hurt my funding chances?
Yes. Investors rely on updated books for financial health assessment. Outdated records create ambiguity and distrust.
Q. Are ad-hoc accounting practices a bad sign?
Definitely. Non-standard accounting practices raise questions about transparency and accuracy of financial data.
Q. Why are timely statutory payments important?
Unpaid statutory dues indicate financial mismanagement and potential legal trouble.
Q. What if I haven’t complied with foreign payment regulations?
Non-compliance with foreign payment regulations can lead to hefty fines and legal repercussions.
Q. Do I need to take care of TDS (Tax Deducted at Source)?
Yes. Missing TDS compliance raises red flags about tax liabilities and potential penalties.
Q. What happens if I neglect meeting minutes and registers?
Poor record-keeping of minutes and registers hinders transparency and raises concerns about governance practices.
Q. Are missing share certificates a big deal?
Yes. Missing share certificates indicate potential ownership issues and complicate investor due diligence.
Q. Can skipping statutory form filings have consequences?
Absolutely. Unfiled statutory forms raise compliance red flags and might invite legal action.
Last Updated on: 15th February 2024, 04:59 pm
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