Foreign investment in India can be made either through foreign direct investment or downstream investment. A natural or legal person is said to have made foreign direct investment (“FDI”) in India if such person directly makes equity investment in an Indian entity (which may be a private limited company, limited liability company or a partnership incorporated in India) in lieu of a specific percentage of shareholding or capital contribution, as the case maybe. On the other hand, downstream investment means an investment made by an Indian entity (which is owned and controlled by foreign resident(s)) in another Indian entity. Foreign direct investments and downstream investments in India are regulated by the Reserve Bank of India (“RBI”) under the extant foreign exchange control regulations and the FDI Policy issued by the Department of Promotion of Industry and Internal trade, Ministry of Commerce and Industry, Government of India. The focus of this article is on FDI in India and the legal aspects to be considered by the Investors.
Benefits of making foreign investments in India
Some of the key benefits of making foreign investments in India are as follows:
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- Growing market and economic potential: India has a large and rapidly growing economy, projected to be the third largest economy by 2030. Additionally, the rising middle class and upper middle-class population with increasing purchasing power fuels demand for goods and services.
- Favorable Government Policies: The Indian Government offers incentives such as tax benefits, subsidies and simplified compliance under various governmental incentives launched from time to time.
- Cost effective business environment: India offers a low labor cost compared to other economies making it a competitive manufacturing hub.
- Strategic locations and trade agreements: India’s location allows businesses easy access to South Asia, the Middle East and African markets. India has also signed multiple free trade agreements and is part of initiatives like ASEAN -India FTA and comprehensive economic partnership agreements with countries like UAE and Japan.
- Expanding infrastructure and digital transformation: India is a leader in digital transformation with initiatives like Digital India and strong fintech and e-commerce growth.
Legal requirements under the Companies Act, 2013
A foreign investor makes equity investment in a company in lieu of subscription of share capital of such company. A company can issue and allot its share capital to any investor (including a foreign investor) in compliance with the requirements as set out under Section 42 of the Companies Act, 2013. Such a procedure for issuance and allotment of share capital by a company is known as private placement and the following are the steps to be taken in order to issue the share capital in a legally compliant manner:
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- Board resolution approving the issuance of shares to the identified investor: The relevant company is required to approve the issuance of shares to the identified investor in a board meeting.
- Shareholders’ resolution approving the issuance of shares to the identified investors: Post the approval of issuance of shares to the identified investor at the board level, the approval has to be approved at the shareholders’ level through special resolution.
- Filing of the shareholders’ resolution with ROC: The resolution as referred to in point number 2 above has to be electronically filed with the registrar of companies.
- Valuation report: A valuation report of the share capital of the company from the registered valuer is required for the issuance of share capital. Per share price of the share is determined as per the valuation report. As per law, the per share issuance price cannot be less than the fair market value of the share as determined in the valuation report.
- Offer Letter: Once the shareholders’ resolution is successfully filed with the ROC, the company has to proceed with the issuance of offer letter to the identified investor(s). Such identified investor(s) provides its written acceptance of the offer letter to the Company. Once accepted, the offer letter becomes binding on the investor.
- Allotment Resolution: Once the proceeds of investment are remitted to the bank account of the company by the identified investor, the company has to approve the allotment of relevant number of shares to such identified investors at the board level.
- Filing of allotment resolution: The allotment resolution referred to above has to be filed with the registrar of companies along with the valuation report based on which per share issuance price is determined.
Legal Requirements Under the FDI Policy and Foreign Exchange Regulations
Foreign direct investments in India by foreign residents can be made in accordance with the provisions of the FDI Policy and Foreign Exchange Management (Non-Debt Instrument) Rules, 2019 issued by the Ministry of Finance, Government of India (“NDI Rules”) (hereinafter collectively referred to as “FEMA Regulations”). As per the FEMA Regulations,
Foreign investments in private Indian companies can be made under the following two routes
Automatic Route
Foreign investments can be made under the automatic route in the sectors (as listed in Schedule I of the NDI Rules) for which no prior approval of the RBI or Indian central government is required. Such foreign investments may be subject to sectoral caps, pricing guidelines, and attendant conditions as per the FEMA Regulations.
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- Example: Foreign investment in the manufacturing sector falls under the automatic route, allowing up to 100% foreign investment. However, government approval is required for trading (including through e-commerce) in respect of food products manufactured and/or produced in India.
Government Route
Foreign investments can be made only under the government route for sectors where prior government approval is required. Investment in such sectors is also subject to sectoral caps, pricing guidelines, and attendant conditions.
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- Example: Investment in FM radio services falls under the government route, allowing foreign investment of only up to 49%.
Prohibited Sectors
Foreign investment is not allowed in the following sectors:
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- Lottery businesses
- Gambling and betting
- Chit funds
- Real estate business or construction of farmhouses
Share Capital Instruments
Foreign investors can subscribe to equity shares, convertible debentures, preference shares, and share warrants issued by an Indian company in accordance with the provisions of the Companies Act, 2013.
Reporting Requirement
The company is required to file Form FC-GPR with the Reserve Bank of India within 30 days from the date on which the equity instruments are allotted to the foreign investor.
Prior Approval for Investors from Land Border Countries
As per Press Note 3 (2020 Series) issued by the Department of Promotion of Industry and Internal Trade, foreign entities incorporated in countries sharing land borders with India, or where beneficial ownership vests in such countries, can invest in India only under the government approval route.
Pricing Guidelines
As per the NDI Rules, the price of equity instruments issued by an Indian unlisted company to a foreign investor cannot be lower than the fair market value determined by an internationally accepted pricing methodology. The valuation must be certified by a chartered accountant, a SEBI-registered merchant banker, or a practicing cost accountant.
Legal Documentation Required
Share Subscription Agreement
While not mandatory, it is recommended to outline the terms, conditions, and obligations of the company, founders, and investors. Key clauses include:
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- Conditions precedent and subsequent
- Closing actions
- Indemnification obligations
- Confidentiality
- Dispute resolution
- Governing law
Shareholders’ Agreement
This agreement regulates relationships between shareholders and the company. Key clauses include:
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- Share transfer restrictions
- Lock-in and reverse vesting of founders’ shares
- Exit mechanisms
- Information and inspection rights
- Confidentiality, non-compete, and non-solicitation
- Governing law and dispute resolution
Amendment of Articles of Association (AOA)
Given that the articles of association (“AOA”) of a company is the governing document and overrides any contractual documents, it is very important to incorporate the relevant clauses of shareholders’ agreement into the AOA. This exercise ensures that there is no inconsistency
between the AOA and the shareholders’ agreement and in case of any dispute, the rights of the investors are not jeopardized merely because of the inconsistency between the AOA and the shareholders’ agreement.
Key Practical Aspects to Consider by Foreign Investors
Choice of Equity Instrument
Foreign investors should prefer subscribing to Compulsorily Convertible Preference Shares (CCPS) due to:
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- Preferential Rights: CCPS holders have liquidation preference over ordinary shareholders.
- Special Rights: CCPS holders may enjoy veto rights or reserve matter rights regarding key decisions.
- Compliance with FEMA Regulations: Foreign investors can only subscribe to instruments that are compulsorily convertible into equity.
Subscription to a Different Class of CCPS
As per the bankruptcy law in India, shareholders holding same class of shares shall be treated at par with each other at the time of distribution of liquidation proceeds. In this view, it is recommended that an investor should always subscribe to a separate class of CCPS which is not subscribed to by any other shareholder and should also ensure that no other shareholder subscribes to that class in the future. This exercise helps the investor in ensuring that at the time of liquidation of the company, the liquidation proceeds are distributed as per the liquidation preference as agreed in the term sheet and the shareholders’ agreement.
Validity of Valuation Report Under FEMA Regulations
While nothing is contained in law which expressly provides for the validity of the valuation report for the issuance of shares, the market practice and experience with the relevant regulators suggest that the acceptable validity of a valuation report for issuance of shares under FEMA Regulations is ninety days from the date of the financial data of the company utilized to arrive at the valuation of shares. The investors are accordingly advised to ensure the validity period of the valuation report issued under FEMA Regulations.
Legal and Financial Due Diligence
Importance of carrying out legal and financial due diligence on the target company before making the investment cannot be emphasized enough. The purpose of carrying out legal and financial due diligence is to find out the overall legal and financial risk involved in making the investment. Legal due diligence helps the investor to find out the degree of legal compliance, outstanding legal disputes, total value of secured and unsecured loans, contractual obligations applicable to the company, IP owned and licensed by the company and the extent to which the assets of the company are insured. Financial due diligence helps the investor to review the audited and unaudited financial statements of the company and whether company has complied with all its tax obligations and statutory contributions.
Key Clauses in the Shareholders’ Agreement for Investor Protection
Right of First Refusal (ROFR)
This clause ensures that if an existing shareholder of the company wants to transfer all or any of its shares, such shareholder should first solicit an offer from a third party. Once such an offer is obtained, the selling shareholder is required to offer such shares to the investor at the same price and same terms and conditions which were offered by the third party.
This mechanism ensures that a third party becomes the shareholder of the company only after the investor has refused to purchase the shares.
Anti-Dilution Protection
This clause helps the investors to maintain their shareholding in the company in the event a down round investment is undertaken by the company. Down round investment means a round of investment in which the per share price offered to the incoming investors is less than the per share price paid by the existing investors.
Liquidation Preference
Liquidation preference lists down the order of priority which shall be applicable in distribution of the liquidation proceeds derived
from the winding up of the company or any other similar liquidation event as defined in the shareholders’ agreement. It has to be ensured that the investor (who has subscribed to CCPS) is given priority over the ordinary shareholders in distribution of the liquidation proceeds. The clause of liquidation preference should also be aligned with the relevant provisions of the bankruptcy laws of
India.
Reserve Matters
Depending on the amount of investment made and the percentage of shareholding which will be held by the investor after the investment is made, the investor should ensure that it has reserve matter rights. This ensures that the key decisions in respect of the agreed matters are not taken without prior written consent of the investor.
