M&A Consolidations in Indian Start-Ups by Unicorns

With Indian start-ups seeing a steep rise in valuations and funding from institutional investors, we are increasingly witnessing a trend of acquisition of start-ups by growth stage companies, particularly new unicorns.

Depending on where the acquirer sees value in the target and its business, consolidation transactions are structured as either share purchase or asset purchase/business transfer.

A share acquisition grants the acquirer ownership of the target's business lock, stock and barrel, and is effected either through a cash buyout, share swap or a combination of the two. Cash buyout involves purchase of 100% shareholding of the target from its existing shareholders for cash; in share swaps, the target's shareholders transfer their shareholding to the acquirer and, as consideration, receive shares of the acquirer.

One obvious advantage for exiting investors in share swaps is that they receive shares of a comparatively larger company, with the realistic possibility of a more lucrative exit in future. However, such investors are required to make a sharp shift from being a big fish in a small pond to being a small fish in a big pond, as well as suffer tax on sale of their stakes without really getting liquidity of their investment at the same time.

Share acquisitions also have Indian foreign exchange law implications, given that most start-up investors are non-residents and, therefore, cannot receive more than the fair market value of their shares from Indian acquirers.

The acquirers can purchase identified assets of the target (such as the app, employees and/or data) with separate consideration allocated to separate assets. Since it would attract indirect tax (GST) on sale of individual assets, acquirers also consider acquisition of a business undertaking at a consolidated price without ascribing individual values to each asset and liability forming part of such undertaking.

An increasingly occurrence in the start-up space is an acquihire transaction, where unicorns target start-ups for their team of employees and a few limited assets, rather than the entire business itself.

In case of asset sale or business transfers, M&A consideration goes to the target which would then distribute it to the founders, employees and the investors. This also requires another layer of corporate structuring and actions. 

Even for share acquisitions, there are invariably issues relating to differential pricing for different stakeholders, due to liquidation preference clauses, unvested shares of founders and employees, phantom stocks for advisors, proposed lock-in on founders, etc. Differential pricing between resident and non-resident sellers itself leads to complications under various tax and foreign exchange regulations. 

While traditional share or business acquisitions see promoters exiting the target, acquisitions in the start-up space typically see founders being hired, post-acquisition, to continue to operate the target business but as an employee rather than an owner. In many instances, the acquisition is contingent on founders agreeing to become employees, particularly in an acquihire transaction where significant value is attributed to the management team of the target business.

While this shift from owner to employee is not easy, we do see founders of the target accepting this due to the incentive structures, independence and operational flexibility offered by unicorns, even in such employee roles. The pressure from the existing investors of the target to provide them with an exit, as well as the realisation by the founders that their idea will become a successful reality only through the unicorns, due to potential synergies and availability of funds, do play an important role. Further, in case of a not-so-good valuation, founders may end up receiving minimal cash, with most of their consideration coming in the form of stock options, which has its own set of issues for example, lock-in, cliff period, taxation, vesting and claw-back.

Tax continues to play an important role in such M&A deals, sometimes more so than in traditional M&As. For instance, any share or asset sale/business transfer will attract taxation on capital gains made by the sellers in such transactions the rate of which depend on various factors, such as acquisition cost versus sale price and the duration for which the shares/assets were held. Since there is no upfront exit or liquidity for the target's stakeholders (except in case of cash buyout), it is very important to structure and minimise tax, especially for the individuals involved. 

While most acquisitions in this space get the benefit of de minimis exemption in India (now available until March 2027), it is important to check the competition angle, which may otherwise play the role of spoilsport. The risk of scrutiny and denial of approval, as well as the implications of any foreign and extra-territorial competition laws, continue to be relevant especially in case of offshore-located unicorns acquiring an Indian start-up.

While the above issues may be common in traditional M&As, a crucial aspect that sets these particular acquisitions apart is the prodigious risk appetite of unicorns.

Traditional M&A involves rigorous due diligence and extensive contractual protections, such as elaborate warranties and an indemnities package. However, with global investors being bullish and unicorns seeking to acquire market share and increase the customer-base inorganically, unicorns have shown a high risk appetite.

We see potential targets being chased by competing acquirers; therefore, it has become important for unicorns to cut short deal times and close deals quickly, before competitors are able to make a better offer to the targets.

Nonetheless, it is imperative for unicorn acquirers to balance the need for speed with internal governance issues and to undertake a proper due diligence so as to avoid future surprises. It cannot be denied that it is investors' money which is at stake, so this does attract questions.

Given the seemingly endless financial resources of Indian unicorns and multinationals powered by global investors the continuing boom in the start-up space is unlikely to slow down anytime soon.

Keshav Vijayan (senior associate at IndusLaw) also contributed to this article.