New Delhi, Aug. 11 -- India's entrepreneurial ecosystem is maturing. As businesses grow and founders accumulate wealth, a robust succession plan is becoming an increasingly important part of the entrepreneurial journey. For many, this may coincide with the entry of institutional investors, since an investment round is often when founders first consider shareholding structure and long-term wealth transfer.
However, what founders often see as a personal succession exercise may become a governance issue for investors at the time of funding. Investors and founders approach these structures from different perspectives, and bridging that gap can be tricky.
The investor's perspective
Founders usually use private trusts to implement a succession plan. The founder transfers shares held in the company and other personal assets to the trust for the benefit of family members, while typically retaining control as trustee or through a family-controlled entity. However, what appears to founders to be a private family arrangement can raise legitimate concerns for investors.
Investors do not just back a company, they back the founder. When the founder's shares move into a trust, investors naturally begin to ask a few detailed questions: Will the founder still have enough skin in the game? Could family disputes affect decision-making at company level? Will the trust dilute the founder's control or introduce unknown parties to the shareholding structure?
A trust deed operates independently of any shareholders' agreement and governs the relationship between the settlor, trustee, and beneficiaries. Investors worry that provisions in the trust deed could conflict with the carefully negotiated shareholders' agreement, or worse, could be used to circumvent it entirely.
Accordingly, investors generally seek visibility into the trust structure, including details of the settlor, trustees, beneficiaries, powers to add or remove them, the decision-making process, and distribution provisions relating to equity securities. They are also keen to understand how the trust will interact with transfer restrictions, lock-in provisions, and consent requirements under the shareholders' agreement.
If a trust structure already exists at the time of investment, investors may seek amendments to align it with the shareholders' agreement, as a condition precedent to investment, potentially delaying the transaction. If no structure exists, any future transfer, including to a family trust, will be subject to transfer restrictions and require investor consent, as per the shareholders' agreement.
From an investor's standpoint, this is not overreach but simply prudent risk management aimed at protecting the investment.
The founder's perspective
From a founder's standpoint, so long as the trust (through its trustees) is bound by the shareholders' agreement, investors should not be required to examine the trust deed. The shareholders' agreement can specifically record that its terms will prevail over any inconsistent provisions of the trust deed, ensuring that the founder's obligations as a shareholder remain intact regardless of where the shares are held.
For founders, however, the issue extends beyond legal documentation. Founders view a trust as a private family matter. Beneficiary information could reveal family dynamics or inheritance plans that founders may not be comfortable sharing with anyone outside the family.
What investors consider to be reasonable due diligence, founders may see as an intrusion into private family affairs. To founders, there is a line between corporate governance and personal autonomy, and investor rights should not extend into family succession matters unrelated to running the business.
Finding common ground
There is no one-size-fits-all solution and much depends on the relationship between the parties and their specific concerns. However, several approaches can balance investor protection with founder privacy.
Founders may choose to share limited and relevant information about the trust, including the redacted trust deed containing only the relevant provisions. This allows investors to confirm compliance without full visibility into private family matters.
Investors may, amongst other things, typically seek:
(a) consent rights over changes to trustees and beneficiaries, since these are effectively changes to the persons who may ultimately hold shares in the company;
(b) a covenant where founders agree not to exercise trust rights in a manner conflicting with the shareholders' agreement, providing substantive protection to the investor; and
(c) a warranty confirming that no provision of the trust deed conflicts with shareholder obligations, providing investor comfort without opening the deed to negotiation.
These targeted protections can often provide investors with sufficient comfort without requiring broad oversight of family succession planning arrangements.
Founders view trusts as succession tools, whereas investors view them through the lens of governance and investment protection. Successful transactions respect both sentiments.
For founders, the key is to be open and ready to share certain relevant information with the investors and be amenable to aligning their succession structures with the shareholders' agreement. For investors, the key is to tie protections to specific, identifiable principles rather than seeking broad oversight of family arrangements.
Founder trusts are likely to remain one of the more sensitive aspects of fundraising negotiations. With thoughtful drafting and reasonable negotiations, both sides can arrive at a workable middle ground.
Bhavik Narsana is partner and Kamayani Mittal is an associate at Khaitan & Co. Views expressed are personal
Published by HT Digital Content Services with permission from VC Circle.