This article is written by Miheer Jain pursuing Diploma in Companies Act, Corporate Governance and SEBI Regulations from LawSikho.

Venture capital fund

The venture capital fund (VCF) is a pooled investment vehicle for private investors. It can be founded or incorporated as a trust, a corporation, a limited liability partnership, or another entity that accepts assets from investors and invests them according to a defined investing strategy for the benefit of its stakeholders. As financing is growing amongst strong investors in India, it becomes important to understand the guidelines on venture capital funds as well as its current scenario in the Indian context. In this article, we will understand the eligibility and investment criteria in venture funds, the related tax matters, legal instruments and documentation required and finally, the take of judiciary on fostering a favorable investment atmosphere in the world of venture capital.

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Types of venture capital funding

The many types of venture capital are classified according to how they are used at different stages of a company’s life cycle. Early stage funding, growth financing, and acquisition/buyout financing are the three main types of venture capital. 

The venture capital fundraising process is divided into six stages, each of which corresponds to different stages of a company’s development. 

  1. Seed money is a small amount of money used to test and develop a fresh idea. 
  2. Start-up: Funding is required for new businesses to cover marketing and product development costs. 
  3. Manufacturing and early sales funding are covered in the first round. 
  4. Second-round: Operational money provided to early-stage businesses that are selling items but are not profitable. 
  5. Third-round financing, often known as mezzanine financing, is money used to expand a newly profitable business. 
  6. Fourth-round financing: Also known as bridge financing, the fourth round is recommended to fund the “going public” process.

The current scenario in India

According to Bain and Company’s “India Private Equity Report 2018,” 2017 was a strong year for private equity in India, as the country saw the greatest investment of Private Equity (PE)/Venture Capital (VC) ever, i.e., $26 billion.

By virtue of several legislation, the Securities and Exchange Board of India (SEBI) regulates both domestic and offshore funds. Domestic venture capital funds are governed by the SEBI (Alternate Investment Fund) Regulations, whereas offshore venture capital funds are governed by the SEBI (FVCI) Regulations, 2000. 

Venture capital fund eligibility and investment criteria 

The main objective of the memorandum of association or trust deed for venture capital funds must be to carry on the business of the venture capital fund, which includes prohibiting the memorandum of association and articles of association from making an invitation to the public to subscribe to its securities. 

Furthermore, a Director, Principal Officer, Employee, or Trustee must not be involved in any securities-related litigation and must not have been convicted of any crime involving moral turpitude or economic crime at any time. Also, in the event of a body corporate, it must have been formed under federal or state laws, and the applicant must not have been denied a certificate by SEBI (Rule-4, SEBI (Venture Capital Funds) Regulations 1996)

By issuing units, a venture capital fund can attract investment from any investor (Indian, foreign, or non-resident Indian), and no venture capital fund will accept an investment of less than five lakhs. Only the VCF’s staff, principal officers, directors, and trustees, as well as the fund manager and asset management company (AMC) personnel, are exempt. VCF must also have a clear commitment of at least five crores from investors before it can begin performing its functions. Before registering a fund, it must disclose its investment plan to SEBI, make no investments in connected companies, and keep track of the fund’s life cycle. It will not invest more than 25% of its capital in a single venture capital undertaking. A minimum of 66.67 percent of the investible funds must be used in venture capital undertaking unlisted equity shares or equity linked securities. 

It is also mandatory to invest no more than 33.33 percent of the investible funds in the following manner:

  1. Initial public offering (IPO) subscription for a venture capital firm (VCU). The term “IPO” refers to the procedure by which a private company sells its stock to the general public for the first time.
  2. A loan or debt instrument issued by VCU in which VCF has already invested. 
  3. A one-year lock-in term applies to preferential allotment of equity shares in a publicly traded firm. 
  4. The equity shares or equity-related securities of a publicly listed industrial corporation that is financially distressed or unwell. 
  5. Investment facilitation through VCF-created SPVs (special purpose vehicles).

RBI and investment criteria

A foreign venture capital investor who looks to conduct venture capital business in India must register with the Securities and Exchange Board of India (“SEBI”) and meet the SEBI Foreign Venture Capital Investor Regulations’ eligibility criteria and other requirements. The SEBI Foreign Venture Capital Investor Regulations impose the following investment guidelines, which may have an impact on foreign venture capital firms’ overall financing strategies. 

  1. The foreign venture capital investor must disclose its investment strategy and life cycle to SEBI, and by the conclusion of its life cycle, it must have met the investment conditions. 
  2. Unlisted equity shares or equity related instruments must account for at least 66.67 percent of investible funds. 
  3. A maximum of 33.33 percent of the investible money may be invested in the following ways.
    • Subscription to a venture capital firm’s initial public offering, whose shares are expected to be listed. 
    • Debt or a debt instrument issued by a venture capital firm in which a foreign venture capital investor has already made an equity investment. 
    • Preferential allotment of equity shares in a publicly traded corporation, subject to a one-year lock-in period. 
    • The equity shares or equity linked instruments of a financially weak or ill industrial company whose shares are listed (as defined in the SEBI FVCI Regulations). 
    • A foreign venture capitalist might put all of his or her money into one venture capital fund.

Tax matters related to venture capital funds

Under Section 10(23FB) of the Income Tax Act, 1961, Indian venture capital funds are permitted to tax repayment. Any income received by a SEBI-registered venture capital fund (formed as a trust or a business) set up to raise funds for investment in a venture capital undertaking is tax-free[16]. It will also apply to domestic VCFs and VCCs that receive international venture capital investments, provided that these VCFs/VCCs follow the same standards as domestic VCFs/VCCs. On the other hand, if the venture capital fund is willing to renounce the tax benefits provided by Section 10(23F) of the Income Tax Act, it is free to invest in any sector.

Instruments

Outside of equity, some of the preferred instruments for a VC fund are:

  1. Compulsorily convertible preference shares, which have a preferential right over dividends and give investors a preferential right to recover their investment in the event the company is wound up; 
  2. Compulsorily convertible debentures are another option. It is a loan instrument that must be converted into equity after a set length of time; 
  3. Convertible notes are now permitted as an investment option for startups as of January 10, 2017. A foreign investor can buy up to twenty-five lakh rupees worth of convertible notes in a single tranche. 

Convertible Note’ means an instrument issued by a start-up company evidencing the receipt of money initially as debt, repayable at the holder’s option, or convertible into such number of equity shares of such start-up company, within a period not exceeding five years from the date of issue of the convertible note, upon the occurrence of specified events as per the other terms and conditions agreed to. 

Documentation

A VC fund typically engages into different documents in conjunction with its investment, including;

  1. A term sheet: a term sheet is used to capture capital financing. It includes a variety of essentials such as the company’s valuation, the board’s composition, the ability to veto, departure rights, future funding, and the right to financial information, among others. 
  2. Share subscription agreement: it provides for the issuance of new shares to the investor in exchange for a consideration based on the company’s valuation. It specifies the purpose for which the funds may be used, the founder’s representations and warranties regarding the startup, and protects the investor from any liability arising from the firm’s legal, regulatory, or tax responsibilities, among other things.
  3. Shareholders’ agreement: it specifies the structure of the board of directors, the appointment of investor directors to the board, the founder’s obligation to provide investors with financial reports on a regular basis, pre-emptive rights, right of first refusal, and the investors’ exit options, among other things.

The following are the exit options/routes open to investors

The right to exit the portfolio firm is one of the most important components of a VC fund’s investment. Exit alternatives often include:

  1. An initial public offering, 
  2. A buyback of shares, 
  3. Redemption of fully paid-up preference shares/debentures, and 
  4. A sale of the company. 
  5. Registration rights: an investor’s right to register his or her stocks for sale if the company’s securities are listed on a foreign stock market. 
  6. Tag along rights: an investor can sell his or her share to a third party on the same terms and conditions as the company’s leaving shareholders. 
  7. Drag-along rights: an investor can force other shareholders to sell their shares to a third party on the same terms and conditions as the investor. 
  8. Put option: An investor can sell shares to other shareholders at a predetermined price and terms. 
  9. Call option: an investor can purchase another shareholder’s shares at a predefined price/terms and circumstances as set forth in the shareholders agreement.

Take of the judiciary

With recent judicial rulings, Indian courts are likely to instill more trust in investors, fostering a favorable investment atmosphere. In a recent decision, the Delhi High Court upheld an international arbitral award in favor of a foreign investor and against the promoters of an Indian company for concealing information about proceedings brought against them by the United States Food and Drug Administration while selling their shares. The court maintained the arbitral ruling in Docomo’s favor in another case, NTT Docomo v. Tata Sons Limited. The court’s ruling clearly demonstrated the importance of creating a favorable climate for foreign investment by holding Indian parties liable for their contractual commitments and preventing them from using the Foreign Exchange rules as a defense.

Conclusion

Any country’s economic success is dependent on sustained company growth and an atmosphere that fosters investor confidence. Investor trust can be assured when investors are able to quit companies after making profits and without suffering any losses as a result of the other shareholders’ or promoters’ willful default or deception. India is anticipated to achieve substantial investment and company growth in the coming years, thanks to admirable court precedents and liberal laws.

References

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