CHAPTER IV AN OVERVIEW OF VENTURE CAPITAL IN INDIA

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1 CHAPTER IV AN OVERVIEW OF VENTURE CAPITAL IN INDIA Introduction The government of India undertook initiatives to establish the venture capital industry in India. The earliest efforts by the Indian government can be traced back to 1970s and even today there is confusion with respect to the regulatory framework pertaining to this industry. Venture capital investments marginally declined in and gained momentum from This chapter traces the chronological sequence of events that have led to the present state of the industry in India and the characteristics of this industry in India Objectives The main objectives of this chapter are To trace the evolution of the venture capital industry in India. To understand the structuring of ventvire capital funds in India. To understand the regulatory frame work pertaining to the venture capital industry in India. To understand the recent trends in the industry in terms of investors in venture capital funds, sectors attracting investments and instruments used for investing Evolution In 1973, government of India appointed a committee under the chairmanship of Mr.R.S.Bhatt to find out ways for funding small and medium enterprises. It was called the Bhatt Committee. The committee recommended starting of venture capital industry in India for financing small and medium technology based enterprises. In 1975 IFCI established Risk Capital Foundation for encouraging technologists and entrepreneurs to set up enterprises. In 1976 IDBI launched the seed capital scheme. They were different from venture capital as they only provided finance and were not offering value added services. 117

2 ICICI launched a venture capital scheme in 1984 under which funds were given to new enterprises developing indigenous technology, a new product or for adaptation of imported technology. In 1986 the R&D Cess Act was passed under which a Cess of 5% was levied on all imported technology and this was used to create a pool of venture capital fund. In 1987 the first private venture capital fund was created by ANZ Grindlays.' In November 1988, the government of India with a view to institutionalise venture capital issued certain guidelines, which were very restrictive. The Controller of Capital Issues implemented these guidelines. The guidelines stated that ventxire capital should be invested only in enterprises developing new technology and promoted by first generation entrepreneurs. This made venture capital investments very unattractive and risky. In 1988 The Technology Development and Information Company of India Ltd (TDICI) was established jointly by ICICI and UTI. TDICI invested in a number of enterprises such as Wipro, Mastek, Microland, Sim Pharmaceuticals etc. Some of the investments were profitable and some were made in ventures that were not commercially viable. The personnel of TDICI helped in the institutionalisation of venture capital but the process of proposals getting approved at the junior level before presenting them at the higher levels resulted in wrong decisions. The World Bank also took some initiatives and selected a few institutions including TDICI, GVFL, Can Bank Venture Fimd, APIDC etc. for making venture capital investments in India. In fact more than the government's initiatives, the World Bank initiatives contributed to the development of venture capitalism in India. Post 1991, CCI guidelines were abolished and venture capital industry became unregulated. In 1995 the government allowed foreign fimds to invest in India and many of them therefore started making investments in Indian enterprises.'^ In 1992 SEBI was formed, which today is the nodal agency for regulating and monitoring venture capital in India. Vinod Khosla, General Partner at Kliener, Perkins, Caufield and Bayers came to India in 1993 and spent 3 years in India exploring the environment. He was one of 118

3 the founders of Sun Microsystems and therefore had entrepreneurial experience. He joined Kliener, Perkins, Caufield and Bayers in In 1996 he returned to Silicon Valley convinced that the environment was not conducive to the development of venture capital in India. In 1993 Indian Venture Capital Association was formed to provide a platform to venture capitalists in India to voice their suggestions to the government and to network with each other. Nasscom is another association that lobbies for venture capital reforms in India. Draper International became the first foreign venture capital fund based in India with the objective of investing in Indian companies and American companies having operations in India. It was followed by Walden International.^ In 1997 the Information Technology boom gave a boost to the venture capital industry in India because most of the enterprises in the Information Technology sector were funded by venture capitalists. Bangalore in Kamataka became the hotbed for Information Technology startups and venture capital investments in the state increased. The dotcom bust affected venture capital investments in India also. There was a fall in the deal flow in After 2003, venture capital investments again picked up till recently. The current economic slowdown has taken a toll on the venture capital investments. Currently there are around 132 domestic venture capital funds and 129 foreign venture capital funds registered with SEBI as per the SEBI website.'* This list includes both venture capital fiinds and private equity funds. According to an official from TSJ Media-Ventureintelligence, which is the most reliable source of data related to venture capital and private equity investments in India, there are only around 40 venture capital firms that are active in India now. What is evident from the above points is that in the initial stages of the development of the venture capital industry in India only development financial institutions and nationalized banks were allowed to carry on venture capital activities. The performance of such venture capital institutions was poor due to obvious reasons such as; the personnel did not have either entrepreneurial experience or the risk appetite to be able to make informed investment decisions. 119

4 4.3.0: Structuring Of Venture Capital Funds In India: The stages in the venture funding process would be the same all over the world. However the time taken and the structuring of deals may vary depending on the regulatory and legal framework, the entrepreneurial culture, the legal aspects pertaining to setting up a new firm etc. The primary considerations in structuring of deals are taxation, valuation, instruments to be used for financing, exit options and rights of the investor. The most common structures of venture capital fimds in India are described in the following paragraphs Domestic Funds: When the funds are raised within India, a domestic investment vehicle in the form of a trust or company is established. This investment vehicle pools ftmds fi'om investors. An investment advisor or an asset management company is set up for managing the fund. The asset management company or the investment advisors identify investee companies and invests the fimds in them. The following diagram explains the structure of domestic funds in India. D 4.1 Structure Of A Domestic Fund Investors India Domestic investment vehicle- Trust/Company Investment Advisors/Asset Management Company Company 1 Company 2 Company 3 Source: Hirani, Akhil 120

5 Offshore Funds An investment vehicle that pools funds from foreign investors is established in a tax favourable jurisdiction. The investment vehicle makes investments in venture capital undertakings in India. Most of the offshore funds have set up investment vehicles in Mauritius because India has a Double Tax Avoidance Agreement (DTAA) with Mauritius. The investment vehicle may be established in the form of a limited liability partnership or limited liability company. The fund is managed by an offshore manager in Mauritius and usually has an investment advisor in India to identify companies for investment. In this type of a set up it is important to structure the relationship between the offshore fund, offshore manager and the Indian advisor so as to avoid the Indian advisor from being considered as a Permanent Establishment (PE). If it is considered as a Permanent Establishment it can have adverse tax implications. The following diagram shows the structure of an offshore fund. D 4.2 Structure Of An OfTshore Fund Foreign Investors Investors' Jurisdiction Offshore fund Overseas Offshore Jurisdiction Company 1 Company 2 Company 3 Indian Advisor Source: Hirani, Akhil 121

6 Unified Funds: Under this structure domestic investors as well as overseas investors participate in the venture capital flind. A domestic fund is created in the form of a trust and is registered with the Securities and Exchange Board of India as a domestic venture capital fund. Domestic investors invest directly in the fund. Overseas investors pool their funds and make investment in an offshore fiind in a foreign tax favourable jurisdiction such as Mauritius. The offshore fund invests in the domestic fund, which in turn invests in domestic venture capital undertakings. D 4.3 Structure Of An Unified Fund Foreign Investors Investors' jurisdiction Offshore fund Overseas managers Overseas Jurisdiction Indian Investors Domestic Trust Indian Advisor India Company 1 Company 2 Company 3 Source: Hirani, Akhil^ Recently the government has passed a resolution allowing the formation of Limited Liability Partnership form of organisation in India. It is the most common form of structure adopted by venture capital organisations in other countries. In India, it may take some time for venture capital organisations to change from their present structures to the new structure as the tax implications are not very clear. 122

7 4.4.0 Types Of Venture Capital Funds In India Venture capital funds operating in India can be broadly classified into Domestic Venture Capital Funds and Foreign Venture Capital Funds. These can be fiirthcr classified based on the organisation promoting the venture capital ftind. The following diagram shows the different types of venture capital funds operating in India. D 4.4 Types Of Venture Capital Funds Types of Venture capital funds JT Domestic ventuie capital funds Foreign venture capital funds Source Researchers own contribution Domestic venture capital funds: There arel32 domestic venture capital funds registered with SEBI. This list includes private equity players also. Out of 132, only around 40 of them make venture capital type investments and rest of them that are active make late stage investments. There are six types of domestic venture capital funds operating in India. The six comprise of venture capital arms of development financial institutions, venture capital arms of banks, venture capital funds launched by state industrial development corporations, venture capital funds of multilateral agencies, corporate venture capital funds and independent venture capital funds. 123

8 D 4.5 Types Of Domestic Venture Capital Funds Domestic venture capital funds, Venture capital arms of DFIs Venture capital arms of banks VC funds of State Industrial Development Corporation VC funds of multilateral agencies I Corporate venture capital funds Independent Venture capital funds V V. Source. Researchers own contribution Venture capital arms of development financial institutions: In the initial stages of the development of the venture capital industry in India, only public sector banks and development financial institutions were allowed to make venture capital investments. ICICI Ventures, SIDBI venture Capital etc. are examples of venture capital arms of development financial institutions. Venture capital arms of banks: Nationalised banks such as Canara bank and State Bank of India have set up venture capital funds. Venture Capital funds of state industrial development corporations: A few state govememnts in India have set up venture capital arms. APIDC, GVFL etc. are examples of such venture capital funds. Venture Capital funds of multilateral agencies: IFCI had sponsored a venture capital arm in India. Apart from this multilateral organisations such as World Bank contribute to venture capital investments in India. 124

9 Corporate venture capital funds: In 1990s many MNCs started setting up venture capital arms for the purpose of making investments in external startups. There are very few homegrown corporate venture capital funds in India. Reliance Technology ventures Ltd, Strategic Innovation and Research Fund of Mahindra and Mahindra etc. are examples of venture capital funds launched by Indian companies. Independent venture capital funds: There are a few venture capital funds launched by independent fund managers in India. Axis Holdings, Ventureast etc. arc traditional independent venture capital funds operating in India Foreign Venture Capital Funds: There arc around 129 Foreign venture capital funds registered with SEBI, which includes private equity players also. All are not active. There are three types of foreign venture capital funds operating in India. There are Foreign independent venture capital funds, venture capital arms of foreign companies and venture capital arms of foreign banks operating in India. In the 2006 several foreign venture capital funds entered India and started making investments. D. 4.6 Types Of Foreign Venture Capital Funds Foreign venture capital funds Independent venture capital funds Venture capital arms of foreign banks Corporate venture capital funds Source Researchers own contribution. Corporate venture capital funds: Venture capital arms of MNCs arc making investments in India. Intel Capital, Siemens, Blue Run ventures (venture capital arm of Nokia) are examples of such funds in India. As per the reported deals 125

10 among the foreign corporate venture capital funds, Intel Capital has made maximum investments in the last five years. Independent venture capital funds: Helion Ventures, Matrix Partners, Draper Fisher Jurvetson etc. are examples of independent foreign venture capital funds in India. Venture capital arms of foreign banks: HSBC Private Equity and venture capital arm of Citi Bank are examples of venture capital arms of foreign banks that have invested in India Regulatory Framework In India The regulatory framework in a coimtry affects the venture capital industry and investments in many ways. In countries such as the United States, Israel, Taiwan etc. where the industry has flourished, there are minimum regulations governing the industry. The governments in most of these countries have undertaken measures to create an enabling environment to promote a robust venture capital industry. Dossani Rafiq has undertaken a detailed study of the regulatory environment pertaining to the venture capital industry in India and has made several recommendations to create an enabling environment to the policy makers. Some of them have been implemented, while some are yet to be implemented. Between 1980 and 1997, Indian entrepreneurs established 565 enterprises in Silicon Valley. This goes to show that given the right envirorunent Indians are also willing to take risks Agencies governing the venture capital industry in India: An understanding of the governing bodies/agencies governing venture capital investments in India is necessary to get insights into the challenges faced by the industry. 126

11 D 4.7 : Agencies Governing The Venture Capital Industry In India Agencies governing venture capital investments in India X Securities and Exchange Board of India!L Central Board of Direct Taxes Source: Researcher's own contribution The market regulator, the Securities and Exchange Board of India set up under the Securities Contracts Regulations Act, 1992, was entrusted with the responsibility of regulating and monitoring venture capital investments in The central bank of the country, the Reserve Bank of India regulates all investments including venture capital investments. SEBI routes all applications from foreign venture capital investors for starting operations in India through RBI. The Central Board of Direct Taxes (CBDT) provides for the taxation on income earned by venture capital firms. When there arc three governing bodies such as this, there has to be consistency in the provisions made by them, which will otherwise lead to confusion and ambiguity. There is lack of consistency and as a result ambiguity. They need to be harmonized : Key legislations impacting venture capital investments in India: As seen earlier there are three government agencies that regulate and monitor the venture capital industry in India. This is done through various regulations and legislations enacted by these agencies. In India it has been observed that frequently new regulations arc imposed and changes arc made in the old/existing legislations. This can create confusion and difficulty in making investment plans for venture capital firms. 127

12 D 4.8 Key Legislations Pertaining To The Venture Capital Industry And Investments In India. Source. Researchers own contribution SEBI (Venture Capital Funds Regulations) Act, 1996 SEBI notified the SEBI Venture capital Funds Regulations in The SEBI guidelines define a venture capital company, venture capital fiind and venture capital undertaking. As per SEBI (Venture Capital Fund) Regulations, 2000: A "Venture Capital Fund" means a fimd established in the form of a trust or a company including a body corporate and registered under these regulations which (/) has a dedicated pool of capital; (//) raised in a manner specified in the regulations; and (/// ) invests in accordance with the regulations. A "Venture Capital Undertaking" means a domestic company (i) whose shares are not listed on a recognized stock exchange in India; (ii) which is engaged in the business for providing services, production or manufacture of article or things or docs not include such activities or sectors which are specified in the 128

13 negative list by the Board with the approval of the Central Government by notification in the Official Gazette in this behalf. The negative list specified by SEBI is as follows: 1). Non-banking financial services excluding those Non-Banking Financial Companies which are registered with Reserve Bank of India and have been categorized as Equipment Leasing or Hire Purchase Companies. (2) Gold financing excluding those Companies which are engaged in gold financing for jewellery. (3) Activities not permitted under industrial policy of Government of India. (4) Any other activity which may be specified by the Board in consultation with Government of India from time to time.^ The important provisions in these regulations are: SEBI allows venture capital firms in India to be set up as a Trust or a Company including a body corporate. If it is established as a Trust, it will be governed by the Indian Trusts Act, The Trust Deed has to be registered under the Registration Act, If the venture capital fund is established as a company, then it has to be incorporated under the Indian Companies Act, 1956.' Venture capitalists in India prefer the Trust form of structure so that they can avoid the dividend distribution tax, which is applicable to company form of organization." A venture capital fimd can also be established as a body corporate under an Act of Parliament or State Legislation. This shows that in India the law does not permit venture capital fimds to be set up as Limited Liability Partnerships or Limited Liability Companies. Recommendations for allowing venture capital fimds to be established as Limited Liability Partnerships or Limited Liability Companies have been made by many experts and high level committees.''' The limited liability structure allows flexibility and a liability shield to investors. It is a separate legal entity and the partners' liability is limited to their shareholding or investment. A recent news paper article says that the government has notified that limited liability partnership form of organization can be established in India. It remains to be seen whether this will be extended to venture capital fimds. 129

14 There is a stipulation with respect to the minimum investment to be accepted from an investor by the fund. Excluding employees, principal or directors of the venture capital fund, minimum investment to be accepted from any investor should be Rs.500,000. The minimum capital commitment from its investors should be Rs. 50 million or 5 crores. This may prevent the problem of low capitalization but such stipulations discourage small investors and small funds from making investments in venture capital. This can create problems for startups looking for small investments from venture capital funds. A venture capital fund cannot make investments in associate companies. Associate company for this purpose has been defined as any company in which a director, a trustee, a sponsor or settler of the venture capital fund or the investment manager holds either individually or collectively, equity shares in excess of 15% of the paid up equity capital of the venture capital undertaking. This provision has been made to protect the interest of the investors in a fund. Otherwise the fund managers may invest in those undertakings in which they have an interest and which may not yield adequate returns to investors. The venture capital fund cannot invest more than 25% of its corpus in a single undertaking. This provision is essential to protect the interest of the investors. This will ensure that the investments of a fund are diversified and risk reduced. At least 66.67% of the investible funds of the venture capital fund should be invested in unlisted equity shares or equity linked securities of venture capital undertaking. Not more than 33.33% of the investible funds are to be invested by way of subscription to initial public offer of a venture capital undertaking whose shares are proposed to be listed, debt or debt instrument of a venture capital undertaking in which the venture capital fimd has already made investment by way of equity, preferential allotment of equity shares of a listed company subject to a lock in period of one year, the equity shares or equity linked instruments of a financially weak company or a sick industrial company whose shares are listed and Special Purpose Vehicles which are created by a venture capital fund for the purpose of facilitating or promoting investment in accordance with these Regulations. The stipulation that 66.67% of investible fund to be invested in the 130

15 equity of unlisted venture capital undertakings is essential. In the absence of this venture capital funds would start investing more and more by way of debt and in shares of listed companies. This stipulation will ensure that venture capital funds make substantial investments in early stages of the life cycle of the venture capital undertaking. Venture capital fund may invest in securities of foreign companies subject to such conditions or guidelines that may be stipulated or issued by the Reserve Bank of India and the Board from time to time. In April 2007, the Reserve bank of India notified through a circular that domestic venture capital funds registered with SEBI will be permitted to invest in foreign companies. The SEBI in August 2007 notified that a venture capital fund can invest only up to 10% of its investible ftinds subject to an overall limit of $500million. The venture capital funds can invest in equity and equity linked instruments of only those foreign companies that have an India connection. For this purpose SEBI has defined an offshore venture capital imdertaking as a foreign company whose shares are not listed in any recognized stock exchange in India or abroad.'"* The SEBI venture capital regulations restrict a venture capital fund from listing its securities for a period of three years from the date of their issue. This is essential to discourage speculative trading of the units of the venture capital fund until it is well established. The affairs of a venture capital fund registered under SEBI will be subject to inspection/investigation by an officer appointed by SEBI. While it is important to monitor the operations of venture capital funds, too much of scrutiny especially by government officers can create problems. It is a fact that venture capital is a very different financial intermediary. People with experience will only be able to understand the venture fimding process. The officer appointed by SEBI may not have the expertise to understand the operations of a venture capital fund. 131

16 SEBI (Foreign Venture Capital Investor) Regulations, 2000: The term foreign venture Capital Investor has been defined under the SEBI (Foreign Venture Capital Investor) Regulations to mean an investor incorporated or established outside India, is registered under these regulations and proposes to make investment in accordance with these regulations. In India, offshore funds or Foreign Venture Capital Investors are very active. Amendments were made to SEBI (Foreign venture Capital Investor) Regulations, 2000 in 2001,2004 and The important provisions in these regulations are: The foreign venture capital fund can invest its total fund committed in one domestic venture capital fiind. Many foreign venture capital investors invest in a domestic venture capital fund instead of investing directly in venture capital imdertakings. Survey data shows that overseas investors are the largest source of funds for domestic venture capital funds in India. A circular issued by SEBI dated 03/07/09 states that applicants desirous of registering with SEBI as the Foreign Venture Capital Investors, henceforth, shall obtain firm commitment from their investors for contribution of an amount of at least USD 1 million at the time of submission of applications seeking registration as FVCIs. This has been done to bring about parity between Domestic Venture Capital Fimds and Foreign Venture Capital Investors in India.'^ This is an important move and will definitely bring m parity. However, it may discourage smaller Foreign Venture Capital Investors from starting operations in India. At least 66.67% of its investible funds are invested in unlisted equity shares or equity linked instruments of venture capital imdertaking. Not more than 33.33% of the investible funds are to be invested by way of subscription to initial public offer of a venture capital undertaking whose shares are proposed to be listed, debt or debt instrument of a venture capital imdertaking in which the foreign venture capital investor has already made investment by way of equity, preferential allotment of equity shares of a listed company subject to a lock in period of one year, the equity shares or equity linked instruments of a 132

17 financially weak company or a sick industrial company whose shares are listed and Special Purpose Vehicles which are created by a ventiire capital fund for the purpose of facilitating or promoting investment in accordance with these Regulations. A foreign venture capital investor is required to appoint a domestic custodian and will have to enter into an arrangement with a designated bank for the purpose of operating a special non-resident Indian rupee or foreign currency account. SEBI is the nodal agency for all necessary approvals including the permission of the Central Bank for operating the bank account. Foreign venture capital investors cannot invest in these sectors namely, Non Banking Financial Services (NBFCs, excluding those that have been registered with RBI as hire purchase companies or equipment leasing companies), gold financing and any other activity prohibited under Foreign Direct Investment (FDI) Regulations.'^ Benefits of registration with SEBI as a foreign venture capital investor: It is not mandatory for foreign venture capital fimds operating in India to get registered with SEBI. However, registration offers the following benefits to the foreign venture capital fund: Investments made in venture capital undertakings made by a registered foreign venture capital investor would be eligible for the automatic route. Otherwise, approval of Foreign Investment Promotion Board (FIPB) and Reserve Bank of India (RBI) would be required. The eligibility for automatic route would be subject to conditions prescribed in Foreign Direct Investments (FDI) Regulations. Approval usually takes 4-6 weeks for clearance. The entry and exit pricing regulations are not applicable to foreign venture capital investors registered with SEBI. Otherwise when shares of an Indian company are purchased by a non-resident, the minimum price to be paid is linked to the net asset value of the shares. When a non-resident wants to transfer shares to a resident, the exit price is capped at the price of the shares on the stock exchange if it is listed and the net asset value if it is unlisted. In 133

18 case of foreign venture capital investors registered with SEBI, they may acquire and sell securities of an Indian venture capital undertaking at a price that is mutually acceptable to both parties. This makes it easier for a foreign venture capital fund to exit via a strategic sale or buy-back arrangements with the promoters. However, one of the foreign venture capital investor interviewed by the researcher said that they prefer to follow the pricing guidelines rather than getting registered with SEBI. Transfer of shares from Foreign Venture Capital Investors registered with SEBI is exempted from the public offer provisions vmder the SEBI (Substantial Acquisition of Shares and Takeover) Regulations, 1997, if the portfolio company gets listed on a stock exchange post the investment. This ensures that if the promoters buy-back the shares from the foreign venture capital investor, they will not be burdened with the public offer requirement which would otherwise require an offer to the other shareholders of the company to buy up to 20% of the paid-up capital of the company. This provision will help the promoters in retaining control and avoid dilution of ownership when the foreign venture capital investor makes an exit via the buy-back route. A foreign venture capital investor registered with SEBI is accorded the status of Qualified Institutional Buyer (QIB) and is therefore eligible to subscribe to the securities though the book building process when a venture capital undertaking makes an initial public offering. This provision is very useful as Foreign Venture Capital Investors can invest up to 33.33% of the investible funds in the shares of a venture capital undertaking when it makes the initial public offering and which is proposed to be listed. This is a good incentive to venture capital investors for the risks that they undertake by investing at early stages of the life cycle of venture capital imdertakings. Under the SEBI (Disclosure and Investor Protection) Guidelines, 2000 (DIP Guidelines), the entire pre-issue share capital for an initial public offering is subject to a lock in period of one year. This means, when investors subscribe to the shares of a company just before it makes an initial public offering, they 134

19 cannot sell the shares for a period of one year after the initial public offer is made. However, both domestic and foreign venture capital investors are exempted from this requirement and they can make an exit within a year of the venture capital undertaking going public. The venture capitalists will get substantial benefits if the market price of the shares increases post initial public offering. Usually in a bullish market, the prices of shares have a tendency to increase just after the initial public offering and listing. There are certain requirements applicable to "promoters" under the SEBI (Disclosure and Investor Protection), 2000, Guidelines. For this purpose, there is a broad definition of the word promoter, which includes any person who has a role to play in the decision of a company to go for an initial public offering. The venture capital investors play a key role in the initial public offering decision of their portfolio firms. However, in case of Foreign Venture Capital Investors registered with SEBI, they are not treated as promoters when their portfolio firms make the initial public offering.'^ All these benefits more or less make it mandatory for foreign venture capital investors to get themselves registered with SEBI. The Income Tax Act, 1961: This Act provides for the taxation on income earned by venture capital funds on investments made in venture capital undertakings. Sections 10(23F), 10(23FA) and 10(23FB) of the Income Tax Act clearly state that the income of the VCF received in the form of dividend or long term capital gain from any venture capital undertaking will not form a part of the total income of the VCF for taxability purposes as well. Section 115 U of the Income Tax Act specifies that the income received from the investment made in any Venture Capital Fund shall be chargeable to income tax in the hands of the investor. This means that the venture capital fund or company enjoys the pass through status for taxes on the income earned by way of investment in venture capital undertakings. They are only appropriating/ allocating the funds for which they receive a management fees.' Income earned by a domestic SEBI registered VCF (whether a trust or a company) from an investment in a venture capital undertaking is exempt from tax. (Section 10(23 FB) of 135

20 the Income Tax Act, 1961 (the "Act")-) Such VCFs have been accorded a "pass through" status, i.e., the investors in the VCF are directly taxed on any income distributed by the VCFs as though the investors have made direct investments in the portfolio companies. (Section 115U of the Act.) However, to avail this "pass through" status, the VCF's investments must be made in domestic companies whose shares are not listed on any recognized stock exchange in India. Prior to the finance bill of 2007, income earned by venture capital fimds was eligible for tax pass through and was taxed in the hands of the investor as if the investor had directly invested in the venture capital undertaking. Further, the domestic investee companies must only be engaged in the following activities: (a) Dairy or poultry industry; (b) Nanotechnology; (c) Information technology relating to hardware and software development; (d) Seed research and development; (e) Biotechnology; (f) Research and development of new chemical entities in the pharmaceutical sector; (g) Production of bio-fiiels; or (h) Building and operating composite hotel-cum-convention centers having a seating capacity of more than 3000 persons. The tax treatment of the income that is subject to "pass through" status will depend on the nature of the income. Dividend income is tax fi-ee in the hands of shareholders, but is subject to a dividend distribution tax of % payable by the company distributing the dividend. Otherwise, capital gains tax is charged on the sale of shares of the investee companies. Shares held for 12 months or more are subject to long-term capital gains tax. Long-term capital gains tax is chargeable at the rate of 20% in case of a gain on transfer of imlisted shares. In case of listed shares, long-term capital gains tax is exempted provided Securities Transaction Tax ("STT") is paid on such sale. Short-term capital gains on sale of unlisted shares is chargeable to tax depending on the type of assessee, i.e., for individuals, the rate varies between 10% to 30% and for corporate bodies, the rate is 30% for domestic companies and 40% for foreign companies. On sale of listed shares, the tax rate for short-term capital gains is 15%. 136

21 The above rates are further subject to a surcharge at the rate of 10% for residents and 2.5% for foreign bodies, and an education cess of 3%. In the event where the VCF invests in securities which are listed on recognized stock exchanges, it will have to bear the STT. Purchase or sale of equity shares settled by way of actual delivery or transfer of the shares is subject to STT at the rate of 0.125%. For sale of shares settled otherwise than by actual delivery or transfer, STT is levied at 0.025%. There is no specific tax exemption for foreign venture capital investors ("FVCI"). However based on the jurisdiction from which the FVCI invests in India, it can avail the benefits in the corresponding Double Taxation Avoidance Agreement ("DTAA") that India may have with that jurisdiction. (Section 90 of the Act.) On account of its favorable tax treaty with India, Mauritius has become the most popular jurisdiction for investing into India. Specifically with respect to capital gains, the India- Mauritius DTAA exempts capital gains earned by a resident of Mauritius from tax in India.'' The Companies Act, 1956 and Trusts Act: As seen earlier, in India venture capital funds can be established as a trust or a company or a body corporate. 99% of the venture capital funds operating in India are registered as trusts. If a venture capital fund is structured as a company, then the provisions of the Companies Act are applicable. Very few are established as companies because the dividend distribution taxes have to be paid by companies. In India the Rajasthan Asset Management Company Pvt. Ltd., the managers of Rajasthan Venture Capital Fund is one of the few venture capital fimds established as a company. ^^However, one advantage of the company form of organization is that, the criteria of ownership and control is well defined, whereas in the trust form of organization, there are only beneficiaries and no owners. This clarity is important when there are non-resident investors in a venture capital fiind. Foreign Exchange Regulations: The foi-eign exchange regulations impact venture capital investments because bulk of investments in venture capital in India comes from foreign investors. Indian venture capital fimds are also allowed to invest in foreign 137

22 venture capital undertakings. Foreign venture capital investors can make investments in domestic venture capital funds or directly in Indian venture capital undertakings subject to certain conditions. In a notification of RBI dated 26/12/07, it is stated that, "The amount of consideration for investment in VCFs/IVCUs shall be paid out of inward remittance from abroad through normal banking channels or out of funds held in an account maintained with the designated branch of an authorised dealer in India in accordance with regulations." With respect to maintenance of bank account the notification further states that "The Reserve Bank may, on application, permit a FVCI which has received 'in principle' registration from SEBI to open a Foreign Currency Accoimt and/or a Rupee Account with a designated branch of an authorised dealer with the following permissible transactions : i. Crediting inward remittance received through normal banking charmels or the sale proceeds (net of taxes) of investments, ii. Making investment in accordance with the provisions, iii. Transferring fiinds from the Foreign Currency Account of the FVCI to their own Rupee account, iv. Remitting funds fi-om the Foreign Currency or rupee account subject to payment of applicable taxes. V. Meeting local expenses of the FVCI." Foreign Direct Investment Policy: Foreign Venture Capital Investors registered with SEBI can make investments through the automatic route but within the limits of sectoral caps. Foreign Venture Capital Investors, who are not registered with SEBI have to get FIPB approval. Many changes are expected to be made in the regulatory frame work and taxation policies pertaining to venture capital in India. Policy measures can help in encouraging venture capital investments, startups and entrepreneurship : Venture Capital Investments In India: In India as distinction is not made between venture capital and private equity, most of the data available includes both venture capital and private equity deals. Investments made in early and mid stages of the life cycle of a company can be termed as venture capital investments, while, investments 138

23 made at later stages are private equity investments. The following table shows the early stage and mid stage deals, which constitute venture capital investments in India from 2000 to 2005 T 4.1 Venture Capital Investments In India From 2000 To 2005 Early stage deals Value of deals in US$million No. of Seed stage deals No. of Series A & B deals Source: I Adapted from Aggarwal A lok, 2006, p.: 5.3 The interesting facts that emerge from the above table are: The value and number of deals peaked in 2000 because of the Information Technology boom. The decline in value of deals from 2001 is due to the dotcom bust. Fall in the number of seed stage deals is attributed to the fact that the middleclass in India is becoming affluent and "Love money"^'* is easier to get. The fiind requirement at seed stage is usually small and entrepreneurs are able to get funds from family, relatives and friends. As a result the dependence on venture capital for seed stage funding is declining and may continue to decline in the near fixture. 139

24 The following table shows the late stage or private equity deals in India from 2000 to 2005 T 4.2 Private Equity Investments In India From 2000 To 2005 Private equity/late stage deals No. of deals Value of deals in US$million Source: Adapted from Aggarwal, Alok, 2006 p.3 The facts to be noted are: Number of late stage deals also peaked during 2000 and fell from The peak again can be attributed to the success of the Information Technology industry in India around that time. The fall is because of the dotcom bust. In 2001, though the number of deals fell, the value increased. This is because deal size increases at later stages of investments. Fewer deals of larger value seem to be the trend. Often during times of economic downturn, venture capitalists and private equity players invest in existing portfolio companies and avoid making fresh deals. Venture capital investments in India from 2004 to 2009 have been analysed in detail in the chapter titled Analysis of Secondary Data. The downturn triggered mainly by the dotcom bust in had led to a decline in venture capital investments till was a year of resurgence of venture capital investments in India Latest Trends The economic downturn has certainly impacted venture capital investments in India. Capital raising may take longer and first time ftmds may find it difficult to raise capital, while ftmds with a track record find it easier. (Chaudhary, Deepti, 2009)^^ Venture capitalists are looking at new sectors such as Education, Health Care, and Cleantech etc. which are fairly insulated from economic downturns. 140

25 C 4.1 Number Of Venture Capital Deals From 2004 To 2008 In India NO OF INVESTMENTS NO OF INVESTMENTS ^^P '^'^ p W 1^9 HIP Source Researchers own contribution. After the dotcom bust of , the recovery in venture capital investments started from 2004 and it increased phenomenally in 2006 to peak in The last quarter of 2008 saw a decline in venture capital deals due to the economic downturn that started in the western countries Sectors attracting venture capital investments in India A detailed statistical analysis of venture capital deals in India in the last five years has been presented in a later chapter. The researcher has made the following observations Venture capitalists operating in India have invested in a variety of sectors over the years. Among them Information Technology and Infonnation Technology Enabled Services have attracted maximum investments. Biotechnology, Consumer Internet, Education, Health Care and Life Science etc. are the sectors that are attracting investments from venture capital funds in India. 141

26 C. 4.2 Sector Wise Break Up Of Investments From 2004 To 2008 SECTOR WISE BREAK UP OF NUMBER OF INVESTMENTS Food & Beverages _ 3%. 3% Energy 3%. Media & Entertainment 5% Retail Telecom Manufacturing 3%,, Education 2% Healthcare & Life Sciences 10% Source Researchers own contribution Contributors to venture capital funds in India In India the major contributors to venture capital funds arc Foreign Institutional Investors accounting for 52.46%, and all Indian Financial Institutions account for 24.43% of the venture capital investments. The other major contributors include Multilateral Agencies (8.34%), Other Banks (6.02%), Foreign Investors (2.23%), Private Sector (1.27%), Nationalised Banks (1.09%) and others (2.55%). The main reasons behind the increasing role of Foreign Investors are the favourable regulations made by the government of India for foreign investments. The tax treatments for venture capital funds were liberalized and procedures were simplified by the government of India. In % of venture capital was invested in the form of equity, 21.35% in the form of redeemable preference shares, 8.88% in non-convertible debt, 6.16% as convertible instruments and other instalments constituted 0.75%.(Mohanan, 2006)"' The biggest Limited Partners (LPs) in India are General Insurance Corporation of India, Life Insurance Corporation of India and State Bank of India in that order. The HNI class (High Net worth Individuals) is gaining traction. But unlike the West, where huge pension funds, university endowment funds, family offices and lastly fund of funds make 142

27 commitments to Private Equity funds, in India, the domestic Limited Partner base is quite restricted. (Agrawal Shrija, 2009)^^ The top venture capital firms in India The SEBI list of registered domestic and foreign venture capital funds is long but many of them are not active. The industry is dominated by foreign funds. This is evident from the secondary data obtained from TSJ Media and the following two tables. T4.3 Top Venture Capitalists in India in Terms of Number Of Investments Name of the venture capital firm Sequoia Capital India Ventureast S Intel Capital Helion Venture Partners DFJ India Nexus India Capital NEA IndoUS Ventures IDG India Ventures Kleiner Perkins Norwest Venture Partners Canaan Partners Inventus Capital Partners 3 Source Prabhudesai. (2009) 28 All of them are Foreign Venture Capital Investors registered with SEBI. In India the venture capital industry is dominated by foreign venture capital institutions. 143

28 T4.4 Top Venture Capitalists in India in Terms of Value of Investments in USSMillion Name of the venture capital Arm Sequoia Capital India Intel Capital Norwest Venture Partners Helion Venture Partners Nexus India Capital DFJ India Ventureast NEA IndoUS Ventures Canaan Partners Kleiner Perkins IDG India Ventures 14 8 Source Prabhudesai. (2009) 29 In both, that is, niunbers of investments and amount, the same venture capitalists top the list. There is however, a difference in the order. This is because some of them may be early stage investments while some may be growth stage investments. There are also differences in the average deal size. Usually, the amount invested at the growth stage tends to be more than the amount invested at early stage as enterprises require small sums of investments at earlier stages Challenges Faced In the initial stages of the development of the industry only development financial institutions and banks were allowed to make venture capital investments in India. They did not have the experience and the right attitude towards risk for making venture capital investments. The regulations are ambiguous and complex and there is a need for harmonisation. The capital meirket is shallow and venture capitalists have few exit options. 144

29 4.9.0 Insights Gained The venture capital industry in India emerged due to the initiatives taken by the government. It is still at the infancy stage. The downturn in did impact venture capital investments in India but the decline was only marginal. From 2004, there has been a steady growth in venture capital investments. There are three agencies governing venture capital investments in India. Venture capital firms are structured as trusts or companies in India. Till recently, the Limited Liability Partnership form of organisation was not allowed in India. The Information Technology and Information Technology Enabled Services sectors have attracted maximimi venture capital investments so far Conclusions The regulatory framework in India is complex s there are three agencies governing venture capital mvestments in India. Initially only development financial institutions and banks were allowed to launch venture capital fiinds in India and that is the reason why there were no private venture capital fimds in India in the initial stages. The high technology industry offered and continues to offer good opportunities for venture capital investments in India. 'Rao, Gayatri. (2004).Genesis of Venture Capital in India. In V.Suubbulakshmi, (ed), Venture Capital Industry-An Introduction (pp ). Hyderabad: ICFAI Books, ICFAI University Press. ^ VC IN INDIA, (n.d). Retrieved July 28,2009, from ^ Rao, Gayatri. (2004).Genesis of Venture Capital in India. In V.Suubbulakshmi, (ed). Venture Capital Industry-An Introduction (pp ). Hyderabad: ICFAI Books, ICFAI University Press. '' List of Venture Capital Funds Registered with SEBI. (n.d). Retrieved July 28,2009, from and List of Foreign Venture Capital Investors Registered with SEBI. Retrieved July 28, 2009, from ' Hirani, Akhil. VC Investments into India. (n.d).retrieved April 25,2009, from Ooverview.pdf * Hirani, Akhil. VC Investments into India. (n.d).retrieved April 25,2009, from Ooverview.pdf 145

30 ^ Hirani, Akhil. VC Investments into India ( n.d). Retrieved April 25,2009, from Ooverview.pdf ' SECURITIES AND EXCHANGE BOARD OF INDIA (VENTURE CAPITAL FUNDS REGULATIONS), 1996, p.4-5. Retrieved April 14, 2009, from id=3 ' SECURITIES AND EXCHANGE BOARD OF INDIA (VENTURE CAPITAL FUNDS REGULATIONS), 1996, Third Schedule, p.24 Refrieved April 14, 2009, from id=3 '" Ajinkya, Bijal., & Goradia; Shefali. (2004). Regulatory Framework for Venture Capital Investments in India. In V.Suubbulakshmi, (ed). Venture Capital Industry-An Introduction (pp ). Hyderabad: ICFAI Books, ICFAI University Press. " Verma, Sunny., & Anm, S. (2009). New Rules Complicate FDI status of ventiu-e capital investments. Financial Express. Refrieved July 19, 2009, from '^ SECURITIES AND EXCHANGE BOARD OF INDIA (VENTURE CAPITAL FUNDS REGULATIONS), 1996, p.4.retrieved April 14, 2009, from id=3 13 Report of the committee on Technology Innovation and Venture Capital, Planning Commission, Government of India. (2006). Retrieved April 15, vcr.pdf '" BS Reporter. (2007). SEBI caps VCs foreign investments at 10%.Retrieved July 19,2007, from " DEPUTY GENERAL MANAGER, INVESTMENT MANAGEMENT DEPARTMENT, DIVISION OF FUNDS 1, IMD/DOF-1/FVCI CIR. NO 1/2009. (2009). Retrieved July 7,2009, from '* Desai; Vyapak. (2009). DEAL TERMS & WHY YOU NEED AGOOD LAWYER. A paper presented at the IVCJ's Workshop on Venture Capital for SMEs. '' Ajinkya, Bijal., & Goradia, Shefali. (2004). Regulatory Framework for Venture Capital Investments in India. In V.Suubbulakshmi, (ed). Venture Capital Industry-An Introduction {^p ). Hyderabad: ICFAI Books, ICFAI University Press. " Bothra, Nidhi., & Kothari, Vinod. (n.d). Venture Capital Regulations in India. Retrieved July 15,2009, from " Hirani, Akil. (n.d). VC INVESTMENTS INTO INDIA, Retrieved July 7, 2009, from %20a%201egal%20and%20structural%20overview.pdf ^" The official website of Rajasthan Venture Capital Fund. (n.d.). Retrieved July 7,2009, from org/ 146