Venture Capital in India: Issues in Regulation
The venture capital industry in India has been undergoing a downward trend for the past two years. In the current upbeat economic scenario in the country, it is imperative to promote innovation, enterprise and conversion of scientific technology and knowledge based business ideas into commercial activity. The country’s success in the IT and IT related services have provided an impetus to the economy in general and have stimulated development in other sectors as well. The moment one talks about venture capital, it is normally understood as funds available solely for technological innovations. In reality, venture capital caters to different areas of business such as biotechnology, pharmaceuticals and drugs, agriculture, food processing, telecommunications, services, etc. The inherent strength of India lies in its skilled and cost-competitive manpower. If adequate policy support is made available to Indian entrepreneurs, India’s current development can be sustained and it is sure to pace towards the targeted 8 per cent economic growth with ease.
Venture capital plays a catalytic role in making entrepreneurial ideas reality. It is understood that in the life cycle of any business, venture capital funds play an important role in solving the problem of raising the required finances prior to the initial public offering. The main characteristics of venture capital finance are the willingness of the financier to withstand high risk and his expectation of high return. Venture capitalists, besides providing finance, offer hands-on management support and other skills to convert the entrepreneurial idea into a viable business. The factors that a venture capitalist considers before deciding on financing a venture are given below:
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What Does a VC Look For? The Team: This is the most crucial factor in getting VCs to invest in new companies. Forget the great idea, but think the great team. The kind of experience the company’s core founders have, how well their skills are suited to grow the business, their understanding of technology and business trends and more importantly, their ability to implement them in a cost efficient manner, are critical issues. Scalable Business Model: Finding the right niche is fundamental to success. VCs are on the lookout for companies doing extremely well in defined niche segments. However, companies need to chalk out a clear growth path for themselves within the niche and make sure they have the ability and infrastructure to take on market forces. Positioning: As a majority of players are focused on the segment of improving efficiency, rather than cutting edge technologies, it is imperative for the VC to have a good idea about how the company is positioned to take on the competition. Quicker Growth: Gone are the days of dreamy eyed projections. VCs want a realistic picture but expect companies to ramp up quickly. Given that the Made in India brand is no longer an issue, VCs are expecting companies to grow much quicker. |
Source: www.dqindia.com
A promising venture capital industry in India is likely to fill the gap between the capital requirements of technology and knowledge-based start-up enterprises and funding available from traditional institutional lenders such as banks. The gaps arise due to a relatively higher degree of dependence on intangible assets by these start-ups. Benefits of venture capital include the possibility of taking the company public once its business takes off; higher economic activity fuelled by VC funds leading to higher economic growth; employment opportunities, etc.
There are many success stories, both in India and abroad, of entrepreneurs who realised their dreams with help of VC. The quality of enterprise in India is on an ascending curve. The current atmosphere is now ripe for creating the right regulatory and policy environment for sustaining the momentum for high technology entrepreneurship. It is high time that an organised environment is created for the venture capital industry in India.
The government of India issued guidelines in September 1995 for overseas venture capital investment in India. There were three sets of regulations dealing with venture capital activity: SEBI (Venture Capital) Regulations 1996; Guidelines for Overseas Venture Capital Investments issued by Department of Economic Affairs in the Ministry of Finance in the year 1995; and CBDT’s guidelines for venture capital companies issued in 1995, which were later modified in 1999. Hence, a need was felt for the consolidation of all these into one single set of regulations to provide for uniformity and remove any ambiguity in any interpretation.
Based on the recommendations of the KB Chandrasekhar Committee, SEBI was made the nodal regulator for Venture Capital Funds (VCFs) that provides a uniform, single window regulatory framework. SEBI also notified regulations for foreign venture capital investors. These foreign venture capital investors (FVCIs) should also be registered with SEBI.
To promote the venture capital industry in India, the Securities and Exchange Board of India (SEBI) set up an advisory committee on venture capital under the chairmanship of Dr. Ashok Lahiri, chief economic advisor, Ministry of Finance, government of India, for advising SEBI in matters relating to the development and regulation of venture capital funds in India. This committee removed some earlier restrictions and recommended measures like permitting venture capital funds to invest in real estate, removing lock-in period for shares of listed venture capital undertakings and reducing the proportion of funds raised that have to be invested in unlisted companies from 75 per cent to 66.67 per cent and so on. After the last amendment of SEBI’s venture capital regulations in 2000, there were no major issues raised in the industry. Nevertheless, all regulations need to evolve to keep pace with the changing economic scenario, particularly in a dynamic industry such as venture capitalism. This committee, constituted for the said purpose, deliberated on various issues that are related to venture capital, broadly divided into three categories: operational, tax related, and foreign exchange related issues.
Currently, VCFs and FVCIs registered with SEBI cannot invest more than 25 per cent of the funds in shares at the time of IPO or in debt or debt instruments of a company in which the VCF has already invested by way of equity. VCFs and FVCIs are subjected to a lock-in period of one year and cannot exit immediately on listing of the shares. This acts as a deterrent factor, as it does not give an opportunity to VCFs to acquire shares in companies in the focus areas of the fund, and obtain early liquidity and returns to investors in the VCFs. The committee recommended that the restriction relating to the lock-in period be removed.
As per SEBI regulations, VCFs and FVCIs are required to invest at least 75 per cent of the investible funds in unlisted equity shares or equity linked instruments. This restricts the registered VCFs from investing in listed companies. It was recommended that this restriction should be reduced by bringing the amount to be invested in unlisted companies. The committee recommended a reduction on the minimum limit of investment in unlisted companies from 75 per cent to 66.67 per cent. The remaining 33.33 per cent (or less, depending on how much is invested in unlisted companies) may be invested in listed securities. The committee argues that because of the risky nature of investment in unlisted companies, as well as the time lag between investment and payback, this measure will help VC funds to protect their net asset value (NAV) during the initial period.
SEBI regulations stipulate that the VCFs and FVCIs can invest 75 per cent of the investible funds in the form of equity or equity-linked instruments. Some portion of the investible funds is allowed to be invested in debt or debt-related instruments provided the VCF or FVCI has already invested in the venture capital undertaking by way of equity. The industry sought freedom to invest in instruments that give them flexibility to invest in some kind of hybrid instruments that are optionally convertible. Equity-linked instruments, by definition, should be compulsorily convertible into equity. This deprives the VCFs of any flexibility in future investment. Therefore, the Ashok Lahiri Committee recommended that some types of hybrid instruments, which are optionally convertible into equity, may be permitted for investment within the 66.67 per cent portion of the investible funds, allocated for investment in unlisted companies.
Special Purpose Vehicles (SPVs) are independent, stand-alone entities specifically set up for the purpose of a single transaction or project. Since the SPV has its own separate legal identity, it can raise capital in its name, own assets and create a charge over them. SPVs ensure that shareholders have a liability limited to the extent of their unpaid shares. This protects the shareholders from liabilities arising from the contracts entered into by the business earlier. There are instances in which VCFs and FVCIs need to resort to innovative financing structures by creating SPVs in the form of trusts or holding companies that will issue shares on the underlying business. The committee suggested some measures to facilitate the process of setting up SPVs and their operations.
Currently, VCFs are not permitted to invest in the non-banking financial services sector. The committee recommended that given the risky nature of the business in this sector, VCFs may only be allowed to invest in NBFCs engaged in equipment leasing and hire purchase. The committee also recommended that real estate investments by VCFs and FCVIs be permitted. According to the current SEBI regulations, financing gold is not a permitted activity for VCFs and FCVIs. It has been recommended that this restriction on financing of gold be removed. At the same time, the restriction continues on financing for speculation in gold.
The venture capital industry believed that SEBI registered VCFs should be permitted to invest up to a certain percentage of their corpus in overseas companies. This is expected to help the Indian VCFs to invest in offshore companies and also allows them to have global management exposure. The members of the committee resolved this issue by recommending that VCFs be allowed to invest in offshore VCUs. It was suggested that the RBI may periodically specify the overall limit for such investment, which may be monitored by the SEBI.
The committee also recommended the appointment of a custodian by each FVCI to facilitate the maintenance of records and to ensure a smooth transition when the VCU’s shares get listed. Furthermore, to faciltate the overall growth of the VC industry and ensure faster flow of venture capital funds into India, SEBI may from time to time expand the definition of Venture Capital Undertaking (VCU) suitably.
The performance of VCFs is often judged based on their successful exit from the VCUs. These exit routes may take any of the following forms: initial public offer, merger or acquisition or a management buy-out. M&A is the most common route. When a foreign company acquires a VCU, the consideration is paid through cash or through issuance of securities of the foreign company. The VCFs then realise cash by sale of such foreign securities. The committee felt that a clarification should be issued on the tax issues related to these exit routes through a Central Board of Direct Taxes (CBDT) circular.
Most of the FVCIs prefer to have a wholly owned subsidiary in India to act as an advisor and for carrying out various investment and post-investment activities. FVCIs opine that the activities carried out by these subsidiary companies do not require investment of any funds. But they are compelled to lock cash into their Indian advisory subsidiaries to meet the minimum capitalization requirement. It has been recommended that wholly owned Indian subsidiaries of FVCIs registered with SEBI may be exempted from the minimum capitalisation requirements.
Venture capital investments in India have fallen by 34 per cent in 2002 according to the Indian Venture Capital Association (IVCA). In 2001, the decline was 4.3 per cent. The decline in the industry is surprising, given that some big ticket VC deals have taken place in the country. Ironically, individual deals have grown exponentially, ranging between $10m and $100m per investment. The reasons that can be attributed to the current declining trend in the VC industry are: the nature of the VC activity and the so called third generation VC funds – Infinity Ventures, Indian Direct Fund (IDF) and eVentures India – have started cleaning out their portfolios through strategic sales.
But 2004 is going to prove fruitful for the VC industry in India. This bright forecast came from the meeting of foreign venture capitalists in November 2003 in Hyderabad, at a global conference to explore the possibilities of financing new ventures in India. Several funds based in Europe and the US expressed their keen interest in investing in India either directly or by creating a separate India fund aimed at supporting start-ups. Silicon Valley Bank is planning to set up an office in India to support its clients willing to set up operations in India. VC firms are attracted by the stupendous performance of the country – Asia’s third largest economy. According to the Indian Venture Capital Association, India received $550m in venture capital funding in 78 companies in 2002, second only to South Korea’s $906m in Asia outside of Japan. Venture capital investments in the six months ending September 2003 are said to have touched $400m and are expected to touch $650m mark by the end of March 2004. India offers bright promises for ventures in areas such as IT and biotechnology. In a strategic review of the VC industry for 2004, the National Association of Software and Services Companies (NASSCOM) has observed that the Indian venture capital sector faces a challenging environment. The recommendations of the advisory group for foreign venture capital investors (FVCIs) are expected to improve the prospects of the industry and Indian entrepreneurs should be able to steer ahead in their ventures.