Commercial Disputes in Startups

Thank you so much.

Okay, so I think disputes don't start when the money arrives. I think they start on day one. It is always late. The money just removes the reasons to keep the, keep pretending that they aren't there. So I think when there's nothing to divide, everybody's job is just survival.

That's what we see in startups. I think the ambiguity is in the founding arrangement that they have. That costs you nothing, the ambiguity in the beginning. I think value of the business makes the ambiguity expensive. So it's always the trigger, I believe.

In my experience, I've seen there's always a trigger, although, as I said, the disputes are always latent. But the trigger is almost never the money itself. The trigger is generally one event. So that could be a funding round, an acquisition offer, a co-founder wanting something else, maybe he wants to go part time, he wants to divert his attention somewhere else. A new investor demanding a thorough cleanup, because there are certain, there would be certain shareholdings between friends and family, for example.

So maybe an investor would want a cleanup of that they wanted more structured. So this would force founders, you know, to answer certain questions that they were sweeping under the carpet for all this while. So whatever you were deferring all this while, I think all of that comes to the front and that becomes the trigger for such a dispute to arise. I think sometimes it all becomes a problem of plenty.

You know, a struggling company does not have the resources or the wherewithal to actually fund a fight. As we know, is expensive. So I think once that the money comes into the business, then probably businesses also think towards discussing it legally or taking it legally. Also, I think at the seed stage, when the documents that are drafted, they are at that stage really not worth the paper they are on because the company itself does not have any underlying assets. So in that sense, say there are three shareholders, there are three founding partners.

So the 33% split with no vesting, no deadlock mechanism, no exit rights, all of that doesn't sound very harmless at that stage when it's a zero valuation. But I think when it comes to the valuation goes to 500 crores, for example, then that document becomes a done. So, you know, that really, I think, is a sum total of what you asked.

So essentially, you're asking that what happens when, when there is when you don't put in the, as I said, essentially, as I said earlier, once you don't have the parameters in the agreement, correct in the beginning, and you rely upon relationships more. So that is where it hurts you eventually, as I said earlier, in the beginning, it won't really hurt you as much because you really don't have the business is not worth anything to fight for. So I think success by itself doesn't change people, it changes their options.

So as I said, a zero valuation, you don't have any alternatives. So everybody then, you know, cooperates with each other. And of course, they also want the business to be successful to run. So at that stage, they also try to cooperate and work towards that common goal.

I think when when that amount becomes a larger amount, then every founder has an outside offer, they have a rival investor, they have their personal balance sheets to look at. So then exiting from that particular company becomes rational at that stage. So this is exactly at the point in which you know, the contract has to start doing the work that the relationship was doing earlier. Because because now the contract will dictate what your relationship will at least legally is.

No, this is very important. I think if you own 40% of the company, I think you have that sense of some kind of you have a sense of ownership of the company, that's 40%. And even it's a you're the, you're in that sense, the largest shareholder, but not the majority shareholder, but you feel that you have that sense of authority with the company. I think what you do is you own the economics, but you don't do not own the control over the company. They are very different. Yeah. And generally, I've seen founders trade one way for the other without really noticing.

See, 40% gets you 40% of whatever survives when the liquidation preference waterfall mechanism and it works. And that's probably a statutory right to information of the company. So that is really it.

So control comes from three separate places, you know, the board, the reserve matter list, the statutory voting thresholds. I think the numbers that every founder should know is so 50% of the voting rights carry ordinary resolution, including appointment removal of director, that's section 169. 75% is needed for special resolutions. So if you have to amend the articles altering the capital of the company. So if we look at them the other way, anybody else owning 26% is has a veto in that sense, for all the special resolutions of the company.

So that is a blocking stake for that matter. So he could very well, I mean, the other investor or the other founder could very well block every special resolution without owning anything close to a majority. So even if you're 40, if the other person is 26, he can block almost everything that that probably would want to structurally change.

I mean, that brings me to your question. I think the board, the board itself is the real seat of power, because that is where the duty authority sits in a company. And it's not with the shareholders. So if you're an investor, let's say with two out of five seats, plus the right to appoint the independent director, you're 40% shareholding, then just become decorative. If the investor has that, and you don't have that if he has control over three out of five directors, then you're 40% really is decorative.

So I mean, you have then the only protection that you're left with then is then probably to go under sections 241 and 242 of the Companies Act and then ask for oppression and mismanagement, all of that. So that is a different point. I mean, that then you have to, that's a fallback option in law. I mean, but that is never as simple as it sounds. And that it's a long protracted litigation and NCLT and there are multiple factors at play.

So what we are looking at now is what you should do to preempt that and not as a response. So I think that is what your question is.

Absolutely. I think this mismatch is stark. Founders I've seen will spend three weeks arguing about the last 2% of the dilution and maybe just 20% on the board composition. So 2% of a company you don't control is really worth less than the veto you just gave away for free. So, you know, so as I said, 26% doesn't let you do anything.

It doesn't let you do anything, but it lets you stop everything. So in a company where the, in this particular company, the veto probably might be worth more than the vote. So it's like, you know, being in a fancy car, you're a passenger with an excellent view, but you're not driving the car. So that is, yeah, I mean, we've all known how Steve Jobs was ousted from his own company.

He started the company from scratch, but he was driven out of his own company because he was not calling the shots in that sense. So, yeah, that's very important.

No, I think this is actually a very tricky question because I mean, I can give a very virtuous answer in law. But in reality, I think this gets very tricky, especially when you're starting out to have complete trust in somebody who you're working with. So that is the reason really you set out to start a venture with them. So I think writing it down is not distrust.

I think it is the thing that lets trust survive the first serious disagreement. Because let's face it, there will be disagreements in every business. So it lets you glide over that first disagreement. So it's not something, writing itself, I think should not be taken as distrust.

Although I must concede, I think relationship-based businesses genuinely work in India and we've seen them. We've seen how generations of maybe the same family members or friends or partners to start off with, they all started on something which was orally decided and that continued in fact for generations. And it works for a good reason. I think that sense of reputation inside a community or that initial trust, that are real investment mechanisms.

Often they are faster and cheaper than a court of law. But then having said that, I think then something happens where it breaks. And then once that breaks, then you have to think of how do you redeem that. So I think where I see them generally break is succession, not the promise when between two people, one person dies or retires.

So I'm not even saying that one person goes back on his promise. But let's see that the person who promised it is no longer there. So the heirs then were never a part of the conversation. So how do they trust your word for it?

Especially when it goes against you or it is uncomfortable. Second is when the companies scale, the promise generally was made say when the company was worth say five lakhs. Now the company is worth five crores. So things then change there. And also when there's an institutional entry, for example, when a VC comes in, a bank comes in, an acquirer comes in.

And the institutions themselves, they can't structurally act on undocumented understandings. So I mean, even if they want to, their own compliances will forbid it. So in those circumstances, it becomes very tricky. Although again, having said that, an oral contract is perfectly enforceable in India.

I'm not saying that every contract or every little piece of thing has to be documented. But as you're aware, enforceability is never the problem. Proof is. So and that is where writing becomes mandatory. Having somebody said one thing, say six years back, maybe even if the two people remain and they're still there,

what they said six months back, six years back, maybe their recollection would be very different from both the same parties who were there. Their recollection of the same incident would be very different. So that is where it is very important that you document, especially the more important and the more substantial things that you must document.

Yes, very important. So I think this 90 percent chance of winning is just your lawyer's number, right? It's not a business number as such. And I'm saying that, I'm sticking my neck out and saying that as someone who does this for a living. So I guess this might by itself be a little misleading.

Even otherwise, even if I take your word for it, then it is 90 percent chance of winning, 90 percent chance of winning a dispute of 10 crores is not 9 crores. So I think we have to consider it in a different manner. So that is, of course, on the face of it, yes, 90 percent would be 9 crores. But then you deduct the legal costs involved.

You deduct the three to five years at the minimum of the founder's attention, which is the scarcest resource for any company. Then you deduct the enforceable risk after you win, even I mean, as they have, we have those judgments of the Privy Council that says that, you know, the real battle for a litigant starts after he gets the decree. So enforcement or execution of the decree is the real task. Then you deduct what the litigation does to the company where it is, while it is pending.

You know, the cost founders never price is disclosure. You know, every funding round, every acquisition, every banking facility requires disclosure of material litigation. You know, pending 10 crore claim, then buys you a lower valuation, a larger indemnity, escrow holdback, or a buyer who simply walks, you know, that cost routinely exceeds the claim itself. Then there is this issue of, you know, we have to consider, you know, whether the other person is, has the means to even pay the decreed amount.

I mean, what is the point of getting a paper decree when it's actually worth nothing that you can't execute? So, again, as I said earlier, it takes you years to convert that particular decree into money, especially when the other side is asset light. I think you have to ask this question before you file your suit and not after that. You know, if I win, what do I actually execute that against?

So, that is very important. I think there are, I mean, and there are instances when a dispute occurs and you don't, and it's not that for every, I mean, for even the most watertight agreements, disputes do occur. I mean, what if you have everything in writing, but, you know, the other person just turns rogue, what do you do? I mean, there are situations where you have to go to court, but in that sense, there are mechanisms involved, especially in commercial matters, where you now have section 12A of the Commercial Courts Act. So, you go for pre-litigation mediation, or there are other possibilities of, you know, you trying for mediation and trying to,

you know, settle the matter outside of court instead of going through the entire process and then realizing that probably you were better off agreeing to the settlement, albeit a slightly lesser amount at the earlier stage itself, then going through the entire process incurring those costs, as I mentioned earlier. So, I guess, taking a comprehensive view of the matter, I think is more important than jumping into litigation.

I think if I have to pinpoint on one clause, I think it is the exit clause. You know, it is when the founders personally undertake to give the investors an exit by a fixed rate. So, if an investor comes in, they'll ask for the moon. I of course, want to ensure that their money is not stuck or their money is recovered.

And you then promise them the moon saying that, you know, even if the company doesn't do well, after a particular point in time, we will buy back your share at a particular price. That I guess, because, see, otherwise, the company is a separate legal entity. So, your liability as an investor, as a founder, not as an investor, I mean, as a founder, is, of course, restricted to the shareholding that you have in the company or the amount of call money that you've not paid yet. So, if there is no IPO or strategic sale by five years, seven years, the investors would require the founders personally, and not the company, very importantly, to buy back its shares or find them a buyer.

They, I think founders then read this as a boilerplate, saying that this is standard form, and they have to sign this. It is, they don't realize that it is a personal liability sitting entirely outside the corporate wheel. And it survives the company failing. So, as compared to a company failing, where they would not be liable, they are sticking their neck out, and they themselves are saying that, yes, my personal assets, or I am personally liable, and that survives.

So, that is something, I think, the founders need to be a little wary of. There are certain FEMA rules, which if the investor is a foreign entity, then the assured return exits are not permitted. But then there is a put option, then it has to be fair value, all of that, no guaranteed outcome or return. But that does not mean the clause by itself harmless, it makes them discontented, and then there is the years of arbitration and all of that.

So, I think you would rather not stick your neck out because, let us face it, companies fail. I mean, that is the entire basis of them having a separate legal entity and them having, being of limited liability and all of that. Because you would want to take, have the company take certain risks, of course. So, not in all cases is the fact that the founders have done something wrong, maybe the situation changes, maybe the environment changes.

There are 101 factors which are outside your control. So, in those circumstances, sticking your neck out and stating that you would be personally liable for something, I think that is something that one needs to be wary of.

Absolutely. In fact, I cannot emphasize this enough. I said earlier also that they spend a vast amount of time on valuations. Yeah. So, and all of these things, then they keep it on the back burner of the thing that they are all boilerplate. But that is not the case, as I said.

So, why they do that, I think, is because valuation is something which is legible and tangible in terms of you can put a number to this. And these clauses are not. So, valuation being that number that everybody understands and you can announce that it is also in that sense sexy to state that you have raised that particular valuation or your company is valued at a particular figure. Whereas all of these things are boring in nature.

So, I think that is also one of the things, of course, and I do not also blame them because these agreements are also long and have a lot of legalese involved in them. So, a lot of founders or investors, founders would also understand what they would probably mean at that stage. So, that is where you require an experienced lawyer who can vet all these agreements for you. Correct. Yeah. So, generally, these are all agreements, say, 40, 50 pages long, and then multiple clauses that are drafted by the Investors Council.

And anyway, investors would have that position of control or authority at that stage, because you really want that investment to come in. So, and then they would have these artificial time pressures that they would provide saying that you must sign this within, say, by the end of day or by the end of this week. And then if you have any queries, or if you give any feedback, we will see that this is standard, everybody signs it. I think standard is the most expensive word in a term sheet.

So, that needs to be very carefully seen, because that is something that you then cannot wriggle out of very easily.

Yeah. So, I think it is important for the investor, for this person to know, you know, probably what I put in is that, let us say, I am your co-founder. And what happens if, when one of us wants out, and we do not agree on the price, then what do you do? Because see, everything else falls out of this particular question. It forces you to answer how you value your company, who is allowed to buy it, who decides, and what happens if you have a deadlock?

You cannot answer it without building this machinery. So, this makes you think of all of these things that are very important. Because it is very important that you put in place these mechanisms before you need them. You know, founder vesting with clear good lever and bad lever definitions, evaluation method agreed in advance, a formula or a named independent valuer,

not something, as you said earlier, that we figure it out, you know, need a deadlock breaker, whether generally, let us say there are two founder members, two founder partners, then how do you break the deadlock with, you know, there is a buy sell shotgun clause, an agreed casting board, or, you know, an escalation to mediation, or if it goes beyond that, then do you go to arbitration? And, you know, then there is a process that for one founder, reducing involvement without leaving entirely, how do you do that?

So, so I think this is, I believe, would be the one thing that I would really make the particular person think.

Absolutely, absolutely.

No, absolutely. I think so. So this is what, you know, we are as lawyers are trained to look at. So generally, you'll see people who get into a deal or an arrangement, they would in their head, and rightly so, you think that, you know, this is going to turn whatever they touch will turn gold. And this is going to be the most successful thing ever. But as lawyers, we are supposed to, we are, we are trained to think the worst situation possible.

So I think that council is very important for the founders at that stage to come in, you know, I mean, I put a question to you, why do you, why do you think countries invest in large armies? Yeah, so that something, something happens tomorrow, they're ready for it. In fact, it is actually not that. So I think it, I mean, I'll put it differently.

I think it is, it is a deterrent that you don't want the other party to, to, to attack you or, or, yeah, you know, if you if you really love peace, you must be prepared for war. So that's how it is, right? You have to ensure that you don't get into litigation. So for that, for that purpose in mind, you must have the right ammunition with you. I mean, you must have your, yeah, who's available that states that everything is, is, is formulated, it is comprehensive in nature, nothing is left for, you know, no ambiguity is left out so that it could be used.