How Can a Startup Legally Onboard Investors and Draft an Investment Agreement?

Securing funding in today’s rapidly evolving entrepreneurial ecosystem has become both a milestone and a necessity for most of the startups. Raising capital other than just pitching and receiving a cheque also requires a legally sound process that protects startup and investor both. A legally binding investment formalizes the deal as well as sets the foundation for long-term collaboration. This article defines how investors in India are legally onboarded, what are necessary documents required for the process, and how to effectively draft an investment agreement that aligns with best practices and compliance requirements.

Understanding the type of Investment

First and foremost, before any paperwork, it should be decided by the startup what kind of investment structure it is offering. Some common forms of investment structures are:

● Equity financing: Investors provide capital to the startup in return they get ownership shares and become part-owners of the company. They get benefitted, if the company’s value grows however, they are also liable to loss, if company faces loss.

● Convertible Instruments: These are like hybrid financial tools like CCDs (Compulsorily Convertible Debentures) or SAFE Notes, at first, they start as debts, but they automatically get converted into equity at a future date or upon a specific event (like the next funding round).

● Debt Financing: In this model, without taking any ownership stake, investors lend money to the startup for a fixed interest return. Usually over a set term, a startup is legally obliged to repay the loan.

Each funding model has legal and tax implications, hence choosing the best option that aligns with the startup's long-term goals is very crucial for business strategy and long-term growth plans.

Ensuring the Correct Legal Structure

Private Limited Company, governed by the Companies Act, 2013, is most preferred by investors, particularly institutional ones for better governance, transparency and ease of issuing equity shares. Startups that are structured as LLPs or sole proprietorships might be converted into private limited formatting, before the proceedings start, as these structures restrict equity investments.

To ensure that company allow for issuance of new shares, creation of preference shares and accommodate investor rights their Article of Associations (AoA) must be reviewed.

The First Step: Term Sheet

A Term Sheet is a preliminary and non-binding document that highlights the key terms of the investment deal and serves as the basis for drafting legally binding requirements and gives both parties a chance to align their interest in the best; possible way before going any further.

Typically, it includes:

● Startup valuation

● Amount that is going to be invested

● Type of shares (equity or preference)

● Representation rights of board

● Investor protections (voting rights, veto powers, access to information)

● Exit terms (IPO, acquisition, or buyback)

Though, the complete document is not legally binding but there are certain clauses such as confidentiality and exclusivity that can be enforceable and hence, should be taken seriously.

Drafting the Investment Agreement

After finalizing the Term Sheet, the parties can move towards drafting of an Investment Agreement—that is a legally binding contract that sets the terms and conditions under which the investor is going to invest in the startup. Some of the key components include:

● Details of an Investment: It specifies the capital amount, number of share and price of the share.

● Conditions Precedent: This lists the legal and financial steps involved that should be followed by the startup before releasing the funds. (e.g., due diligence, board approvals, corporate approvals, or compliance checks).

● Warranties & Representations: These are legal declarations made by the founders regarding the status of the company. For ex- there are no undisclosed liabilities and that the company holds valid rights over its intellectual property.

● Covenants: These are ongoing commitments taken by startups so that they follow sound governance practices, utilize the funds properly and seek investors' consents before undertaking significant actions like further raising or capital or for changing of business models.

● Dispute Resolution: It specifies the jurisdiction, applicable laws, and the agreeable method for resolving disputes—communally, through arbitration to avoid prolonged litigation.

Shareholders’ Agreement (SHA): Protecting Stakeholder Rights

Along with Investment agreement, a Shareholders Agreement is also signed by startups with an investor. This document ensures clear rules about ownership, control, exit, and the relationship among shareholders.

It covers:

● Voting Rights: To determine what decision requires investor’s approval.

● Transfer Restrictions: It restricts selling or transferring of shares by founders or other shareholders without consent.

● Founder Lock-in: To maintain continuity and stability, a minimum commitment period is imposed during which the founder cannot exit the company.

● Tag-Along and Drag-Along Rights:

1. Tag- Along: This allows minority shareholders (like investors) to sell their shares along with majority shareholders in the event of a sale.

2. Drag-Along: It enables majority shareholders to compel minority shareholders to sell their stake in a full-company sale, to ensure smooth exits.

● Anti-Dilution Protection: Adjust shareholding, if new shares are issued at a lower valuation for investors and protects them from the dilution of their ownership percentage in future funding rounds.

● Access to Information: the right to receive regular financial statements, performance reports, and other business updates are granted to investors to ensure transparency and oversight

Post-Investment Compliance

By just signing agreements, legal documentation doesn’t end. Startups must also:

● Conduct a board meeting for the approval of allotment of shares.

● File Form PAS-3 with the Registrar of Companies (RoC).

● Issue Share Certificates within 60 days of allotment.

● Maintain statutory rights and update the Register of Members.

Compliance under the Foreign Exchange Management Act (FEMA) is essential, For foreign investors Startups receiving foreign direct investment (FDI) must adhere to sectoral caps, pricing guidelines, and entry routes prescribed by the Reserve Bank of India (RBI). filing the Form FC-GPR (Foreign Currency-Gross Provisional Return) through the FIRMS portal and notifying the RBI about the issuance of shares to foreign entities is one of the key-post investment process. Regulatory compliance can be imposed on any kind of delays or non-compliance.

Importance of Legal and Financial Advisors

While investment documents might appear standard, they involve complex legal, financial and regulatory compliances. Hence solely relying on online templates or informal advice can lead startup towards significant risks. A qualified corporate lawyer and chartered accountant should be engaged to ensure that agreements are customized in a way that protect founder’s interests and comply with Indian laws at the same time.

To maintain transparency, build investor confidence, and support sustainable growth as poorly drafted agreements a robust legal framework is need as vague clauses, or missing investor protections can result in legal disputes, equity dilution, or complications in future funding rounds.

In conclusion, a thoughtfully drafted investment agreement and supporting documents provides legal clarity, and helps build investor’s trust at the same time, secures the startup’s interests. Startups that navigate this process correctly position themselves for long-term stability, scalability, and future funding. Founders can focus on driving innovation by being compliant and well-advised. Founders can also focus more on driving innovation—knowing that their legal foundation venture is secure and in today’s competitive world, being legally prepared is not just an option but a mark of professionalism.