FDI in MSM enterprises: sound documentation equals sound protection

The Indian economy, though not as well developed as many of its western counterparts, has always been typified by its entrepreneurial nature. For a foreign investor familiar with the Indian commercial landscape, the Indian promoter is a very recognisable figure. While some of the world’s richest promoters are Indian, India also has a very robust micro, small and medium-scale enterprises (MSME) sector that contributes to about 40% of the gross industrial value in the Indian economy.

High-value foreign direct investment (FDI) transactions in the Indian marketplace may have become a common feature, but foreign investors have increasingly opened up to the viability of investing in the MSME sector. At the same time, the promoters have gradually come to appreciate the value that a foreign investor can bring to the table. Here are a few points that may be relevant to an Indian promoter in the MSME sector when entering into transaction documentation with a foreign investor who is subscribing to a minority equity stake in their enterprise.


While the MSME sector contributes notably to the country’s economy and is also responsible for generating significant employment opportunities, traditionally funding has been a concern in this sector: a foreign investor acquiring an equity stake in an MSME provides this much needed capital infusion. In addition, it is now well recognised that outside of the obvious financial benefit, receiving equity funding in the form of FDI also has the following intangible benefits:

  1. A foreign investor brings with it best practices for corporate governance, exposure to which is beneficial for the MSMEs; and
  2. Having a credible foreign investor on board enhances the enterprise’s public image and increases public confidence therein. This, in turn, may simplify raising further funds in the future for the enterprise.

The governmental and regulatory regime in India is intended to protect the interests of MSME players in the face of challenges from deeper pockets – both domestic and foreign. However, when finalising the legal documentation for an FDI transaction, the same is mostly in the realm of commercial negotiation between the principals, providing no added protection for the MSME promoter against a potentially mightier investor. Therefore, it is in the sphere of drafting of legal documents that the investee enterprise has to take special care. While nuances of documentation for any kind of transaction are difficult to summarise, some basic items are highlighted below.

In the term sheet

The term sheet is often a tricky document to negotiate and finalise. It is intended to form the bedrock of the detailed transaction documentation that would follow and the fundamental commercial terms should ideally be captured here. 
This would include, for instance, the quantum of monies to be invested; the equity stake that the investor would 
receive post investment; the special 
rights that the investor would be getting 
as a minority shareholder (eg nominee director; affirmative voting rights) in the enterprise and any special commitments that would have to be fulfilled by either 
the enterprise (eg any regulatory approval) or the promoter (eg promoter funding). 
The term sheet should also contain the duration of the investment and the exit routes that may be made available to the investor (eg through an initial public offering). In the event that a promoter 
is tentative about certain commercial terms, it may be advisable to try and leave the same open for the detailed documentation stage rather than concede to an undesirable commercial position at the term sheet stage itself, as such lost ground may be difficult to regain at a later stage in the negotiation/documentation process.

In the share subscription agreement

The share subscription agreement (SSA) is the vehicle that essentially describes the rights and obligations of the investor, the enterprise and the promoter for the investment to close ie equity shares of the enterprise to be issued to the foreign investor in consideration of the investment monies received. Some key clauses to be considered by a promoter in this document are as follows:

  1. Conditions precedent: this clause would contain the list of action items that either the enterprise or the promoter would have to fulfill before the investment can take place. Care should be taken to try and ensure that: a) only such action items are included here that necessarily need to be fulfilled for the investment to practically take place in a relatively risk-free manner, as opposed to any and every housekeeping issue that the company may have to address as an ongoing process; and b) if it is felt that in the interests of the enterprise, the investor needs to undertake certain actions before it can be allowed to invest monies and become a shareholder in the enterprise, the same should also be inserted.
  2. Representations and warranties: this 
is a very crucial part of the SSA as 
these representations and warranties by the enterprise/promoter are backward-looking statements by 
them about the credentials of the enterprise and the promoter themselves. Any misrepresentation 
may allow the investor to make an indemnity claim. Furthermore, representations and warranties under the share subscription agreement have a survival period ranging from perpetuity to one year, depending on the nature of the individual representations themselves. Hence, care should be taken to ensure that only such representations are given that the enterprise/promoters can live up to for a prolonged period without incurring the risk of an indemnity claim.
  3. Indemnification: a related clause is that on indemnity. It is in the best interests of the enterprise/promoter that the indemnity coverage that they agree to provide to the investor under the SSA is capped at a level that is bearable for them, even if the investor may prefer an uncapped indemnity clause. De minimis thresholds for indemnity claims are also often favoured.
  4. Termination: care should be taken that under the termination clause, the investor is not able to terminate the SSA (and effectively the transaction) at free will in the event the enterprise and the promoter have fulfilled their obligations under the SSA.
  5. Governing law and dispute resolution: the SSA is typically governed by Indian law. It should also be remembered that a dispute resolution mechanism (more often than not leading into an arbitration procedure) involves both time and expenditure. Accordingly, the promoter should agree to only such a mechanism that it can effectively utilise, if the need to go into dispute resolution arises at all.
In the shareholders agreement

The shareholders agreement (SHA) is the document whereunder the rights and obligations of the enterprise, the investor and the promoter are captured, vis-à-vis the operations and administration of the enterprise. In cases where a minority stake is subscribed to by a financial investor (like a private equity investor), the promoter may want to – as an overarching principal – ensure that they are not giving away such rights as would dilute their management control over the enterprise. Certain relevant provisions for an SHA are:

  1. Investor nominee director: in most transactions, the investor receives 
one or two nominee directors on the board of the enterprise, depending on the promoter’s commercial comfort. 
It should, however, be taken note of that as long as the promoter holds a majority stake in the enterprise, directly or indirectly, they should also retain 
a comfortable board majority in 
their favour.
  2. Affirmative voting rights: typically, an investor will seek affirmative vote rights on matters that are crucial to the business and operations of the enterprise (eg proposed large investments or loans by the enterprise; a proposal to change the scope of the enterprise’s business etc). While giving such minority protection rights is an accepted practice, it should be ensured that this list of affirmative vote items is genuinely on matters of importance and not a long list of actions that practically subverts the promoter’s management control over the operations of the enterprise.
  3. Share transfer restrictions: it is expected that during the course of the investor staying invested in the company, both the investor and the promoter may wish to offload some of their respective shareholding in the enterprise for a variety of reasons. While an investor may seek free transferability of shares under the SHA, care should be taken that this excludes at least transfers by the investor to a competitor of the enterprise, unless the company/promoter has agreed to the same in advance. On the other hand, while the investor may want the promoter to not dilute its stake in the enterprise, efforts should be made to ensure that some flexibility is available to the promoter so that they can carry out: a) inter-promoter transfers; or b) sell shares to a third party to raise necessary capital.
  4. Exit rights: whatever form of exit is provided to the investor (for instance, through a public offering or tag option), ideally it should be ensured that no obligations are placed on the enterprise/promoter that may jeopardise the promoter’s ability to continue running the business subsequent to the investor’s departure. By way of illustration, the promoter may not want to allow the investor to have a drag option, where, at the time of exiting the enterprise, the investor would be able to cause the sale of all or most of the promoter’s shares in the enterprise.
  5. Non-compete: typically, an investor expects the promoter to not actively get involved in any activity or venture that competes with the business of the investee enterprise. The promoter, however, should be careful to ensure that they agree only to refrain from such activities that would actually hurt the business of the investee enterprise.
  6. Governing law and dispute resolution: this issue under the SHA is the same as it is for under an SSA. It should also be ensured that the governing law and dispute resolution clauses for both the agreements are the same.
In the disclosure letter

A disclosure letter is directly related to the representations and warranties provided under the SSA. Any fact about the enterprise or the promoter that will cause or has the potential to cause a representation to become less than completely accurate and true should ideally be included herein. Further, the promoter should try to ensure that disclosures need not be provided against each representation (which can be copious in number) and a fact once disclosed would act as a disclosure against all representations and warranties provided.


While there may be several other pieces that complete the full set of transaction documents (eg side letters, subscription notices and corporate resolutions), another area that a promoter should be specifically careful about is the amendment to the constitutional documents of the enterprise. Typically, the articles of association (and where necessary, the memorandum of association) undergo amendments to incorporate provisions of the SHA. However, it should be ensured that, in the course of carrying out such amendments, no modifications are accepted that are not in line with the SHA or magnify the obligations of the enterprise or the promoter.


While the above attempts to shed some light on the documentation pertaining to a standard financial investment whereby subscription to equity shares is being carried out, most FDI transactions these days are far more complex, what with an array of instruments (like compulsorily convertible debentures and compulsorily convertible preference shares) that are often preferred over direct subscription to equity shares. Furthermore, owing to commercial requirements, often the transaction structure is far more intricate (for instance, purchase of equity shares alongside the equity subscription by multiple investor entities), thereby creating the need for additional documentation. Therefore, it would best serve an MSME promoter to seek legal counsel to ensure that they receive well-drafted transaction documents and make the most of the FDI investment in the enterprise without falling foul of either their commercial requirements from the deal or the applicable legal regime. This would, in turn, go a long way in taking MSMEs, as well as the Indian economy, to the next level of growth.