Private Placement Compliance Pitfalls That Can Sink a Startup Fundraise: A Practical Guide to Section 42

Introduction

Private placement under Section 42 of the Companies Act, 2013 is the unglamorous workhorse behind almost every startup funding round in India. Every time a startup issues equity shares, Compulsorily Convertible Preference Shares (CCPS), or Compulsorily Convertible Debentures (CCDs) to a VC or angel investor, it's doing so through this provision. And yet, because it sits in the background of a fundraise, overshadowed by term sheets, valuation negotiations, and shareholder agreements, it's also one of the most commonly mishandled compliances in the startup ecosystem.

This article walks through where founders, CFOs, and even compliance teams typically go wrong under Section 42, and why these aren't just paperwork slip-ups; they carry real financial and legal consequences.

Section 42 in Brief

Section 42, read with Rule 14 of the Companies (Prospectus and Allotment of Securities) Rules, 2014, governs how any company — public or private — can raise capital by offering securities to a select group of identified persons, instead of the public at large. It covers a wide range of instruments: equity shares, preference shares, CCPS, CCDs, non-convertible debentures, and warrants, which is exactly why it applies to nearly every startup financing round, not just pure equity rounds.

The core mechanics, in sequence, look like this:

The offer can go to no more than 200 persons per kind of security in a financial year — Qualified Institutional Buyers and employees receiving securities under an ESOP scheme don't count toward that cap.

Where Startups Actually Go Wrong

1. Spending the money before PAS-3 is filed

This is the single most common error. The moment application money lands in the company's account, founders treat it as available runway. But Section 42(6) is unambiguous: the company cannot use that money for anything beyond adjusting it against allotment or refunding it, until allotment is complete and the return of allotment in PAS-3 has actually been filed with the RoC. Paying vendors or salaries out of that account before PAS-3 is filed is a contravention, even if the round eventually closes successfully.

2. Letting the 60+15 day clock run out unnoticed

Allotment must happen within 60 days of receiving the money. If it doesn't — perhaps because the round closing is delayed for diligence, documentation, or a regulatory approval — the company has only 15 more days to refund. Miss that, and two things happen simultaneously: the company owes 12% annual interest on the money from day 60 onward, and , more seriously, the unallotted application money can be reclassified as a "deposit" under the Companies (Acceptance of Deposits) Rules, 2014. That pulls the company into Section 73 deposit compliance — a far stricter regime with its own penalties, and in some circumstances, criminal exposure. Founders negotiating a milestone-based or staggered closing should build this 75-day window explicitly into their fundraise timeline, not treat it as a soft internal target.

3. Opening a fresh offer before closing the last one

Section 42(3) prohibits a company from making a new private placement offer until allotments under an earlier offer are complete, or that earlier offer has been formally withdrawn or abandoned. Startups doing rolling closes — bringing in investors in tranches over several months under what they think is "the same round" — can inadvertently breach this if the paperwork isn't structured to reflect a single, continuing offer correctly.

4. Quietly breaching the 200-investor cap

Early-stage startups raising through a series of small SAFE-style notes, convertible instruments, or angel checks can lose track of how many distinct investors they've brought in during a single financial year. Cross the 200-person threshold per class of security, and Section 42(11) is unforgiving: the entire issue is deemed a public offer, pulling in SEBI regulations and the Securities Contracts (Regulation) Act — regardless of whether the company is an unlisted private company that never intended to go anywhere near the public markets.

5. Treating Companies Act compliance as the whole job when foreign investors are involved

When a round includes foreign investors, Section 42 compliance under the Companies Act and FEMA compliance under the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 run on two separate, parallel tracks. Filing PAS-3 doesn't substitute for filing Form FC-GPR with the RBI within 30 days of allotment, and vice versa. Founders who treat the FEMA filing as an afterthought once the "real" compliance (PAS-3) is done frequently end up with a technically valid allotment under company law that's still non-compliant under FEMA — exposing the company to penalties under Section 13 of FEMA that can run up to three times the amount involved, plus a daily penalty for continuing default.

6. Sloppy or late PAS-3 filings 

It's tempting to treat the PAS-3 filing as a back-office formality once the money has already changed hands and the cap table has been updated internally. In practice, PAS-3 and MGT-14 filings become the company's permanent, time-stamped record of how every round actually happened and that record is exactly what due diligence teams reconstruct from during a future fundraise, M&A transaction, or insolvency proceeding. A defective or late PAS-3 can stall a future transaction, trigger indemnity carve-outs in a term sheet, or in the worst case, raise questions about the validity of securities that were issued years earlier.

This Isn't Theoretical: How Enforcement Actually Plays Out

Registrars of Companies have actively pursued adjudication orders against private companies for Section 42 violations — not just for large public-facing issues, but for routine private placement rounds that went wrong procedurally. In one publicly available adjudication order, a company that had accepted share application money without completing allotment within 60 days, and without refunding it within the following 15 days, was penalised ₹2 crore for each of two financial years in which the violation continued — a combined ₹4 crore penalty — in addition to being ordered to refund the money to investors within 30 days, along with 12% interest.

That's the structure of Section 42(10): the penalty can extend up to the amount raised through the private placement or ₹2 crore, whichever is lower, on top of the mandatory refund with interest. Separately, Section 42(9) imposes a penalty of ₹1,000 per day of default in filing the return of allotment, capped at ₹25 lakh. These aren't notional figures — they get applied.

A Practical Checklist for Founders and Their CS/CA Advisors

• Confirm board and special resolutions are passed, and MGT-14 filed, before any offer letter goes out.
• Issue PAS-4 only to investors already named in the board resolution — don't reuse an old offer letter for a new investor.
• Route every rupee of application money through a dedicated bank account, and don't touch it until PAS-3 is actually filed.
• Calendar the 60-day allotment deadline and the 15-day refund window the moment money is received — not when the term sheet was signed.
• Track the cumulative investor count per class of security across the financial year, especially across SAFE notes, convertible instruments, and smaller bridge rounds.
• For any round involving a foreign investor, run the FEMA/FC-GPR timeline as a parallel checklist, not a follow-up task.
• Don't open a new private placement offer until the previous one is allotted, withdrawn, or formally abandoned.
• Treat PAS-3 and MGT-14 as permanent legal records that future investors and acquirers will scrutinise — not as closing-day paperwork.

Conclusion

Private placement compliance rarely makes headlines, and that's precisely why it gets deprioritised during the adrenaline of closing a round. But Section 42 is structured to be unforgiving about timelines and process, regardless of whether the company eventually delivers a clean, successful raise. For startups, where every funding round adds another layer to an already complex cap table, getting Section 42 right the first time is far cheaper than untangling it during a future due diligence process — or facing a ROC adjudication order years down the line.

Disclaimer: This article is for general informational purposes and does not constitute legal or professional advice. Readers should consult a qualified Company Secretary, Chartered Accountant, or legal professional before relying on any of the above for an actual transaction.