Rajeev Doharey and VarshaMullick make an effort to look at the focus and investment strategies of venture capital funds (VCFs). Security and Exchange Board of India (SEBI) is the regulating board for regulating VCF. The SEBI (AIF) Regulations, 2012 as well as the repealed SEBI (VCF) Regulations is been looked into in this attempt to understand how the venture capital market operates and is regulated in India
Venture capital is considered as a subset of private equity on investments in new and maturing companies. Private equity, on the other hand, is a type of equity investment in an asset in which the equity is not freely tradable in the stock market. Private equity firms were generally thought to be investing in assets, which are not in the public market. Big private equity firms invest in assets, which are listed on stock exchange and then take them private.
Venture capital and private equity funds have seen a sharp growth in the past few years and promises for further expansion in the coming years. These investments are one of the most popular routes for foreign investments in India. The concept of venture capital in India is very recent unlike other countries like U.K., U.S.A etc. where VCFs have been operative for a very long time. India doesn’t have an organisedVCF and in the absence of the same, individual investors and development financial investors have hitherto played the role of venture capitalists in India. Unlike private equity funds where investors have control over the management, in case of venture capital funds, the investors don’t have a control over the management. It is basically portfolio investment.
Venture capitalist bear all the risk associated with floating of a new business and if lucky enough he gets the profit out of such investment. Venture capitalist always keeps in touch with the entrepreneur even after making an investment to protect and enhance his investment. This concept of risky yet profitable aspect of venture capital can be traced back from the early time in history. Columbus had set out on voyage towards East to find India but King of Portugal didn’t support it. Finally, Queen Isabella of Spain funded his venture and the returns were more than the risk taken. Thus, one of the essential characteristic features of venture capital funds is to invest in new and growing companies, which are knowledge based assuming a high risk element but promising a sustainable growth and greater rewards in future.
When any investment happens, an investor looks into the past growth of the company by analysing the past earnings, dividends, forecasting its future earnings and dividends and then applying a rational discount rate. For a venture, the task of such valuation is difficult for two reasons:
Venture capital funds are typically funds which are pooled in for a term of 10 years and investing in venture capital undertakings for a period of 3 to 5 years with an expected high return. To protect against losses, venture capital funds provide its expertise, undertake advisory function and invest in the “patient – capital” of the undertaking equities.
Security and Exchange Board of India (Venture Capital Funds) Regulations 1996 used to regulate the working of the venture capital funds in India till 2012 before being repealed and replaced by the SEBI (Alternative Investment Funds) Regulations, 2012 passed on May 21, 2012 and also known as AIF Regulations. Sec 4 of the previous Act mentioned about the eligibility criteria required to apply to the Board for a venture capital fund. Sec 4A said that , “For the purposes of determining whether an application or venture capital fund is a fit and proper person the Board may take into account the criteria specifiedin Schedule II of the SEBI Regulations (Intermediary) 2008. “
Sec 8(b) of the VCF Regulations also mentioned that the sole business purpose of such investment has to be venture capital as the conditions for granting of certificate. Chapter III dealt with Investment Conditions and Restrictions. Investment could be raised from any Indian, foreign, Non-resident Indian as per section 11(1). 11(2) specified that “No venture capital fund set up as company or any scheme of venture capital fund set up as a trust shall accept any investment from any investor which is less than five lakh rupees.” Sec 12 (b) put a bar of not investing more than 25 per cent of the corpus investment on a particular venture. Sec 12(d) made a list of how venture capital fund should be invested.
Sec 12 (1B) of the VCF Regulations had made it mandatory for every domestic VCF to obtain certificate of registration from SEBI in accordance with the regulations. However, registration of foreign venture capital Investors was not mandatory under the FVCI Regulations.
Venture capital funds were not allowed to be listed on any recognised stock exchange till the expiry of 3 years from the issuance of units by the venture capital fund by virtue of sec 13. Sec 14 of the VCF Regulations didn’t allow venture capital to place advertisements in public to call for public offerings for the subscription or purchase of its units. Sec 15 said that venture capital funds can receive money for investment in the venture capital fund for private placement of its units.
Sec 23 provided for winding up of a venture capital fund. Sec 23 (2 ) says that a venture capital fund working as a company would be wound up as mentioned in the Companies Act. Other sub sections mentions about different ways of winding up a venture capital fund. Sec 24 talked about effects of winding up of a venture capital fund.
Though VCF Regulations have been repealed but they will be operative for those VCFs operating till they are wound up. However, the already existing VCFs are not allowed to increase the targeted corpus of the funds. These VCFs however can seek registration under AIF Regulations subject to approval of 66.67 per cent of their investors by value. The VCFs not already registered under VCF Regulations won’t further be allowed to float any new scheme unless they register under the present AIF Regulations as notified by SEBI. Venture capital funds, which have been existent before but not registered under VCF Regulations and can’t even meet the strict AIF Regulations requirements, can seek exemption from the Board from the strict compliance.
Under the present SEBI (AIF) Regulations, 2012 , sec 2 (z) defines venture capital funds as , “venture capital fund means an Alternative Investment Fund which invests primarily in unlisted securities of start-ups, emerging or early-stage venture capital undertakings mainly involved in new products, new services, technology or intellectual property right based activities or a new business model.”
Sec 10 provides for, ‘Investment in Alternative Investment Fund’. Sec 10 (b) categorically mentions that each scheme of the AIF shall have corpus of at least two crore rupees and 10 (c) states that AIF shall not accept from an investor, an investment less than one crore rupees.
With the coming of the new Regulation, the minimum threshold of investment which the investor can make shot up from 5 lakhs to one crore. However, the present Regulation brought in some changes about the listing of the funds on the Stock Exchange. Sec 14 (1) says that, “Units of all close ended AIF may be listed on a stock exchange subject to a minimum tradable lot of one crore rupees.” However, 14 (2) says that listing of AIF units shall be permitted only after final close of the fund or Scheme. Sec 15 provides for General Investment Conditions and the various subsections of sec 15 specifically mention about Category I, II & III AIF investment conditions. This new Act also has provision for alternate dispute resolution method through arbitration in case of any dispute arising. Sec 25 says, “An Alternative Investment Fund, by itself or through the Manager or Sponsor, shall lay down procedure for resolution of disputes between the investors, Alternative Investment Fund, Manager or Sponsor through arbitration or any such mechanism as mutually decided between the investors and the Alternative Investment Fund”. The procedure for winding up of the AIF remains the same as mentioned under sec 29.
However, the present SEBI (AIF) Regulations are much progressive and coming of age. By increasing the threshold of minimum investment required, the Regulation has tried to refine the entry of various investors who don’t seem much potential in the future. With stricter norms, to participate in the venture capital market,it would require furnishing more details and investing more in a particular sector in the market.
SEBI further made amendments to SEBI (AIF) Regulations 2012, in 2013 pursuant to the budget of FY 2013-14, providing for a framework for registration and regulation of “Angel Pools” under sub category “Angel Funds” under Category I of Venture Capital Funds.
There are a few salient features of such funds as follows:
Most venture capital funds invest in some specialised areas which they consider good for investment. Though most of the venture capital funds do not claim to specialise only in high technology investments, but their portfolios include a significant proportion of their investment directed to towards advanced technology. Recycling funds for new investments in the way of capital realisation is one of the important characteristic of venture capital funds. Even where a fund’s opening ended, such as bank sponsored capital funds and there is no need for realisation to make new investments but still the venture capitalist naturally gets motivated to achieve successful realisations.
However, there are few areas where the investment happens in a few stages and venture capitalists specialise in investing in these sectors.
A new business is formed when buy out happens separating completely from the existing business and the existing owners. This buy-out may result to a new management and a set of assets, which may be just a trade name or group of people. However, this process also considers significant risk. Management buy-outs dominate investment strategy in recent times and buy-outs dominate UK venture capital industry presently.
For a venture capitalist point of view, investing in a start-up business or a development business right after R&D is beneficial. Though bearing risk is one of the important essential criteria of venturecapital funding but investing in these sectors would promise good returns as well along with the risk than investing in buyouts, which often may require higher risks with little or rather no returns.
There are many exit routes, which the venture capitalist might opt for but the corporate sale is the best and desired way from the perspective of a venture capitalist. This corporate sale involves two aspects. (i) Why and (ii) at what price /sale of the whole undertaking will take place only if it is advantageous for both the parties. By such corporate sale, a venture capitalist is likely to higher that what he can otherwise get in return for his investment. Such lump sale also offers ready cash to the venture capitalist, which he can profitably employ in some other venture.
There are other exit routes as well like ‘Take Out ‘when a venture capitalist transfers his interest in the unit to another venture capitalist. A venture capitalist chooses this path when he needs immediate finance for some other unit. Almost all venture capital agreements contain the clause that the venture capitalist would at the end of a given period will freely dispose off his stake and the first offer will be made to the promoter. Share repurchase by the promoter is also a profitable way of exit for the venture capitalist as the price of repurchase is mutually agreed upon and predetermined on the commercial criteria, which reflects profit potential of the venture. Buy back, however, isn’t an appropriate or rather sought route for a venture capitalist as an exit route. A venture capitalist may also opt for listing the shares of the company on a stock exchange by which the venture capitalist can hope to get back the returns of his investment and exit but this route also has its own problems.
Winding up of the venture capital fund is always available to a venture capitalist if all other exit routes fail. Appropriating the proceeds after liquidation of the company could be a way for the venture capitalist to get back the returns of his investment and exit
Venture capital is still growing and yet there are lot more left to progress in the venture capital market of India. The trend of investment has been seen generally in high technology based sectors and start up business. Venture capital is yet to make a mark in important public sectors like health, education etc. in India. Though one of the basic features of venture capital is high risk bearing investments but the investors don’t get any initiative to invest in such crucial sectors in the fear of getting no returns or suffering loss. As other sectors are important so are health and education which needs lots of investment for progress. The government should come forward and provide initiative to the venture capitalist to invest in such sectors, which is really essential from the perspective of India.
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