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Navigating the CERT-IN Directions: Implications and Challenges for Indian Businesses

Posted on by Treelife

Introduction

Reason for these Cyber Security Directions

In an increasingly digital world, the threats posed by cyberattacks have become a significant concern for organizations worldwide. Recognizing the urgency of the situation, on April 28, 2022, the Indian Computer Emergency Response Team (“CERT-IN”) introduced new directives that mandate all cybersecurity incidents be reported within a stringent timeframe. This move marks a significant shift in India’s approach to cybersecurity, underscoring the need for rapid response and heightened vigilance.

Scenario before these Directions

Prior to these directives, many organizations struggled with limited visibility into cybersecurity threats, leading to incidents that were either inadequately reported or overlooked altogether. The lack of comprehensive analysis and investigation of these incidents often left critical gaps in understanding and mitigating cyber risks. With the implementation of this directive, organizations are now compelled to reassess their internal cybersecurity protocols, ensuring that robust measures are in place to meet these new reporting requirements.

Highlights of the CERT-IN Directions

Applicability

These directions cover all organisations that come within the purview of the Information Technology Act, 2000. 

Individuals, Enterprises, and VPN Service Providers are excluded from following these directions. 

Navigating the CERT-IN Directions: Implications and Challenges for Indian Businesses
Navigating the CERT-IN Directions: Implications and Challenges for Indian Businesses

Types of Incidents to be Reported

The directions provide an exhaustive list of incidents that need to be reported within the timeframe mentioned (refer Annexure I). In addition to these directions, the entities to whom these directions are applicable also need to continue following Rule 12 of the Information Technology (The Indian Computer Emergency Response Team and Manner of Performing Functions and Duties) Rules, 2013, and report the incidents as elaborated therein. 

Timelines and How to Report

Timeline. All incidents need to be reported to CERT-IN within 6 (Six) hours from the occurrence of the incident or of the incident being brought to the respective Point of Contact’s (“POC”) notice. 

Reporting. Incidents can be reported to CERT-IN via Email at ‘[email protected]’, over Phone at ‘1800-11-4949’ or via Fax at ‘1800-11-6969’. Further details regarding reporting and the format to be followed are uploaded at ‘www.cert-in.org.in’.

Designated Point of Contact (POC)

The reporting entities are mandated to designate a POC to interface with CERT-IN. All communications from CERT-IN seeking information and providing directions for compliance shall be sent to the said POC.

Maintenance of Logs

The directions mandate the reporting entities to enable logs of all their information and communications technology systems (“ICT”) and maintain them securely for a period of 180 days. The ambit of this direction is broad and has potential of bringing in such entities who do not have physical presence in India but deal with any computer source present in India. 

ICT Clock Synchronization

Organizations are required to synchronize the clocks of all their ICT systems by connecting to the Network Time Protocol (“NTP”) Server provided by the National Informatics Centre (“NIC”) or the National Physical Laboratory (“NPL”), or by using NTP servers that can be traced back to these sources.

The details of the NTP Servers of NIC and NPL are currently as follows:

NIC – ‘samay1.nic.in’, ‘samay2.nic.in’

NPL – ‘time.nplindia.org’

However, the government has provided some relief, that not all companies are required to synchronize their system clocks with the time provided by the NIC or the NPL. Organizations with infrastructure across multiple regions, such as cloud service providers, are permitted to use their own time sources, provided there is no significant deviation from the time set by NPL and NIC.

Challenges Faced and Recommendations

Challenges

  • Limited Infrastructure and Resources: Many companies, especially tech startups may struggle to develop the necessary capabilities for large-scale data collection, storage, and management needed to report incidents within a six-hour timeframe.
  • Stringent Guidelines compared to International Standards: For example, Singapore’s data protection laws require cyber breaches to be reported within three days, which aligns with the General Data Protection Regulation (GDPR).
  • Increasing complexity of Cybercrime Detection: Identifying cybersecurity breaches can take days or even months. Additionally, the new guidelines have expanded the list of reportable incidents from 10 to 20, now including attacks on IoT devices. Currently, many organizations do not have an integrated framework that can monitor breaches across different platforms and devices, making it even more challenging to detect and report incidents.

Recommendations to comply with the 6 hours Timeframe

  • Reassess Practices and Procedures: Organisations, especially tech startups should review and update their breach reporting protocols to align with CERT-IN directions. This includes evaluating breach severity, clarifying reporting responsibilities among involved parties, and planning for non-compliance risks. 
  • Enhance Organizational Capabilities: Startups need to strengthen their ability to quickly identify and report cyber breaches. This includes training staff, conducting regular security audits, and managing personal device use. Given their limited resources, robust cybersecurity practices are vital for startups to protect against attacks and ensure their growth.
  • Enable and Maintain Logs: CERT-IN requires organizations to enable and maintain logs. Startups should carefully select which logs to maintain based on their industry to ensure they can promptly identify and report cyber incidents, staying compliant with the reporting timeframe.

Consequences for Non-compliance

  • Failure to comply with the directions can result in imprisonment for up to 1 year and/ or a fine of up to INR 1 Crore (approximately USD 1,20,000).  
  • Other penalties under the IT Act may also apply, such as the confiscation of the involved computer or computer system.  
  • If a company commits the offence, anyone responsible for the company’s operations at the time will also be liable. Furthermore, if the contravention occurred with the consent, involvement, or neglect of a director, manager, secretary, or other officer, that individual will also be considered guilty and subject to legal action.

Conclusion

The CERT-IN Directions issued on 28th April 2022 mark a significant step towards strengthening India’s cybersecurity framework. These directions introduce stringent reporting timelines, enhanced data retention requirements, and new compliance obligations for service providers, intermediaries, and other key entities. By mandating swift reporting of cyber incidents within 6 hours and enforcing strict penalties for non-compliance, CERT-IN aims to bolster the security and trustworthiness of India’s digital infrastructure. The intention behind the introduction of these measures is laudable but from a compliance point of view, the direction can be overreaching and may not be the most efficient manner of dealing with cybersecurity threats. 

Annexure

Types of Incidents to be reported include:

  • Attacks or malicious/suspicious activities affecting systems/servers/software/applications related to Artificial Intelligence and Machine Learning.
  • Targeted scanning/probing of critical networks/systems.  
  • Compromise of critical systems/information.  
  • Unauthorised access of IT systems/data. 
  • Defacement of website or intrusion into a website and unauthorised changes such as inserting malicious code, links to external websites etc.  
  • Malicious code attacks such as spreading of virus/worm/Trojan/Bots/Spyware/Ransomware/ Cryptominers.
  • Attack on servers such as Database, Mail and DNS and network devices such as Routers.
  • Identity Theft, spoofing and phishing attacks.
  • Denial of Service (DoS) and Distributed Denial of Service (DDoS) attacks.  
  • Attacks on Critical infrastructure, SCADA and operational technology systems and Wireless networks.
  • Attacks on Application such as E-Governance, E-Commerce etc.  
  • Data Breach.  
  • Data Leak.
  • Attacks on Internet of Things (IoT) devices and associated systems, networks, software, servers.  
  • Attacks or incident affecting Digital Payment systems.  
  • Attacks through Malicious mobile Apps.  
  • Fake mobile Apps.
  • Unauthorised access to social media accounts.
  • Attacks or malicious/suspicious activities affecting Cloud computing systems/servers/software/applications.  
  • Attacks or malicious/suspicious activities affecting systems/servers/networks/software/applications related to Big Data, Blockchain, virtual assets, virtual asset exchanges, custodian wallets, Robotics, 3D and 4D Printing, additive manufacturing, Drones.

Board Observers: Navigating the Influence Without the Vote

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In the complex world of corporate governance, the role of board observers has emerged as a key component, especially in the wake of increased investor scrutiny, particularly in the private equity (PE) and venture capital (VC) sectors. With growing financial uncertainty, investors are looking for ways to maintain a closer watch on companies without assuming directorial risks. One such method is by appointing a board observer, a role that, although devoid of statutory voting power, can wield significant influence.

A board observer’s position in the intricate realm of corporate governance is crucial and varied. With increased distress particularly in the private equity sector, we may see investors deploying various tools to keep a closer eye on the company’s financial performance. Appointing a board observer is one such tool.

Despite not having statutory authority or the ability to vote, board observers have a special position of influence and can provide productive insights.

Board observers quite literally are individuals who are fundamentally appointed with the task to ‘observe’. They act as representatives typically from major investors, strategic partners, or key stakeholders, and are granted access to board meetings.

Understanding the Role of Board Observers

Board observers are not formal members of the board, nor do they hold the power to vote on corporate decisions. However, their presence in board meetings is a tool used primarily by major investors, strategic partners, and other key stakeholders to monitor the company’s strategic direction and financial health. These individuals are entrusted with providing valuable insights without the direct legal responsibilities that directors typically face.

Although board observers do not have a formal vote, their influence can shape company strategies. This unique role enables them to represent the interests of investors or stakeholders while remaining free from the direct obligations of fiduciary duties.

Board Observer Rights – How does it work?

Investors involved in the venture capital (VC) and private equity (PE) spaces often negotiate for a board seat with the intent to contribute to the decision-making process and protect their interests by having representation on the board. A recent trend, however, indicates that these investors are reluctant to formally exercise their nomination rights owing to the possible risks/liabilities associated with directorships, such as fiduciary duties and vicarious liability that is often intertwined in the acts and omissions of the company, which can lead to such directors being identified as “officers in default”.

The rights and responsibilities of a board observer are distinct from those of a nominee director, primarily due to the lack of formal voting authority. Accordingly, board observers are relieved from the direct fiduciary duties that are normally connected with board membership since their position is specified contractually rather than by statutory board responsibilities.

Is a Board Observer an officer in default?

The Act provides a definition for the term “Officer” which inter alia includes any person in accordance with whose directions or instructions the board of directors of the company or any one or more of the directors are accustomed to act. Additionally, the term “Officer in Default” states that an Officer of the company who is in default will incur liability in terms of imprisonment, penalties, fines or otherwise, regardless of their lack of an official position in the company.

Accordingly, any person who exercises substantial decision-making authority on the board of the company may be covered as an Officer in Default.

While board observers may not be equivalent to formal directors, the litmus test lies in determining where the decision-making power truly resides, leading to potential liabilities that may surpass the protections sought by investors. 

Observers are not subject to a company’s breach of any statutory provisions because their appointment is based on a contractual obligation rather than a statutory one, unlike nominee directors who are permitted to participate in board meetings.

Even though board observers are not designated as directors, they run the risk of being seen as “Shadow Directors” if they have a significant amount of authority or influence over the decisions made by the company.

The Legal Perspective on Board Observers

Unlike nominee directors, who are formally appointed and legally bound to fulfill statutory responsibilities, board observers are appointed through contractual obligations. This shields them from liabilities tied to breaches of statutory provisions. However, as their influence grows, so does the risk of being classified as shadow directors, particularly if they are perceived as playing a significant role in decision-making.

Conclusion

Corporate Governance is an evolving concept, especially in the context of active investor participation. In order to foster a corporate environment that is legally robust, it will be imperative to strike a balance between active investor participation and legal prudence. That being said, as businesses continue to navigate complex and evolving landscapes, the value of a well-integrated board observer cannot be overstated. A board observer can bring clarity to the business and operations of an investee company without attaching the risk of incurring statutory liability for acts/omissions by the company. This is a significant factor that makes the option of a board observer nomination more attractive to PE and VC investors, vis-a-vis the appointment of a nominee director.

FAQs on Board Observers

  1. What is a board observer in corporate governance?
    A board observer is an individual appointed by investors or key stakeholders to attend board meetings without having formal voting power. They offer insights and monitor the company’s performance, primarily to protect the interests of those they represent.
  2. How do board observers differ from directors?
    Unlike board directors, board observers do not have the authority to vote on decisions or take on fiduciary duties. Their role is more about observation and providing feedback rather than participating in the decision-making process.
  3. What are the rights of a board observer?
    A board observer has the right to attend board meetings and access key company information, but they do not hold any voting rights. Their responsibilities and rights are typically outlined in a contractual agreement between the company and the observer’s appointing party.
  4. Can board observers influence corporate decisions?
    Yes, board observers can provide valuable insights and advice that may influence corporate decisions, but they do not have direct decision-making power. Their influence comes from their ability to offer expert advice and represent investors’ interests.
  5. Are board observers liable for company decisions?
    Generally, board observers are not legally liable for company decisions as they are not formal board members. However, if their influence over board decisions becomes significant, they could be viewed as shadow directors, which might expose them to certain legal liabilities.
  6. Why do investors appoint board observers instead of directors?
    Investors often prefer appointing board observers because it allows them to monitor company performance and offer guidance without taking on the fiduciary duties and potential liabilities associated with being a formal board member.
  7. What is the risk of being considered a shadow director as a board observer?
    If a board observer has significant influence over board decisions, they could be classified as a shadow director. Shadow directors can be held liable for the company’s actions, similar to formally appointed directors, especially in cases of misconduct or financial mismanagement.
  8. How does a board observer benefit private equity and venture capital investors?
    Board observers allow PE and VC investors to maintain oversight of their portfolio companies, ensuring the company’s strategic direction aligns with their interests. This role provides investors with valuable insights without the risk of statutory liabilities that come with directorship.

Types of Agreements used in SaaS Industry

Posted on by Treelife

In the ever-evolving landscape of the SaaS industry, understanding the various types of agreements is crucial for businesses to operate effectively and legally. From customer contracts to partner agreements, these legal documents form the backbone of SaaS operations. By navigating the intricacies of these agreements, businesses can protect their intellectual property, establish clear terms of service, and mitigate potential risks. In this comprehensive guide, we will explore the key types of agreements used in the SaaS industry, providing valuable insights for both established companies and startups.

What is SaaS? 

Software as a Service (“SaaS”), is a way of delivering software applications over the internet. Instead of purchasing and installing software on your computer, you access it online through a subscription. This makes it easier to use and manage, as updates, security, and maintenance are handled by the service provider. Examples of SaaS include tools like Google Workspace or Microsoft 365, where everything is accessible from a web browser. This model is convenient for businesses because it reduces upfront costs and offers scalability based on their needs.

What are SaaS Agreements? 

However, beneath the surface of this convenient access lies a complex web of agreements that govern the relationship between SaaS providers and their customers, which are essential to ensuring a smooth and secure experience for all parties involved. These agreements outline the terms of using a cloud-based software service. These agreements specify the rights and responsibilities of both parties, covering aspects such as subscription fees, data privacy, service availability, support, and usage limitations.

This article delves into the various types of agreements that form the backbone of the SaaS industry and it will explore their key components, importance, and how they work together to create a win-win situation for both SaaS providers and their subscribers.

What are the types of Agreement in SaaS Industry

In the SaaS industry, various types of agreements are commonly used to establish the terms of service, licensing, and other legal arrangements between the SaaS provider and its customers. Here are some key types of agreements used in the SaaS industry:

Terms of Service (ToS) or Terms of Use (ToU)

These agreements outline the terms and conditions under which users are allowed to access and use the SaaS platform. They typically cover aspects such as user obligations, limitations of liability, intellectual property rights, privacy policies, and dispute resolution procedures.
Key Components: User obligations, limitations of liability, intellectual property rights, privacy policies, dispute resolution procedures.
Importance: Provides clarity and sets apt expectations for users regarding acceptable use of the SaaS platform, protecting the provider from misuse and establishing guidelines for resolving disputes.

Service Level Agreement (SLA)

SLAs define the level of service that the SaaS provider agrees to deliver to its customers, including uptime guarantees, response times for support requests, and performance metrics. SLAs also often outline the remedies available to customers in the event that service levels are not met.
Key Components: Uptime guarantees, response times for support requests, performance metrics, remedies for breaches.
Importance: Defines the quality of service expected by customers, establishes accountability for the SaaS provider, and offers assurances to customers regarding system reliability and support responsiveness

Master Services Agreement (MSA)

An MSA is a comprehensive contract that governs the overall relationship between the SaaS provider and the customer. It typically includes general terms and conditions applicable to all services provided, as well as specific terms related to individual transactions or services.
Key Components: General terms and conditions, specific terms related to individual transactions or services, payment terms, termination clauses.
Importance: Forms the foundation of the contractual relationship between the SaaS provider and the customer, streamlining the process for future transactions and ensuring consistency in terms across multiple agreements.

Subscription Agreement:

This agreement outlines the terms of the subscription plan selected by the customer, including pricing, payment terms, subscription duration, and any applicable usage limits or restrictions.
Key Components: Pricing, payment terms, subscription duration, usage limits, renewal terms.
Importance: Specifies the terms of the subscription plan selected by the customer, including pricing and payment obligations, ensuring transparency and clarity in the commercial relationship.

Data Processing Agreement (DPA)

DPAs are used when the SaaS provider processes personal data on behalf of the customer, particularly in relation to data protection regulations such as GDPR. These agreements specify the rights and obligations of both parties regarding the processing and protection of personal data.
Key Components: Data processing obligations, data security measures, rights and responsibilities of both parties regarding personal data as laid down in India’s Digital Personal Data Protection Act 2023, and GDPR compliance.
Importance: Ensures compliance with data protection regulations, establishes safeguards for the processing of personal data, and defines the roles and responsibilities of each party in protecting data privacy.

Non-Disclosure Agreement (NDA)

NDAs are used to protect confidential information exchanged between the SaaS provider and the customer during the course of their relationship. They prevent either party from disclosing sensitive information to third parties without consent.
Key Components: Definition of confidential information, obligations of confidentiality, exceptions to confidentiality, duration of the agreement.
Importance: Protects sensitive information shared between parties from unauthorized disclosure, fostering trust and enabling the exchange of confidential information necessary for business collaboration.

End User License Agreement (EULA)

If the SaaS platform includes downloadable software or applications, an EULA may be required to govern the use of that software by end users. EULAs specify the rights and restrictions associated with the use of the software.
Key Components: Software license grant, permitted uses and restrictions, intellectual property rights, termination clauses.
Importance: Establishes the rights and obligations of end users regarding the use of software, ensuring compliance with licensing terms and protecting the provider’s intellectual property rights.

Beta Testing Agreement

When a SaaS provider offers a beta version of its software for testing purposes, a beta testing agreement may be used to outline the terms and conditions of the beta program, including feedback requirements, confidentiality obligations, and limitations of liability.
Key Components: Scope of the beta program, feedback requirements, confidentiality obligations, limitations of liability.
Importance: Sets the terms for participation in beta testing, manages expectations regarding the beta software’s functionality and stability, and protects the provider from potential risks associated with beta testing activities.

These are some of the most common types of agreements used in the SaaS industry, though the specific agreements required may vary depending on the nature of the SaaS offering and the requirements of the parties involved.

Conclusion

In conclusion, the Software as a Service (SaaS) industry relies on a variety of agreements to establish and govern the relationships between SaaS providers and their customers. Each agreement plays a crucial role in defining the terms of service, protecting intellectual property, ensuring data privacy and security, and mitigating risks for both parties involved. From Terms of Service outlining user responsibilities to Service Level Agreements guaranteeing performance standards, and from Data Processing Agreements ensuring compliance with regulations like GDPR to Non-Disclosure Agreements safeguarding confidential information, these agreements collectively form the legal backbone of the SaaS ecosystem. By clearly delineating rights, obligations, and expectations, these agreements promote transparency, trust, and effective collaboration in the dynamic landscape of cloud-based software delivery. As the SaaS industry continues to evolve, these agreements will remain essential tools for fostering mutually beneficial partnerships and driving innovation in the digital economy.

FAQs on Types of SaaS Agreements

Q. What is the significance of agreements in the SaaS industry?

Agreements play a crucial role in defining the legal relationships between SaaS providers and their customers, outlining rights, obligations, and terms of service.

Q. What are the key types of agreements used in the SaaS industry?

Common agreements in the SaaS industry include Terms of Service (ToS), Service Level Agreements (SLAs), Master Services Agreements (MSAs), Subscription Agreements, Data Processing Agreements (DPAs), Non-Disclosure Agreements (NDAs), End User License Agreements (EULAs), and Beta Testing Agreements.

Q. What is the purpose of a Terms of Service (ToS) agreement in the SaaS industry?

ToS agreements establish the rules and guidelines for using the SaaS platform, including user responsibilities, intellectual property rights, and dispute resolution procedures.

Q. How do Service Level Agreements (SLAs) benefit customers in the SaaS industry?

SLAs define the level of service that the SaaS provider commits to delivering, including uptime guarantees, support response times, and performance metrics, offering assurances to customers regarding service quality.

Q. What does a Master Services Agreement (MSA) encompass in the SaaS industry?

MSAs serve as comprehensive contracts governing the overall relationship between SaaS providers and customers, covering general terms, specific transaction details, payment terms, and termination clauses.

Q. What is the purpose of Non-Disclosure Agreements (NDAs) in the SaaS industry?

NDAs protect confidential information exchanged between parties during the course of their relationship, preventing unauthorized disclosure and fostering trust in business collaborations.

Q. How do End User License Agreements (EULAs) affect users of SaaS platforms?

EULAs define the terms of use for software provided by SaaS platforms, including permitted uses, restrictions, and intellectual property rights, ensuring compliance and protecting the provider’s interests.

Q. What is the role of Beta Testing Agreements in the SaaS industry?

Beta Testing Agreements establish terms for participating in beta programs, outlining feedback requirements, confidentiality obligations, and limitations of liability for both parties involved in testing new software releases.

Q. How can businesses ensure they are effectively using these agreements in the SaaS industry?

Businesses should carefully review, customize, and regularly update these agreements to reflect evolving legal requirements, industry standards, and the specific needs of their SaaS offerings and customer base.

Difference between Internal Audit And Statutory Audit 

Posted on by Treelife

In the accounting realm, there are two primary types of audits: internal audits and statutory audits. Both audits are essential for reviewing an organization’s financial records, but they differ significantly in their objectives, scope, and target audience.

While we all know about Internal and Statutory audit, understanding the difference between internal audit and statutory audit is important because they serve different purposes and are crucial for businesses aiming to enhance their financial transparency and compliance. Internal audit is a form of assurance to the board and management of a company that the company’s processes, systems, operations, and financials are in compliance with the company’s policies and procedures. Statutory audit, on the other hand, is conducted to ensure that the company’s financial statements are true and fair, and comply with the relevant statutes and regulations.

Internal Audit: Key Features and Importance

An internal audit involves a thorough examination of an organization’s financial records and internal controls by an independent entity, typically an internal audit department. The primary aim of an internal audit is to provide an unbiased evaluation of an organization’s operations, helping management pinpoint areas for improvement. Here’s a closer look at the key features of internal audits:

Objectives of Internal Audits

The main goal of an internal audit is to ensure that an organization’s internal controls and risk management processes are operating effectively. These audits assess the efficiency, effectiveness, and economy of an organization’s operations, offering valuable insights into potential enhancements.

Scope of Internal Audits

The scope of an internal audit is defined by the organization’s internal audit department and can encompass all aspects of operations, including financial, operational, and compliance areas. This comprehensive approach ensures that all relevant risks and controls are evaluated.

Frequency of Internal Audits

Internal audits are generally conducted on a regular schedule, such as quarterly, semi-annually, or annually. This consistent oversight helps organizations maintain robust internal controls and adapt to changing risks.

Reporting of Internal Audits

After the audit is completed, reports are generated for management, outlining findings and recommendations. These insights are crucial for driving improvements in the organization’s operations, ensuring ongoing compliance and operational excellence.

By understanding the significance of internal audits, organizations can better leverage these evaluations to enhance their financial integrity and operational efficiency.

Statutory Audits: Key Features and Importance

A statutory audit is a mandatory examination of an organization’s financial records conducted by an independent auditor appointed by a government or regulatory body. The primary goal of a statutory audit is to provide assurance that an organization’s financial statements present a true and fair view. Here’s an overview of the key features of statutory audits:

Objectives of Statutory Audits

The main objective of a statutory audit is to deliver an independent opinion on the organization’s financial statements. This opinion assures stakeholders—including shareholders, investors, and lenders—that the financial statements are accurate and reliable.

Scope of Statutory Audits

The scope of a statutory audit is defined by the relevant regulatory body or government agency that mandates the audit. Typically, it encompasses a thorough review of the financial statements and accompanying notes, ensuring comprehensive scrutiny of the organization’s financial health.

Frequency of Statutory Audits

Statutory audits are generally conducted annually, although the frequency can vary based on specific regulatory requirements or the nature of the organization’s operations.

Reporting of Statutory Audits

After the audit is complete, the auditor prepares a report intended for stakeholders such as shareholders, investors, and lenders. The auditor’s opinion is included in the organization’s annual report, which is made publicly available, enhancing transparency and accountability.

By understanding the importance of statutory audits, organizations can ensure compliance with regulatory standards and build trust with their stakeholders.

This guide provides an overview of the differences between the two types of audits, including the scope and objectives of each.

Internal Audit vs. Statutory Audit: Comparative Table

Sr No.ParticularsInternal AuditStatutory Audit
1MeaningInternal Audit is carried out by people within the Company or even external Chartered Accounts (CAs) or CA firms or other professionals to evaluate the internal controls, processes, management, corporate governance, etc. these audits also provide management with the tools necessary to attain operational efficiency by identifying problems and correcting lapses before they are discovered in an external auditStatutory Audit is carried out annually by Practising Chartered Accountants (CAs) or CA Firms who are independent of the Company being audited. A statutory audit is a legally required review of the accuracy of a company’s financial statements and records. The purpose of a statutory audit is to determine whether an organization provides a fair and accurate representation of its financial position
2QualificationAn Internal Auditor need not necessarily be a Chartered Accountant. It can be conducted by both CAs as well as non-CAs.Statutory Audits can be conducted only by Practising Chartered Accountants and CA Firms.
3AppointmentInternal Auditors are appointed by the management of the Company. Form MGT-14 is to be filed with ROCStatutory Auditors appointed by the Shareholders of the Company in its Annual General Meeting. Form ADT-1 is to be filed with ROC.
4PurposeInternal Audit is majorly conducted to review the internal controls, risk management, governance, and operations of the Company and to try and prevent or detect errors and frauds.Statutory Audit is conducted annually to form an opinion on the financial statements of the Company i.e whether they give an accurate and fair view of the financial position and financial affairs of the Company.
5Reporting ResponsibilitiesReports are submitted to the management of the Company being audited.Reports are submitted to the shareholders of the Company being audited.
6Frequency of AuditConducted as per the requirements of the management.Conducted annually as per the statute.
7IndependenceAn internal auditor may or may not be independent of the entity being audited.A statutory auditor must always be independent.
8Removal of auditorInternal auditors can be removed by the managementStatutory Auditors can be removed by shareholders in an AGM only.
9Regulatory requirementsInternal audit is not a regulatory requirement for all private limited companies. The requirements for internal audits are prescribed in Section 138 of the Companies Act, 2013.All Companies registered under the Companies Act are required to get Statutory audits done annually.

Key Difference Between Internal Audit And Statutory Audit

Similarities Between Internal Audit And Statutory Audit 

Having discussed the differences between internal audit and statutory audit, let’s now take a look at the similarities between the two.

  • The primary similarity between internal audit and statutory audit is that they both require an independent area of operation that should, ideally, be free from any sort of managerial interference or organizational control.
  • Both internal and statutory audits follow the same procedural path—planning, research, execution, and presentation. These paths may vary slightly from one auditor to another, but they largely stick to the same pattern.
  • Be it an internal audit or a statutory audit, both types are dependent on the availability and access of clear, reliable, and accurate data. If an organization offers its resources in a transparent manner, the audit would be fair and just.
  • The long-term purpose of internal and statutory audits is to prevent mistakes, maintain clarity, enhance efficiency, and present a precise snapshot of the firm’s financial position.

When should you conduct Statutory Audit?

Statutory audits are essential for ensuring financial transparency and compliance with regulatory standards. Here are the key circumstances under which statutory audits should be conducted:

  1. Annually: Statutory audits are generally required on an annual basis to verify the accuracy of financial statements and ensure compliance.
  2. At Year-End: Conduct audits at the end of the financial year to evaluate the organization’s overall financial health and performance.
  3. Regulatory Mandates: Whenever dictated by government regulations or industry standards, statutory audits must be performed to meet compliance obligations.
  4. Following Significant Changes: Initiate audits after major organizational changes, such as mergers, acquisitions, or restructuring, to assess financial impacts.
  5. In Response to Stakeholder Concerns: If shareholders, investors, or lenders express concerns regarding financial accuracy, a statutory audit should be conducted without delay.
  6. Before Major Financial Transactions: Conduct statutory audits prior to significant financial activities (e.g., IPOs, large loans) to provide assurance to stakeholders.
  7. When Compliance Issues Arise: If there are signs of non-compliance with laws or regulations, initiate an audit to investigate and address potential issues.
  8. At the Start of New Financial Periods: Audits can help establish a clear financial baseline when entering a new financial period.
  9. When Planning for Expansion: Before expanding operations or entering new markets, a statutory audit can assess financial readiness and compliance.

When should you conduct Internal Audit?

Internal audits are vital for evaluating an organization’s internal controls and operational efficiency. While Statutory Audit is compulsorily required to be conducted annually, as an organization you should choose to conduct an Internal Audit if you want to:

  1. Analyze the fairness of your firm’s internal controls, processes, and operations
  2. Compare your actual performance with budgets and estimates
  3. Evaluate policies, strategies, and compliances
  4. Devise appropriate measures to meet organizational objectives
  5. Identify risks within the organization, focusing on high-risk areas that require closer examination
  6. Conduct audits prior to launching new projects or initiatives to ensure that appropriate controls and procedures are in place
  7. Identify concerns or areas for improvement
  8. Identify and report errors, frauds, wastage, or embezzlement, if any.

Conclusion 

While internal audit helps the management in ensuring operational efficiency, controls, corporate governance etc. are working effectively in their organization , statutory audit ensures that their financial statements give a true and fair view and are compliant with all applicable laws and regulations.

Treelife’s multidisciplinary team has the right domain expertise in the startup ecosystem and can provide you with the necessary insights and guidance to make the right decisions for your business and auditing requirements.

Frequently Asked Questions (FAQs)

1. Can an Internal Auditor and Statutory Auditor be the same?

A statutory auditor of the Company cannot be its internal auditor

2. Can a statutory auditor rely on an internal auditor?

A statutory auditor can use the report of an internal auditor in a meaningful manner to identify key risk areas and key internal controls in place and accordingly plan their statutory audit procedures. The Standards on Auditing applicable in India (SA-610) also prescribes the extent and manner in which a statutory auditor can use the work of an internal auditor.

3. Can the Board of Directors appoint a statutory auditor of the Company?

Only the first statutory auditor of the Company can be appointed by the board of directors within 30 days from the date of incorporation. In the first Annual General Meeting (AGM) of the Company, the shareholders are required to appoint the statutory auditor of the Company and thereafter statutory auditors can only be appointed in the AGM of the Company by shareholders.

4. What is the difference between an internal and external auditor?

An internal auditor is someone who is appointed by the management of the Company and might also be an employee of the Company. An external auditor can never be an employee of the Company and should be independent of the Company/entity they are auditing.

5. Why Are Audits Important for Organizations?

Organizations require audits for various reasons, including compliance with regulatory requirements, attracting investors, securing loans, and enhancing internal controls.

6. Who Conducts Audits?

Audits are typically carried out by certified public accountants (CPAs) or other qualified auditors trained to evaluate financial records and operational processes.

7. What Does the Audit Process Involve?

The audit process generally consists of four main stages: planning, fieldwork, reporting, and follow-up. During planning, auditors define the scope and objectives. In the fieldwork stage, they examine financial records and operations. The reporting phase involves issuing a report with findings and recommendations, while follow-up ensures that any suggested improvements are implemented.

8. What Is the Purpose of an Audit Report?

The primary purpose of an audit report is to provide stakeholders—such as shareholders, investors, and lenders—with assurance that an organization’s financial statements are accurate and complete.

9. What Is an Audit Trail?

An audit trail is a comprehensive record of all transactions and activities within an information system. It serves to track changes, identify errors, and maintain the integrity of the system.

10. What Is a Management Letter?

A management letter is a report issued by an auditor to management, detailing findings and offering recommendations for enhancing internal controls and operational efficiency.

11. How Frequently Should Organizations Conduct Audits?

The frequency of audits varies based on organizational needs and regulatory requirements. Internal audits may be conducted regularly—quarterly, semi-annually, or annually—while statutory audits are usually performed on an annual basis.

Navigating GIFT City: A Comprehensive Guide to India’s First International Financial Services Centre (IFSC)

Posted on by Treelife

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As India marches towards its goal of becoming a $5 trillion economy, innovation and global connectivity in finance have become critical components of this journey. At the heart of this transformation lies the Gujarat International Finance Tec-City (GIFT City)—India’s first operational International Financial Services Centre (IFSC). Launched in 2007, GIFT City is not just a hub for international finance; it represents India’s vision of becoming a leader in global finance, technology, and innovation. GIFT IFSC provides a comprehensive platform for financial activities, including banking, insurance, capital markets, FinTech, and Fund Management Entities (FMEs). Its attractive tax incentives and solid regulatory framework make it a gateway for both inbound and outbound global investments, drawing businesses and investors from around the world.

At Treelife, we are excited to present “Navigating GIFT City: A Comprehensive Guide to India’s First International Financial Services Centre (IFSC).” This guide offers insights into the current legal, tax, and regulatory framework within GIFT IFSC, highlighting the strategic advantages of establishing a presence here, with a focus on the FinTech and Fund Management sectors. Whether you’re an investor, financial institution, or corporate entity exploring opportunities, we believe this guide will be a valuable resource in navigating the exciting prospects within GIFT IFSC.

What Does GIFT City Offer?

GIFT City is positioned as a global hub for financial services, offering a range of services across banking, insurance, capital markets, FinTech, and Fund Management Entities (FMEs). By combining smart infrastructure and a favorable regulatory environment, GIFT City is becoming the go-to destination for businesses seeking ease of doing business, innovation, and access to global markets.

Here are some key takeaways from the guide:

1. Introduction to GIFT City and IFSCA

GIFT City is the epitome of India’s ambition to establish a world-class international financial center. The International Financial Services Centres Authority (IFSCA) is the primary regulatory body that oversees operations within GIFT City, ensuring a seamless and globally competitive financial environment. IFSCA’s unified framework offers businesses ease of compliance and flexibility, making it an attractive hub for both domestic and international entities.

2. Regulatory Framework for Permissible Sectors with Treelife Insights

Our guide provides an in-depth look at the regulatory landscape governing GIFT City’s key sectors, including banking, insurance, capital markets, and many more, with a special focus on FinTech, and Fund Management Entities (FMEs). Alongside Treelife insights, we highlight how the city’s regulatory framework promotes innovation, offering businesses a fertile ground for growth. 

3. Setup Process

Our guide walks you through the step-by-step setup process for entities looking to establish operations. Whether you are a startup, a financial institution, or a multinational company, guide through GIFT City’s infrastructure and compliance processes.

4. Tax Regime

One of the standout advantages of operating within GIFT City is its favorable tax regime. Businesses enjoy significant tax exemptions, including a 100% tax holiday on profits for 10 out of 15 years, exemptions on GST, and capital gains tax benefits. These incentives are designed to attract global businesses and investors, positioning GIFT City as a competitive alternative to other international financial hubs. Our guide details these tax benefits and how businesses can leverage them for maximum advantage.

Why This Guide is Essential

Our guide provides a comprehensive overview of the opportunities within GIFT City, focusing on FinTech and Fund Management sectors. It also includes a detailed analysis of the tax incentives, setup processes, and regulatory requirements that make GIFT City an attractive destination for global financial institutions.

Whether you’re an investor looking to tap into India’s expanding economy, or a business exploring new markets, this guide will serve as your roadmap to success within GIFT City.

Download the Guide

Discover how GIFT City is shaping the future of finance and how you can be part of this exciting journey. Download our guide to learn more about the opportunities, regulatory framework for the permissible sectors, incentives, and innovations that await in India’s first IFSC.


For any questions or further information, feel free to reach out to us at [email protected].

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Understanding ESOPs in India: Process, Tax Implications, Exercise Price, Benefits

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Introduction

In the contemporary competitive job market, companies are constantly seeking innovative ways to attract and retain top talent. Employee Stock Option Plans (hereinafter ESOPs) have emerged as a popular tool, offering employees a stake in the company’s success and fostering a sense of ownership. ESOPs have become a game-changer, offering employees a chance to foster a sense of ownership in the company and to partake in its success.  But ESOPs are more than just a fancy perk in a landscape where talent reigns supreme; understanding how the process flow works, the tax implications involved in India, and the factors that influence the exercise price – the price employees pay for the stock – is crucial for both employers and employees.  

What are ESOPs?

Simply put, ESOPs are financial instruments that grant employees the right to purchase company shares at a predetermined price (also known as the exercise price) within a specified period (also known as the vesting period). These are typically structured as a performance-based equity incentive program, where employees are granted stock options as part of their compensation package.

ESOPs serve as a means to align the interests of employees with those of the company’s shareholders and can play a significant role in driving employee engagement, productivity, and long-term company performance. Additionally, ESOPs can be used as a tool for attracting and retaining top talent, as well as incentivizing employees to contribute to the company’s growth and success.

Benefits of ESOPs

ESOPs serve as a means to align the interests of employees with those of the company’s shareholders and can play a significant role in driving employee engagement, productivity, and long-term company performance. Additionally, ESOPs can be used as a tool for attracting and retaining top talent, as well as incentivizing employees to contribute to the company’s growth and success.

How do ESOPs Work?

The ESOPs work in following manner, primarily Finalizing Terms, ESOP Policy Adoption, Grant of ESOPs, Vesting of ESOPs, Exercise of ESOPs, Payment and Allotment of Shares.

  1. Finalizing Terms: The company agrees on terms of ESOP policy such as grant, vesting, exercise, etc. 
  1. Adoption of ESOP policy: The company through board and shareholder resolutions, adopts the ESOP policy.
  1. Grant of ESOPs: The eligible employees (as determined by the ESOP policy and/or the board of the company) will be granted options through issue of grant letters. 
  1. Vesting of ESOPs: In accordance with the vesting schedule set out in the ESOP policy/grant letter issued by the company, and upon completion of the milestones thereunder, the employees will be eligible to purchase the ESOPs.
  1. Exercise of ESOPs: In accordance with the procedure set out in the ESOP policy and the grant letter, the employee will exercise the ESOP options.
  1. Payment of Exercise Price: In accordance with the conditions set forth in the grant letter and the ESOP policy, the employee will pay the exercise price to purchase the vested ESOP options.
  1. Allotment of Shares: Upon receipt of the exercise price, the company will allot the relevant shares to the name of the employee. It is important to note here that the shares given to the employees will be within the ESOP pool. Any proposed ESOPs that exceed the available pool will require that the pool first be increased. 

Please see the image below describing the process flow of ESOPs:

Understanding ESOPs in India: Process, Tax Implications, Exercise Price, Benefits
Understanding ESOPs in India: Process, Tax Implications, Exercise Price, Benefits

We have provided a brief description of the important terms used in the ESOP process flow below:

TermBrief description 
Grant dateDate on which agreement is entered into between the company and employee for grant of ESOPs by issuing the grant letter 
Vesting periodThe period between the grant date and the date on which all the specified conditions of ESOP should be satisfied
Vesting dateDate on which conditions of granting ESOPs are met 
Exercise The process of exercising the right to subscribe to the options granted to the employee
Exercise pricePrice payable by the employee for exercising the right on the options granted
Exercise periodThe period after the vesting date provided to an employee to pay the exercise price and avail the options granted under the plan 

What is the eligibility criteria for the grant of ESOPs?

The grant of ESOPs by a publicly listed company is governed by the Securities and Exchange Board of India, which prescribes strict conditions within which such public companies can reward their employees with stock option grants. 

However, private companies are governed within the limited purview of the Companies Act, 2013 and the corresponding Companies (Share Capital and Debenture) Rules, 2014. Under this, the ESOPs can be granted to:

  • a permanent employee of the company who has been working in India or outside India; or
  • the director of the company including a whole-time director but not an independent director; or
  • a permanent employee or a director of a subsidiary company in India or outside India or of a holding company.

However, the legal definition of an employee excludes the following categories of “employees”:

  • an employee who is a promoter or a person belonging to the promoter group; or
  • a director who either himself or through his relative or through any body corporate holds more than 10% of the outstanding equity shares of the company, whether directly or indirectly.

Note: These exceptions are not applicable to start-ups for a period of 10 years from the date of their incorporation/registration.

Tax Implication of ESOPs – Explained through an Example

The example below demonstrates on a broad level how ESOPs are typically taxed in India:

Employee Mr. A is granted ESOP of Company X (not assumed to be an eligible startup as per Section 80-IAC of Income Tax Act, 1961), which entitles him to get 1 equity share per option:

No. of Options = 100

Exercise Price = INR 10

Fair market value (FMV) of the share on exercise date = INR 500

FMV of share on the date of sale = INR 600

Assuming that all options have vested to Mr. A and are exercised in the same year, the tax liability would be as below:

On Exercise of ESOPsOn Sale of ESOPs
Number of shares = 100Number of shares = 100
FMV = INR 500 per shareFMV = INR 600 per share
Exercise price paid by employee = INR 10 per shareFMV on date of exercise of option = INR 500 per share
Gain to employee = INR 490 per shareGain to employee = INR 100 per share
Taxable income = INR 4,90,000 (taxable as salary income)Taxable income = INR 1,00,000 (taxable as capital gains)

Deferred Tax Liability for Startups

In order to ease the burden of payment of taxes, employees of “eligible startups” (i.e., startups fulfilling eligibility criteria as specified under Section 80-IAC of the Income Tax Act, 1961 and obtaining an Inter-Ministerial Board Certificate) can defer the payment of tax or employers can defer the deduction of TDS for employees arising at the time of exercise of ESOPs. In other words, there is no taxable event for eligible startups on the date on which the employee exercises the options.

The tax liability will arise within 14 days from the earliest of any of the following events :
(a) after completion of 48 months from the end of relevant accounting year; or
(b) date of sale of shares by the employee; or
(c) date from when the assessee ceases to be an employee of the ESOP-allotment company.

Determining the exercise price of a stock option

The exercise price is a crucial element of a stock option and denotes the predetermined rate at which an employee can procure the company’s shares as per the ESOP agreement. This price is established at the time of granting the option and remains fixed over the tenure of the option. 

Factors Influencing Exercise Price

  • Fair Market Value (FMV): This is a key benchmark. Ideally, the exercise price should be set close to the FMV of the stock on the grant date. However, there can be variations depending on the company’s life stage, liquidity, and overall ESOP strategy. The exercise price is often tethered to the prevailing market value of the company’s shares. If the existing market value exceeds the exercise price, the option is considered “in the money,” rendering it more lucrative for the employee. Conversely, if the market value falls below the exercise price, the option is “out of the money,” potentially reducing its attractiveness.
  • Company Objectives: The ESOP policy outlines the rationale behind granting stock options and the intended benefits for employees. A lower exercise price can incentivize employees and align their interests with the company’s growth.
  • Dilution Impact: Granting options increases the company’s outstanding shares. The exercise price should consider the dilution impact on existing shareholders. The inherent volatility in Indian stock markets significantly impacts the exercise price. Heightened volatility tends to inflate option premiums, including the exercise price, owing to the increased likelihood of significant price fluctuations in the underlying shares.
  • Accounting and Legal Considerations: Indian Accounting Standards (Ind AS) and tax implications need to be factored in to ensure proper financial reporting and tax treatment. Tax consequences can vary based on the timing of the exercise and the type of ESOP. 

Conclusion

In a nutshell, ESOPs have emerged as a significant instrument in India’s corporate landscape, fostering a sense of ownership and alignment between employees and companies. Understanding the key features including the process flow, tax implications and exercise price determination associated with ESOPs is paramount for companies to highlight maximized potential benefits to employees. 

Frequently Asked Questions (FAQs) about ESOPs in India

Q. How is Exercise Price determined?
A. Exercise Price can be whatever price the Company chooses at the time of issuing the grant letter. Some firms use a minimal exercise price (for example, INR 10) while others choose an exercise price depending on the company’s latest round value. The greater the difference between FMV and exercise price at the time of ESOP sale, the more money you create.

Q. How is a Vesting Schedule fixed?
A. The most typical vesting plan is uniform yearly vesting over four years, which means that after the first year of mandatory ‘cliff’ vesting, you will get 25% of the total ESOPs guaranteed to you every year for the next four years.

Q. What happens to the ESOPs when an employee leaves the Company?
A. This is typically governed by the ESOP Policy adopted by the Company. In short, unvested ESOPs are returned to the ESOP pool when an employee leaves and the employee may exercise the vested options in accordance with the ESOP Policy.

Q. Can ESOPs be subject to transfer restrictions?
A. This would again be subject to the ESOP Policy but yes, a Company can subject these shares to restrictions such as Right of First Refusal or Right of First Offer, in order to create visibility on any transfers for the Company.

Q. How is ESOP liquidity made available to employees?
A. This is again, subject to the ESOP Policy. It is important to note that employees can only profit from the ESOPs if a liquidity event (such as secondary transaction, repurchase or IPO) occurs.

Q. What are the tax benefits of ESOP for the employer?

A. ESOPs amount treated as a perquisite upon exercise of the option is considered a salary cost and is an allowable expenditure in the company’s hands. However, the company must deduct TDS on the same as per the provisions for TDS on salary.

Q. Are ESOPs part of CTC?

A. Yes, ESOPs may be included in the Cost to Company (CTC) of an employee.

Q: What is the tax treatment for ESOPs in the hands of the employee at the time of exercise?

A: The difference between the Fair Market Value (FMV) of the shares on the date of exercise and the exercise price (amount paid by the employee) is taxed as a perquisite or a part of the employee’s salary income at the time of exercise.

Q: What is the tax treatment when the employee sells or transfers the shares later on?

A: When the employee subsequently sells or transfers the shares, the difference between the actual sale considerations realized and the FMV considered at the time of exercise is treated as capital gain.

Q: Can the Fair Market Value be adjusted for indexation during subsequent sale or transfer?

A: Yes, the Fair Market Value can be adjusted for indexation if the holding period of the shares is more than 12 months for shares of listed companies and more than 24 months for shares of unlisted companies.

Q. How do I defer tax on ESOP?

A. One way to defer tax liability on perquisites related to ESOPs is to opt for an Inter-ministerial Board Certificate and defer the tax liability on perquisites till 14 days from earlier of the below events instead of date of exercise of option: (i) expiry of five years from the end of year of allotment of shares under ESOPs; (ii) date of sale of the such shares by the employee; or (iii) date of termination of employment.

Q. Is TDS applicable on ESOP?

A. Yes, the employer must deduct TDS as per the provisions for TDS on salary on the perquisite amount at the time of exercise of the option.

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Dispute Resolution in the Articles of Association (AOA)

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Introduction

As part and parcel of a transaction, companies seeking investment provide their investors with certain rights, which are contractually negotiated. These range from receiving periodic reports on the business and financials of the company to representation on the board of directors and the right to be involved in certain key decisions required to be taken by the company in the course of their growth. Such rights are typically requested by investors based on factors such as the nature of the investment (i.e., financial or strategic) and the level of insight into the business, operations and management of the company required. In such transactions, these rights (and the extent) are agreed upon and captured in a shareholders’ agreement (“SHA”) between the parties, whereas the rights and obligations pertaining to the fundraising itself are governed by the investment agreement.

 Typically, investors (especially foreign) and companies/founders agree to arbitrate any disputes arising from the investment agreement or the SHA. However, referring a dispute to arbitration is often not as clear-cut as a contractual agreement between parties. Indian courts have repeatedly been required to provide rulings on whether or not arbitration can be invoked by the parties to a SHA. This issue is complicated further by conflicting judicial precedents which have ultimately resulted in an unclear understanding of the law forming the basis of how parties can agree to arbitrate any disputes.

 In this article Dispute Resolution in the Articles of Association (AOA), we have provided an overview of the contested legal position and our suggestions for navigating the murky landscape, with the fundamental goal of ensuring the parties’ contractually documented intent is protected and legally enforceable.

Relationship between a Shareholders’ Agreement and the Articles of Association (‘AOA’)

What is the AOA?

Similar to how the constitution of India forms the basis of Indian democracy, the memorandum of association (‘MOA’) and AOA form the basis for a company’s legal existence. The MOA can be seen as the constitutional document that lays down the fundamental elements and broad scope within which the company, business, and operations will typically operate. However, it is the AOA that puts in place a ‘rulebook’, prescribing the regulations and by-laws that govern the company and in effect, enshrining and giving effect to the principles of the MOA. 

It is crucial to understand that because a company is seen as a separate legal person, the AOA is a critical document that establishes the legal relationship between the shareholders of the company inter se and with the company. In order to lay the framework for the operations of the company, an AOA will include provisions (in accordance with applicable laws) that: 

(i)    regulate internal affairs and operations of the company; 

(ii)   provide clarity on procedures the company must follow; 

(iii)  govern the issue/buyback of securities and clarify the legal rights and obligations of shareholders holding different classes of securities; and 

(iv)  legitimize the authority of the board of directors and their functions. 

It is, therefore, a reasonable presumption that any action undertaken by a company must be authorised by the AOA/MOA. Any amendment or alteration to these documents would not only require the assent of the board, but also of the shareholders (i.e., members of the company), and requires filing with the competent Registrar of Companies under the Companies Act, 2013. While these procedures are in place primarily to protect the shareholders from mischief by the company, the lengthy process involved in altering the AOA serves to highlight how essential a document it is for a company’s action to hold legal justification.  

How does the shareholders’ agreement typically become enforceable? 

Often in transaction documents, a critical mechanism that enables the enforcement of the investor rights agreed in the SHA is captured in the investment agreement, where as part of the conditions required to be satisfied upon receipt of the investment amount by the company, the company, and founders must also ensure that the AOA is suitably amended to codify the investor rights. 

However, the legal justification for this action in itself finds a conflict between two different schools regarding the enforceability of provisions from the SHA that have not been incorporated into the AOA: 

(i) The “incorporation” view – the prominent authority for this view is the ruling of the High Court of Delhi in World Phone India Pvt. Ltd. & Ors. v. WPI Group Inc. USA (the “World Phone Case”)[1], where it was held that a board resolution passed without considering an affirmative voting right granted to a shareholder under a joint venture agreement, was legally valid in light of the company’s AOA, which contained no such restriction. Relying on the decision of the Supreme Court in V.B. Rangaraj v. V.B. Gopalakrishnan (the “Rangaraj Case”)[2] and subsequent decision of the Bombay High Court in IL&FS Trust Co. Ltd. v. Birla Perucchini Ltd. (the “Birla Perucchini Case”)[3], the Delhi High Court was of the view that the joint venture agreement could not bind the company unless incorporated into the AOA. 

The Rangaraj Case is of particular interest in this school of thought because while the issue dealt with share transfer restrictions, the Supreme Court held that it was evident from the provisions of the erstwhile Companies Act, 1956 that the transfer of shares is a matter regulated by the AOA of the subject company and any restriction not specified in the AOA was not binding on the company or its shareholders. Crucially, the World Phone Case poses a problem in the legal interpretation of the “incorporation” view because the Delhi High Court has carried the ratio of the Rangaraj Case to a logical conclusion and observed that even where the subject company is party to an SHA, the provisions regarding management of affairs of the company cannot be enforced unless incorporated into the AOA. 

(ii)   the “contractual” view – the prominent authority for this view is the ruling of the Supreme Court in Vodafone International Holdings B.V. v Union of India (the “Vodafone Case”)[4], where the Supreme Court disagreed with the ratio in the Rangaraj Case, without expressly overruling it, and held that freedom of contract includes the freedom of shareholders to define their rights and share-transfer restrictions. This was found to not be in violation of any law and therefore not be subject to incorporation within the AOA. This has also been supported by the Delhi High Court in Spectrum Technologies USA Inc. v Spectrum Power Generation[5] and in Premier Hockey Development Pvt. Ltd. v Indian Hockey Federation[6]. In fact, in the latter case, the Delhi High Court was of the view that the subject company, being party to both an SHA and a share subscription and shareholders agreement containing an obligation to modify the AOA to incorporate the SHA, was conclusive in binding the subject company to the same despite an absence of incorporation into the AOA. 

How can this fundamental disagreement be reconciled?

It is difficult to reconcile the issues caused by conflicting rulings from the same judicial authority. Given that the circumstances of each case provide scope for situation-specific reasoning, we cannot conclusively say one view is preferred, or more appropriate, over the other. Further, where the courts have stopped short of conclusively overruling previous judgments (for instance the Supreme Court on the Vodafone Case only disagreed with the ratio of the Rangaraj Case), the result is an unclear understanding of the legal position regarding the enforceability of SHA without incorporation in the AOA.   

It is also pertinent to note that the issues in the above rulings also deal with the enforceability of certain shareholder rights that have been contractually agreed upon (such as affirmative votes or share transfer restrictions). By contrast, dispute resolution is a mechanism contractually agreed upon between the parties in the event of any dispute/breach of the SHA and cannot be characterized as a “right” of any shareholder(s), in the true sense of the word. However, in light of the conflicting principles guiding the “incorporation” and “contractual” views, the lack of clarity extends to the inclusion of dispute resolution in the AOA simply to make the intent of parties to approach arbitration, enforceable. 

Incorporation of arbitration clauses

Flowing from the “incorporation” view, the Delhi High Court, relying on the Rangaraj Case, World Phone Case, and the Birla Perucchini Case, held in Umesh Kumar Baveja v IL&FS Transportation Network[7] that despite the subject company being a party to the SHA, it was the AOA that governed the relationship between the parties and that since they did not contain any arbitration provision, the parties could not be referred to arbitration. A similar ruling was passed by the Company Law Board, Mumbai in Ishwardas Rasiwasia Agarwal v Akshay Ispat Udyog Pvt. Ltd.[8], where it was held the non-incorporation of the arbitration clause into the AOA of the subject company was fatal to the request for a reference to arbitration, despite findings that the dispute was contractual in nature and arbitrable. 

A second line of reasoning flowing from the “contractual” view has attempted to uphold the contractual intent of the parties reflected in an SHA. In Sidharth Gupta v Getit Infoservices Pvt. Ltd.[9], the Company Law Board, Delhi was required to rule on the reference to arbitration. Relying on the facts that the SHA had been incorporated verbatim into the AOA and the subject company was a party to the SHA, the Company Law Board rejected the argument from an “incorporation” view and remarked on the importance of holding shareholders “to their bargain” when significant money had been invested on the basis of the parties’ understanding recorded in the SHA. It is pertinent to note in this case, that the Company Law Board had been directed by the Supreme Court to dispose of the case without being influenced by the decisions of the Delhi High Court. This led the Company Law Board to not consider the ruling of the Delhi High Court in the World Phone Case as binding. 

An unusual third line of reasoning has also been provided by the High Court of Himachal Pradesh in EIH Ltd. v State of Himachal Pradesh & Ors.[10]. In this case, a dispute regarding a breach of AOA was referred to arbitration under the arbitration clause of the constitutive joint venture agreement to which the resultant company was not a party. The High Court held that the joint venture agreement and the AOA of the subject company were part of the same transaction, where the primary contractual relationship was contained in the joint venture agreement, and that the AOA functioned as a “facilitative sister agreement” to the same. Given the critical nature of the AOA to the internal governance of the subject company as a juristic person however, this line of reasoning where the AOA is relegated to a “sister agreement” is likely to not stand the test of a comprehensive judicial review of this issue.

Navigating the landscape and concluding thoughts

The startup growth trajectory continues to contribute significantly to the Indian economy, with funding crossing USD 5.3 billion in the first six months of 2024 and over 915 investors participating in funding deals[11]. This will see a proportional rise in investor-company disputes, and when reference to arbitration is contractually agreed but not enshrined in the SHA, this can lead to further delays at the stage of dispute resolution, where the competent court would be required to first rule on whether the reference to arbitration can even be enforced. However, the conflicting judicial precedents are only the tip of this murky iceberg; party autonomy is a fundamental guiding principle to any reference to arbitration. Where judicial precedent sets the grounds for formal incorporation into the AOA as a condition to enforcing this party intent, however, a question of whether the parties’ contractually documented intent is being ignored, is raised. 

Further, the legal basis for the “incorporation” view is itself under question. A key component from the Rangaraj Case is that the Supreme Court based its ruling on the issue of share transfer restrictions and basis the provision of Companies Act, 1956 that stated a company’s shares are “transferable in the manner provided by the articles of the company”. This position has also been questioned by a larger bench of the Supreme Court in the Vodafone Case and by academics and has been distinguished and disregarded by lower High Courts on slim grounds. Consequently, the judicial precedent has been applied to a non-share transfer context as well, forming the basis for the incorporation view on arbitration clauses.  

In conclusion, while it is our opinion that a contract-centric approach is more reflective of party intent, especially with reference to arbitration, the insistence on incorporating provisions of the SHA into the AOA would pose a potential roadblock in the event the parties are required to approach dispute resolution. Pending clarity from the judiciary on this issue, the best approach to dealing with this situation is adopting a conservative approach of incorporating dispute resolution provisions within the AOA, preventing delays in the event of a dispute between the parties. 

[1] World Phone India Pvt. Ltd. v. WPI Group Inc. USA 2013 SCC OnLine Del 1098.

[2] V.B. Rangaraj v. V.B. Gopalakrishnan (1992) 1 SCC 160.

[3] IL&FS Trust Co. Ltd. v. Birla Perucchini Ltd. 2002 SCC OnLine Bom 1004

[4] Vodafone International Holdings B.V. v. Union of India (2012) 6 SCC 613.

[5] Spectrum Technologies USA Inc. v. Spectrum Power Generation, 2000 SCC OnLine DEL 472

[6] Premier Hockey Development Pvt. Ltd. v. Indian Hockey Federation, 2011 SCC OnLine Del 2621

[7] Umesh Kumar Baveja v. IL&FS Transportation Network, 2013 SCC OnLine Del 6436

[8] Ishwardas Rasiwasia Agarwal v. Akshay Ispat Udyog Pvt. Ltd., C.A. 328/2013 in CP 117/2013 (Compay Law Board, Mumbai Bench) (Unreported).

[9] Sidharth Gupta v. Getit Infoservices Pvt. Ltd., C.A.128/C-II/2014 in CP No. 64(ND)/2014 (Company Law Board, New Delhi Bench) (Unreported).

[10] EIH Ltd. v. State of Himachal Pradesh, Arb Case 60/2005 (H.P. H.C.) (Unreported).

[11] https://inc42.com/buzz/at-5-3-bn-indian-startup-funding-stays-flat-yoy-in-h1-2024/#:~:text=According%20to%20Inc42’s%20’H1%202024,the%20first%20half%20of%202024.

Equity Dilution in India – Definition, Working, Causes, Effects

Posted on by Treelife

Equity dilution is a critical concept in the realm of finance, particularly in the context of corporate structures and investments. In the dynamic landscape of India’s burgeoning economy where businesses constantly seek avenues for growth and expansion, understanding the intricacies of equity dilution becomes paramount for entrepreneurs, investors, and stakeholders alike.

This article delves into the multifaceted aspects of equity dilution providing a comprehensive overview of its definition, mechanics, underlying causes, and real-life examples. By unraveling the complexities surrounding this phenomenon, the article will give valuable insights into its implications for companies, shareholders, and the broader market dynamics.

What Is Equity Dilution?

Equity dilution refers to the reduction in ownership percentage and/or value of existing shares in a company as a result of any circumstance resulting in either a drop in the valuation of the shares itself or upon new securities being issued, causing a decrease in the overall stake. Equity dilution is a mathematical consequence of commonly undertaken corporate decisions such as raising funding, incentivizing employees through stock options, or acquisition/liquidation of any businesses. While equity dilution is a common phenomenon in corporate finance, its implications can be far-reaching and have significant effects on the company’s stakeholders. 

In the context of India, where innovation, entrepreneurship and investment in the startup ecosystem are thriving, equity dilution plays a pivotal role in shaping the trajectory of businesses across industries. Founders often resort to equity dilution as a means to access much-needed capital for growth and expansion. By selling a portion of their ownership stake to investors, founders can infuse funds into the business, fueling innovation, scaling operations, and penetrating new markets.

However, equity dilution is not without its challenges. For existing shareholders, the prospect of their ownership stake being diluted can be concerning, as it can dilute not only the impact of their voting rights and stake on future earnings, but also the value of the shares themselves, potentially triggering disagreements between shareholders and founders regarding the company’s worth.

When Does Equity Dilution Happen?

Equity dilution or share dilution is a is caused by any of the following actions: 

  • Conversion by holders of optionable securities: Holders of optionable securities (i.e., securities they have a right to purchase and hold title in their name once successfully purchased) may convert their holdings into common shares by exercising their stock options, which will increase the company’s ownership stake. This includes employees, board members, and other individuals.
  • Mergers and acquisitions: In case of a merger of corporate entities or amalgamation/acquisition thereof, the resultant entity may buy out the existing shareholders or have a lower valuation, leading to a lower price per share and an economic dilution of the equity stake.
  • Issue of new stock: A company may issue new securities as part of a funding round. Where any equity shares or equity securities are issued, the existing shareholders’ would see a dilution to their shareholding on a fully diluted basis (i.e., all convertible securities are converted into equity shares for the purpose of calculation).

Working of Equity Dilution

Given the nuanced commercial terms involved, a company may opt to pursue any of the following in the ordinary course of business, and as a result experience equity dilution:

  • Issuing New Shares for Capital: This is the most common cause of dilution. Companies raise capital by issuing new securities to investors. The more shares issued, the smaller the percentage of ownership held by existing shareholders ultimately becomes. Economic dilution happens here when the shares are issued at a lower price than the one paid by the existing shareholders.
  • Employee Stock Options (ESOPs): When companies grant employees stock options as part of their compensation package, they are essentially creating a pool of shares that will only be issued in the future to employees. The right to purchase these securities (at a discounted price) is first granted to an employee, creating an option. Upon fulfillment of the conditions of the ESOP policy, employees exercise their options and purchase these shares in their name. The creation or increase of an ESOP pool will lead to a mathematical dilution in the overall percentage distribution, affecting a shareholder’s individual stake in the company.
  • Convertible Debt: Some debt instruments, such as convertible notes or compulsorily convertible debentures, can be converted into equity shares at a later date and on certain predetermined conversion terms. This conversion leads to an increase in the total number of equity shares, leading to dilution of the individual percentage stakes. Depending on the terms of the convertible debt securities, there could also be an economic dilution of the value of the equity shares held by existing shareholders.
  • Stock Splits: While a stock split doesn’t technically change the total value of a company’s equity, it does increase the number of outstanding shares. For example, a 2-for-1 stock split doubles the number of shares outstanding, which dilutes ownership percentages without affecting the overall company value.
  • Acquisitions Using Shares: When a company acquires another company using its own shares as currency, it issues new shares to the acquired company’s shareholders. This increases the total number of outstanding shares and dilutes existing shareholders’ ownership. This is commonly seen with schemes of arrangement between two sister companies under common ownership and control.
  • Reacquired Stock Issuances: If a company repurchases or buys back its own shares (reacquired stock) and then issues them later, it can dilute the existing shareholders’ ownership. This impact can be both stake-wise and economic, especially if the shares are essentially reissued at a lower price than the original price.
  • Subsidiary Formation: When a company forms a subsidiary and issues shares in that subsidiary, it technically dilutes its own ownership stake. However, this is usually done for strategic reasons and doesn’t necessarily impact the value of the parent company.

Example of Equity Dilution

Infographic Illustration

Fundamentally, each company is made of 100% shares (remember the one whole of something is always 100%).  Let’s understand this with an example to get clarity.

  • 2 Founders viz. A and B are holding 5,000 shares each with 50% of ownership in the Company.
  • An investor, C comes with an investment of 1Mn dollars considering the valuation of 3Mn dollars
Equity Dilution in India - Definition, Working, Causes, Effects
Equity Dilution in India - Definition, Working, Causes, Effects

Now have a look at the figures in below table to understand this quickly:

Here, the number of shares has been increased basis the ratio to post investment i.e. 25% (1Mn/4Mn). The investor can keep any ratio post investment basis the agreement.

We can understand that post investment round, the holding % of founders are getting diluted and their controlling interest has been reduced from the original scenario.

There are various types of dilution, including dilution of shares in a private company. It’s also important to know the equity dilution meaning and examples of equity dilution in startups.

There is no exact solution to how much equity to dilute; it depends on the stage of the business you are at. Too much dilution can be of concern to a future incoming investor and too little dilution concerns investors as they should have skin in the game. The ultimate goal is to grow the business. So even if the dilution numbers are skewed from the expected dilution you have in mind, the growth of the business is primary, and investment helps you get closer to that goal.

Pre-money valuation is the value of the company prior to receiving the investment amount. It is derived through various internationally accepted valuation methods like the discounted cash flow method. Investors offer equity based on pre-money valuation; however, the percentage sought is based on post-money valuation.

Understanding dilution and cap tables are pertinent metrics for fundraising and talking to investors. Founders often neglect it due to a lack of clarity of these concepts. A grasp on concepts like dilution and the cap table enables the founder to have better control of the startup equity. 

Effects of Equity Dilution 

During share dilution, the amount of extra shares issued and retained may impact a portfolio’s value. Dilution affects a company’s EPS (earnings per share) in addition to the price of its shares. For instance, a company’s earnings per share or EPS could be INR 50 prior to the issuance of new shares, but after dilution, it might be INR 18. However, if the dilution dramatically boosts earnings, the EPS might not be impacted. Revenue may rise as a result of dilution, offsetting any increase in shares, and earnings per share may remain constant.

Public companies may calculate diluted EPS to assess the effects of share dilution on stock prices in the event of stock option exercises. As a result of dilution, the book value of the shares and earnings per share of the company decline.

Equity dilution, a fundamental consequence of issuing new shares, is a double-edged sword for companies. While it unlocks doors to growth capital, it also impacts existing shareholders’ ownership and potential control. Understanding the effects of dilution is crucial for companies navigating fundraising rounds and strategic decisions. 

Example: If a company having 100 shares issued, paid up and subscribed, each representing 1% ownership, issues 20 new shares, the total number of issued, paid up and subscribed shares becomes 120. Consequently, the existing shareholders’ ownership stake is diluted post-issue, as each share now represents only 0.83% (100/120) of the company. This translates to a decrease in:

  • Ownership Percentage: Existing shareholders own a smaller portion of the company.
  • Voting Power: Their voting rights are proportionally reduced, potentially impacting their influence on company decisions.
  • Earnings Per Share: If company profits remain constant, EPS might decrease as profits are spread over a larger number of shares. This can affect short-term stock price performance.

How to minimize equity dilution? 

Companies can employ various strategies to minimize dilution and maximize the benefits of issuing new shares:

  • Strategic Valuation: A higher valuation during fundraising allows the company to raise the target capital while offering fewer shares. However, maintaining a realistic valuation is crucial to attract investors without inflated expectations.
  • Debt Financing: Exploring debt options like loans or convertible notes can provide capital without immediate dilution. However, debt carries interest payments and other obligations.
  • Structured Equity Instruments: Utilizing options like preferred shares can offer different rights and value compared to common shares, potentially mitigating the dilution impact on common shareholders.
  • Phased Funding with Milestones: Structuring investments in tranches tied to achieving milestones allows the valuation to climb incrementally, reducing dilution in later rounds.
  • Focus on Organic Growth: Prioritizing revenue and profit growth naturally leads to higher valuations. This requires less equity dilution to raise capital in the future.

Pros of Equity Dilution:

Equity dilution, while often viewed with apprehension by existing shareholders, can also bring several advantages to a company. By issuing new shares and thereby diluting existing ownership, companies can access capital and unlock opportunities for growth and expansion:

  • Access to Capital: Equity dilution allows companies to raise funds by selling shares to investors. This infusion of capital can be instrumental in financing expansion projects, funding research and development initiatives, or addressing financial challenges.
  • Diversification of Shareholder Base: Bringing in new investors through equity dilution can diversify the company’s shareholder base. This diversification can enhance liquidity in the stock, broaden the investor pool, and potentially attract institutional investors or strategic partners.
  • Alignment of Interests: Equity dilution can align the interests of shareholders and management, particularly in startups or early-stage companies. By offering equity stakes to employees, management can incentivize them to work towards the company’s long-term success, fostering a culture of ownership and commitment.
  • Reduced Financial Risk: Diluting ownership through equity issuance can reduce the financial risk for existing shareholders. By sharing the burden of ownership with new investors, shareholders may benefit from a more diversified risk profile, particularly in cases where the company’s prospects are uncertain.

Cons of Equity Dilution:

While equity dilution offers certain advantages, it also presents challenges and drawbacks that companies and shareholders must carefully consider. From the perspective of existing shareholders, dilution can erode ownership stakes and diminish control over the company. Let’s delve into some of the key drawbacks of equity dilution:

  • Loss of Ownership and Control: One of the primary concerns associated with equity dilution is the loss of ownership and control for existing shareholders. As new shares are issued and ownership is spread among more investors, the influence of individual shareholders over corporate decisions may diminish.
  • Dilution of Earnings Per Share: Equity dilution can lead to a reduction in earnings per share for existing shareholders. This dilution occurs when the company’s profits are spread across a larger number of shares, potentially decreasing the value of each share and impacting shareholder returns.
  • Potential for Share Price Decline: The issuance of new shares through equity dilution can signal to the market that the company is in need of capital or that its growth prospects are uncertain. This perception may lead to a decline in the company’s share price, adversely affecting shareholder wealth.
  • Strain on Shareholder Relations: Equity dilution can strain relations between existing shareholders and management, particularly if the dilution is perceived as unfair or detrimental to shareholder interests. Managing investor expectations and communicating the rationale behind equity issuances is crucial to maintaining trust and credibility.

Conclusion

Equity dilution poses a significant impact on the ownership stakes of founders and investors alike. Whether you are already implementing a corporate equity plan or considering setting one up, equity dilution is a critical aspect to consider. Understanding the fundamentals of equity dilution and how it functions, particularly in the context of stock option dilution, is essential for informed decision-making.

Share dilution, occurring whenever a corporation issues new shares to investors, can significantly affect the value of your financial portfolio. During this process, the corporation must adjust its earnings-per-share and share price ratios accordingly. While share dilution is often viewed unfavorably, it can also signify potential acquisitions that may enhance stock performance in the future. To mitigate any potential surprises, it is prudent to remain vigilant for indicators of stock dilution. By staying informed and proactive, stakeholders can navigate the complexities of equity dilution with confidence and clarity.

Frequently Asked Questions (FAQs) on Equity Dilution in India

1. What is equity dilution?

Equity dilution refers to the reduction in ownership percentage of existing shareholders in a company due to the issuance of new shares. This dilution can occur during fundraising rounds, employee stock option plans (ESOPs), mergers, acquisitions, or other corporate actions.

2. How does equity dilution work in Indian companies?

Equity dilution typically occurs when a company issues additional shares, either through primary offerings to raise capital or secondary offerings for employee incentives or acquisitions. This issuance increases the total number of shares outstanding, reducing the ownership percentage of existing shareholders.

3. What are the primary causes of equity dilution in India?

Equity dilution in India can be caused by various factors, including fundraising activities such as initial public offerings (IPOs), follow-on offerings, private placements, or debt conversions. Additionally, the implementation of ESOPs, mergers, acquisitions, and convertible securities can also contribute to equity dilution.

4. Can you provide examples of equity dilution in Indian companies?

Examples of equity dilution in India include IPOs of startups or established firms where new shares are issued to the public, leading to dilution for existing shareholders. Similarly, when companies offer ESOPs to employees or acquire other businesses through stock issuance, equity dilution occurs.

5. What are the implications of equity dilution for shareholders in India?

Equity dilution can impact shareholders in India by reducing their ownership percentage and voting rights in the company. It may also lead to dilution of earnings per share (EPS) and share price, potentially affecting shareholder value and returns on investment.

6. How can companies minimize equity dilution in India?

Companies in India can minimize equity dilution by carefully managing their capital structure, negotiating favorable terms during fundraising rounds, implementing efficient ESOP schemes, and exploring alternative financing options such as debt financing or strategic partnerships.

7. Are there any regulatory considerations related to equity dilution in India?

Yes, companies in India must comply with regulatory requirements set forth by the Securities and Exchange Board of India (SEBI) and other relevant authorities when issuing new shares or implementing equity-related transactions. Compliance with disclosure norms and corporate governance standards is essential to ensure transparency and accountability.

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