Incorporation Basics, Companies, and One Person Companies

The simplest form of business structure is the partnership firm, requiring a minimum of two members who can be individuals or corporate entities. This entity is formed via a partnership deed containing clauses related to the name, place of business, business objectives, capital contribution, profit sharing ratio, and dispute resolution. Registration with the Registrar of Firms is optional but becomes mandatory if immobile property is involved. An unregistered partnership firm faces disadvantages, such as the inability to sue third parties in disputes and the inability to apply for start-up registration with the Department for Promotion of Industry and Internal Trade (DPIIT).

A Limited Liability Partnership (LLP) serves as a hybrid between a partnership firm and a company, limiting the partners' liability to their capital contributions. The incorporation process starts by defining capital contributions, profit-sharing ratios, registered office details, and business objectives, which eventually form the LLP agreement. Name reservation is processed through the Run-LLP form, allowing two name options per application. Once approved, incorporation documents (Form FiLLiP) must be filed within 90 days along with ID proofs, address proofs, a subscription consent document, and professional certification. The LLP agreement must be filed in Form 3 within 30 days of the Ministry of Corporate Affairs (MCA) issuing the certificate of incorporation.

The incorporation of a Private Limited Company begins with founders agreeing on initial capital, first directors, state of operation, and business objectives, often formalized in a Founders' Document. Name reservation is filed via Spice Plus Part A and is valid for 20 days upon approval, extendable up to 60 days with a fee. The incorporation forms, Spice Plus Part B and Spice Plus Agile Pro, require details of shareholders and directors, constitutional documents, and declarations confirming eligibility. The MCA then issues a Certificate of Incorporation along with PAN, TAN, ESIC, EPF, and a bank account.

A One Person Company (OPC) follows a similar incorporation process but requires the sole member to nominate a successor to ensure perpetual succession. Only an Indian citizen or a Non-Resident Indian (NRI) can incorporate an OPC. Furthermore, an OPC cannot function as a Non-Banking Financial Company (NBFC) or as a not-for-profit Section 8 company.

Prerequisites and Documentation for Incorporation

Several specific prerequisites must be met prior to incorporating an LLP or a company. Since filings are processed online, applicants must obtain a Digital Signature Certificate (DSC), which is password-protected on a USB token and valid for one to three years. Directors and designated partners require an 8-digit unique Director Identification Number (DIN) or Designated Partner Identification Number (DPIN). This identifier remains valid for a lifetime and requires renewal via KYC every three years by June 30th.

The Companies Act mandates a physical, identifiable registered office space to receive communications, which must be declared at incorporation or within 30 days using Form INC 22. A name board must display the company name and address in English and the local language, along with the Corporate Identification Number (CIN), GST number, website, and email.

Incorporation also relies on specific identity and address proofs. If a director lacks a DIN, PAN submission is mandatory alongside ID proofs like a voter ID, passport, or driver's license, whereas Aadhaar is currently not enabled.

Share capital includes Authorized Share Capital (the maximum limit a company can raise) and Paid-up Share Capital (funds already invested), both of which can be increased following statutory procedures.

Post-Incorporation, Start-up Guidelines, and MSME Registrations

Following incorporation, a company must hold a board meeting within 30 days and open a bank account for founders to transfer agreed funds. A company is strictly prohibited from commencing business or borrowing funds until it has allotted shares to the founders and filed Form INC 20A (Commencement of Business). Share certificates must be issued within 60 days of incorporation, and the statutory register of members must be updated. The first auditors must be appointed within 30 days of incorporation, followed by filing Form ADT-1 with the MCA within 15 days of that appointment.

Start-up registration via the DPIIT offers various regulatory benefits. Eligible entities include registered partnership firms, LLPs, and private limited companies focusing on innovation, provided their historical annual turnover does not exceed 100 crores. Sole proprietorships are not eligible. The registration remains valid for 10 years. An entity loses its start-up status if it is formed by splitting an existing business, gets acquired, or is formed in a similar line of business with common directors. Benefits include relaxation of labour law inspections (self-certification), fast-track patent processing, the ability to issue convertible notes, ESOP issuance to promoter directors, and tax holidays.

The MSME registration serves entities in manufacturing, trading, and service sectors.

MSME benefits include reduced loan interest rates, intellectual property subsidies, and protection against delayed payments. Corporate dues to Micro and Small Enterprises (MSEs) must be settled within 45 days. Delays beyond 45 days are tracked and reported to the ministry via Form MSME-1. Other optional or sector-specific registrations include GST, Trademarks, Factories Act, Import Export Code (IEC), Prevention of Sexual Harassment (POSH) via SHe-Box, and Professional Tax.

Governance Structures and Statutory Compliances

The supreme governing body of a company is the shareholders, who delegate operational powers to the board of directors, who then authorize the MD, CEO, or CXOs. The board and shareholders must execute specific annual and event-based compliances to avoid severe penal consequences that impact future fundraising.

Start-up Funding Lifecycle, Sources, and Legal Frameworks

Start-ups rely heavily on external funding across distinct lifecycle stages.

Funds are primarily raised through equity, debt, and grants. Equity capital is considered permanent capital, granting shareholders voting rights on all matters and the highest risk profile, as they are paid last during a winding-up scenario. Preference share capital provides investors priority over equity holders regarding dividend payouts (often with a coupon rate) and repayment during winding up. Preference shareholders primarily vote on matters directly relevant to them unless their dividends remain unpaid.

Debt capital constitutes a liability requiring repayment or conversion into shares. Sources include loans from directors, shareholders, banks, inter-corporate borrowings, convertible notes, and convertible debentures. Borrowing frameworks are strictly governed. Private companies may borrow from shareholders up to 100% of their paid-up capital, free reserves, and securities premium. DPIIT-registered start-ups are exempt from this cap for five years from incorporation. All borrowings require board approval, shareholder awareness, and annual reporting via Form DPT-3.

Borrowing from a company director qualifies as an exempted deposit and has no cap, provided it is supported by a board approval, a formal agreement, and a declaration that the funds are the director's own earnings, not borrowed money. Start-ups must not borrow debt capital from friends or family (e.g., swiping a friend's credit card for expenses) unless they fall under exempted deposit categories, though friends can invest via share capital. Advances against supply are permitted only if adjusted within 11 months, otherwise, they transform into illegal deposits.

Methods of Funding (Rights Issue, Private Placement, Convertible Notes)

Rights Issue

The Rights Issue method protects existing equity shareholders from dilution by offering them the right to purchase new shares proportional to their existing holdings. The board convenes to approve the share issuance and issues an offer letter, which must remain open for a minimum of 7 days and a maximum of 30 days (reducible with shareholder consent). Shareholders may accept, completely decline, partially decline, or renounce the shares to someone else. Silence at the end of the offer period equates to a deemed decline. Once application money hits the bank account, the board must approve the share allotment within 60 days. The company must file Form PAS-3 (return of allotment) with the MCA within 30 days and issue stamped share certificates within two months. If non-resident investors participate, FEMA compliance reporting to the RBI is mandated.

Preferential Allotment and Private Placement

When a company raises funds outside of its exact existing shareholder proportions, it utilizes Preferential Allotment or Private Placement. This method typically issues Equity, Compulsory Convertible Preference Shares (CCPS), or Compulsory Convertible Debentures (CCD) to a highly identified group of investors.

Strict pre-investment compliances dictate this process. The company must ensure sufficient Authorized Share Capital exists, open a separate designated Escrow bank account strictly for receiving application funds, and obtain a valuation report from a registered valuer (or merchant banker for non-residents), valid for only 90 days.

The board must approve the security issuance, followed by a general meeting requiring a Special Resolution (75% shareholder majority). This resolution is filed via Form MGT-14 within 30 days. The company issues a formal Private Placement Offer Letter (PAS-4) by name to specific investors. Investors remit money specifically to the designated bank account. The board allots shares within 60 days of payment and files PAS-3 within 15 days. Crucially, the start-up cannot utilize the invested funds until the PAS-3 filing is complete.

Convertible Notes

A Convertible Note is a hybrid debt instrument containing an option to convert to equity. It is exclusively available to DPIIT-registered start-ups and must have a minimum ticket size of 25 lakhs per single investor. It carries a maximum tenure of 10 years for repayment or conversion. The process is highly streamlined compared to private placement. It requires drafting a note agreement, obtaining board approval, passing an ordinary resolution at a general meeting, and filing MGT-14. It does not require a current valuation report, as valuation (usually incorporating a discount formula) is deferred until a future qualified financing round triggers the conversion.

Due Diligence, Funding Closure, and Post-Investment Management

Before formalizing an investment, investors conduct a Due Diligence (DD) health check, typically starting after a term sheet is signed (triggering a 90-day non-binding period). Due diligence verifies the company's financial condition through accounting records, validates Intellectual Property (IP) status, uncovers hidden/fraudulent transactions, and checks compliance across corporate, tax, labour, and FEMA laws.

Due diligence directly shapes the Share Subscription Agreement and Shareholders Agreement through specific conditions.

If DD uncovers major issues, deals fail or valuations plummet. In specific case studies, unmaintained records and undocumented promoter loans (80 lakhs and 4 crores) resulted in heavy penalties, delayed investments, the need for legal adjudication spanning up to 7 months, and potential loss of directorships.

Fundamentals of ESOPs

An Employee Stock Option Plan (ESOP) is a non-cash incentive granting employees the right to purchase a predetermined number of shares at a future date at a predetermined price. ESOPs aim to attract and retain talent by allowing employees to participate in the company's valuation upside.

Eligible recipients include permanent employees and directors of the company, as well as employees and directors of its holding or subsidiary companies. Ineligible entities include probationers, trainees, interns, consultants, and independent directors. Generally, the promoter group and directors holding over 10% of equity cannot receive ESOPs. However, DPIIT-registered start-ups are exempt from this restriction for 10 years from incorporation.

The ESOP lifecycle spans four distinct phases.

1. Grant: The board allocates options to the employee.
2. Vest: The maturation process. The law mandates a strict minimum cliff period of 1 year from the grant date before any option can vest.
3. Exercise: The employee's formal application and payment of the grant price to convert vested options into shares.
4. Sell: The employee liquidates the shares for monetary gain.

Creating an ESOP requires drafting a scheme, obtaining board approval, securing a Special Resolution from shareholders, and filing MGT-14 with the MCA.

Ultra-Quick Revision (Exam Essentials)

Key Concepts & Distinctions

Must-Know Terms

• Designated Escrow Account: A specialized, separate bank account mandated strictly for receiving funds during a Private Placement round.
• Convertible Note: A hybrid debt instrument exclusive to DPIIT start-ups, allowing investment without an immediate valuation report, requiring a minimum 25-lakh ticket size per investor.
• Exempted Deposit: Specific allowable borrowings (like a loan from a director) that bypass the strict limits on public deposits, requiring a board resolution and a director declaration.
• Vesting Period: The mandatory cooling timeframe in an ESOP structure. Law dictates a minimum 1-year cliff from the grant date before options can begin converting to shares.
• Special Resolution: A shareholder decision requiring a 75% majority vote, necessary for major corporate actions like private placements and adopting ESOP schemes.
• DPIIT Registration: Government recognition offering start-ups tax holidays, the ability to issue convertible notes, ESOP flexibility for promoters, and exemption from borrowing caps for 5-10 years.