Venture Capital Finance has been prevalent in India since the early 1970’s. It is in the recent years that the VC industry has successfully emerged for young companies that have high growth projections. Venture Capital has emerged as one of the best financing alternatives. Private Equity and Venture Capital flows have been termed as the largest component of FDI investment into India. Various studies successfully illustrated that PE & VC funded companies have created significantly more employment. The financial investment process in India has advanced a lot over the past several years. While there were only some financial institutes or commercial banks that provided funding, VC funds have emerged over a period of 30 years. India has now emerged as one of the most favored destinations for disposition of global VC funds. With this article, I have outlined the history of how VC industry started in India as well as outline the regulations that govern registration of VCF.
EVOLUTION OF VC INDUSTRY
The VC industry in India can be traced back to early 70’s where the Indian government appointed a committee under Late Shri R.S. Bhatt to discover a way to fill gaps in the traditional financing methods and make funding accessible for companies with new innovative ideas, technologies and procedures. The committee’s recommendation was the opening of venture capital industry in India.
Through the recommendation, in 1955 VC financing was first presented when Industrial Finance Corporation of India (IFCI) formed Risk Capital Foundation (now known as IFCI Venture Capital Fund Ltd.). Thereafter, in 1976, Industrial Development Bank of India (IDBI) announced a seed capital scheme and national Equity scheme. For the next decade, VC industry consisted financing in the form of risk capital and seed capital. However, it wasn’t until 1986-87 that VC was given recognition.
In 1987, IDBI introduced a VCF scheme seeking development of indigenous technologies or adaption to the new technology. Similarly, the Technology Development and Information Company of India was formed as a venture capital subsidiary by ICICI. It was in 1988 where the government formulated a detailed guideline that governed the VCF. Controller of Capital Issues (CCI) adapted the guidelines and implemented it which were known as CCI for VC. However, due to the liberalization of the economy, CCI was abolished in 1992 and all powers that CCI carried were vested in Securities and Exchange Board of India (SEBI). Guidelines were soon issued by Indian government for overseas investment in India in 1995. SEBI introduced regulations for Venture capital investments coming into India such as the SEBI Venture Capital funds regulation, 1996 (VCF Regulations).
However, the scale up phase of the VC industry in India has been said to be from 2010. Post 2015, the VC industry in India has moved from a scale-up phase to an evolving phase where the investment strategy has changed to placing bets on proven start-ups.
CURRENT REGULATIONS
Until 2012, VCF was governed by VCF regulations of 1996. However, in 2012, SEBI repealed the said act and implemented SEBI Alternative Investment Funds Regulation, 2012 (AIF Regulations) to bring all funds established in India or to be established in India under one statute.
As per Section 3(2) of the AIF Regulations, any funds registered as VCF under VCF regulations (now repealed) shall continue to be regulated by the said regulations till the existing fund or scheme managed by the fund is wound up and such funds shall not launch any new scheme after notification of these regulations: “1) Provided that the existing fund or scheme shall not increase the targeted corpus of the fund or scheme after notification of these regulations.2) Provided further that venture capital funds may seek re-registration under these regulations subject to approval of two-thirds of their investors by value of their investment.”
The AIF’s include VC funds as well as private equity funds that are able to provide short term or long-term capital. The funds created include a wide range of strategies and allow investing “in new ventures, social ventures, start-ups, growth enterprises, infrastructure, real estate, debt funds and other investment strategies, including angel investing through angel funds.”
The AIF regulations covers any fund established in India for taking money from investors, whether Indian or foreign, for investing it in accord to a distinct investment policy. The fund may be established either in form of a trust, company, body corporate or a Limited liability partnership (LLP). Below chart shows the legal structure of AIF under a trust, company or LLP.
Categories of AIF
The AIF Regulations classifies the funds under its applicability into three broad categories based on the impact on economy, exposure as well as overall risk. Section 3(4) of the AIF regulations provides the following categories:
Category I – This category includes AIF’s that tend to have a positive spillover effect on the economy such as venture capital funds, SME funds, social venture funds, infrastructure funds or such other funds. such funds usually cannot involve or participate in any leverage except for gathering temporary funding requirements, no more than 30 days and no more than four times in a year and not more than ten percent of the corpus. Such funds have certain incentives or concessions that could be decided by SEBI or Government of India. The minimum fund size required is Rs. 20 crore. Such funds which are formed as trusts or companies shall be construed as ―venture capital company or ―venture capital fund as specified under sub-section (23FB) of Section 10 of the Income Tax Act, 1961.
Category II – Funds in this category usually have no special concessions or incentives and do not fall under Category I or Category III as well as includes any such funds that do not undertake leverage or borrowing other than to meet day-to-day operational requirements. Investment conditions are prescribed under Section 17 of the AIF regulations. Similar to Category I, such funds usually cannot involve or participate in any leverage except for gathering temporary funding requirements, no more than 30 days and no more than four times in a year and not more than ten percent of the corpus.
Category III – Such funds that have potential negative externalities in specific situations. Such funds include Hedge funds or other funds that trade with a view to make short term returns, or such that are either open ended or close ended and receive no specific incentives or concessions. However, unlike Category I and II, such funds could participate in leverage or borrow subject to consent from investors in the fund as well as the allowed maximum limit that may be detailed by SEBI or government. Such funds must disclose periodically all information relating to overall level of leverage employed, main source of leverage to investors, level of leverage in derivatives held and level of leverage received from borrowing cash. Category III shall be regulated through directions in operational standards, redemption restrictions, conflict of interest and any other such directional specified by SEBI.
Category I and II AIF’s require their funds to have a tenure of minimum three years which are usually close ended. Extension is provided up to two subject to approval by two-thirds of the unit holders based on value of their investment in AIF. While AIF under Category III are not allowed to invest more than 10% of the fund in one investee company, category I and II are allowed up to 25%.When there’s no consent from unit holders of AIF, the AIF shall fully liquidate within one year following expiration of the fund tenure or extended tenure.
Thresholds required under the AIF regulations
o Each category requires a minimum corpus of Rs. 20 crores (Rs. 5 crores for angel funds)
o Any employee or director of the AIF is permitted to invest minimum Rs. 25 lakhs.
o No scheme by an AIF can have more than 1000 investors (200 investors for Angel Fund)
AIF Registration
Eligibility Criteria for AIF Registration:
o Memorandum of Association (MOA) /Trust Deed/Partnership Deed should have permits that allow carrying on the activity of AIF
o Trust Deed/Partnership Deed should be registered under respective governing laws
o In case the applicant is a limited liability partnership, the partnership is duly incorporated, and the partnership deed has been duly filed with the Registrar under the provisions of the Limited Liability Partnership Act, 2008;
o In case the applicant is a body corporate, it is set up or established under the laws of the Central or State Legislature and is permitted to carry on the activities of an Alternative Investment Fund;
o MOA/Trust Deed/Partnership Deed should forbid making an invitation to the public to subscribe its securities
o The Applicant, Sponsor and Manager are “fit and proper” based on the criteria specified in Schedule II of the Securities and Exchange Board of India (Intermediaries) Regulations, 2008
o At least one personnel working in the key investment team under investment manager of AIF should have minimum five years of experience in advising or managing pools of capital or in fund or asset or wealth or portfolio management or in the business of buying, selling and dealing of securities or other financial assets and any other relevant professional qualification.
o The sponsor or the manager should have all the necessary infrastructure to discharge the activities under AIF.
o The Applicant to clearly describe investment objective, investment strategy, proposed corpus, tenure and target investors.
whether the applicant or any entity established by the Sponsor or Manager has earlier been refused registration by the Board.
Under Section 3(6) of AIF Regulations, the procedure of grant of Certificate is based on:
o The Board may grant certificate under any specific category of Alternative Investment Fund, if it is satisfied that the applicant fulfills the requirements as specified in these regulations.
o The Board shall, on receipt of the registration fee as specified in the Second Schedule, grant a certificate of registration in Form B.
o The registration may be granted with such conditions as may be deemed appropriate by the Board.
With the AIF regulations, the government has helped in creative a better positive environment for the VC industry to grow.“In 2019, some of the key recommendations of the industry such as extension of tax exemptions in IFSCs to Alternate Investment Funds (AIFs, which is what PE &VC firms incorporated in India are called); pass-through of end of fund losses for AIFs to their investors; and exemption from the purview of Angel Tax (Sec 56) were accepted by the government.”
CONCLUSION
Although India has a rich history of entrepreneurship as well as the evolution of VC industry, it wasn’t until recent that the VC industry gained preference as source of funding. While VC as a source of finance has existed since 1980’s, it has played an instrumental role in shaping the young companies since 2010. Planning commission appraised that the VC’s in India have the potential to create a minimum of 2500 new ventures over the next decade. SEBI has done a great job in providing specific regulations & guidelines that allow VCF to function better and promote small companies in need of funding.
DISCLAIMER: Any person relying on this paper is liable & fully responsible for any decision taken on the basis of this paper. This paper only presents my interpretation of the rules and regulations.
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