Venture capital investment in India: market and regulatory overview
A Q&A guide to venture capital law in India.
The Q&A gives a high level overview of the venture capital market; tax incentives; fund structures; fund formation and regulation; investor protection; founder and employee incentivisation and exits.
To compare answers across multiple jurisdictions, visit the Venture Capital Country Q&A tool.
This Q&A is part of the PLC multi-jurisdictional guide to venture capital. For a full list of jurisdictional Q&As visit www.practicallaw.com/venturecapital-guide.
Venture capital and private equity
Historically, start-ups and early-stage companies found it difficult to access funds from traditional lenders such as banks and financial institutions because such companies typically do not have collateral to provide security for loans. As a result, most start-up founders and early-stage companies were dependent on their own savings and funding from non-organised sources (for example, family and friends). In the 1990s, the Indian Government opened the Indian economy to foreign investment.
The Securities and Exchange Board of India (SEBI) enacted the now repealed Securities and Exchange Board of India (Venture Capital Funds) Regulations 1996 (VCF Regulations). The VCF Regulations established a regulatory environment which allowed start-up and early-stage companies to access capital pooled from potential investors in domestic venture capital funds registered with SEBI.
Sources of funding
The usual sources of funding of early-stage companies are:
Personal savings of founders, family and friends.
Domestic and offshore funds (including foreign venture capital funds and alternative investment funds registered with SEBI).
Groups of persons organised as angel investors.
Types of company
Most start-ups, emerging or early-stage companies are incorporated as private limited companies.
Presently, the technology (e-commerce, internet and mobile software companies) and healthcare sectors are receiving a substantial amount of venture capital investment.
The past year has seen three major changes affecting the venture capital industry in India.
Firstly, the Reserve Bank of India now allows alternative investment funds to invest in equity and equity-linked instruments of "off-shore venture capital undertakings" provided:
They have been approved by the Securities and Exchange Board of India (SEBI).
They have an overall limit of US$500 million for all alternative investment funds.
Secondly, by way of an amendment to the Securities and Exchange Board of India (Alternative Investment Funds) Regulations 2012, SEBI has (among other things) deemed investments made by Category I alternative investment funds (which includes venture capital funds and angel funds) in listed shares on "institutional trading platform" to be investment in "unlisted shares". An institutional trading platform is a trading platform recently introduced by SEBI. Companies on this type of platform will have easier access to capital markets if either:
They are in a sector which is technologically intensiveconcentrated sectors, that is, in sectors relating to information technology, data analytics, bio-technology or nano-technology and. Furthermore, at least 25% of their shareholding is held by "qualified institutional buyers" (as defined in the Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations 2009.).
At least 50% of their shareholding is held by qualified institutional buyers.
Thirdly, the Reserve Bank of India now allows foreign investment in alternative investment funds subject to certain terms and conditions.
The SEBI has formed a committee, the Alternative Investment Policy Advisory Committee under the chairmanship of Narayanan Murthy, to make recommendations on the regime governing alternative investment in India. The committee submitted its first draft to the SEBI on 31 December 2015.
Tax incentive schemes
Under the now repealed VCF Regulations, venture capital funds were previously accorded a tax pass-through status for their investment in venture capital undertakings. Income from the venture capital fund was taxed in the hands of the investor rather than the at the fund level, provided the venture capital undertakings met certain criteria set out in the VCF Regulations.
However, the 2015 Union Budget has extended this pass-through status to apply to the income from the investment of the fund, other than business income, to all Category I alternative investment funds (AIFs), including venture capital funds and angel funds. The Union Budget also clarified that dividend distribution tax does not apply to distributions made by the Category I AIFs to its investors.
Domestic venture capital and angel funds must be set up as Category I alternative investment funds (AIFs) under the Securities and Exchange Board of India (Alternative Investment Funds) Regulations 2012 (AIF Regulations). The AIF Regulations allow all types of investors to invest in domestic venture capital funds provided that each investor makes a minimum investment of INR10 million in a venture capital fund and INR2.5 million in an angel fund. The AIF Regulations impose more stringent requirements on investors who wish to invest in domestic angel funds.
Typical investors of domestic venture capital and angel funds include:
Domestic venture capital and angel funds can be organised or established as companies, limited liability partnerships, trusts and other body corporates (Alternative Investment Funds Regulations). For historical reasons and administrative ease, especially for making distributions to investors, domestic venture capital and angel funds tend to be organised as trusts.
The investment objectives of venture capital funds are based on the provisions of the AIF Regulations which mandate certain investment objectives for domestic venture capital and angel funds.
Venture capital funds
A venture capital fund must invest at least two-thirds of the investible funds in unlisted shares or equity-linked instruments of a "venture capital undertaking" (Alternative Investment Funds Regulations (AIF Regulations) ). Venture capital undertakings include domestic companies which:
Are mainly involved in new products, new services, technology or intellectual property rights-based activities.
Have a new business model.
Do not invest in investee companies which are involved in activities prohibited by the AIF Regulations.
Venture capital funds can invest the remaining investible funds in other specified investments. This includes debt and debt instruments in companies in which the venture capital fund has an equity interest. Venture capital funds cannot invest more than 25% of their investable funds in an investee company (AIF Regulations).
Angel funds are a sub-set of venture capital funds. They raise funds from "angel investors" and invest in "venture capital undertakings". In addition to the general requirements referred to above (see above, Venture capital funds), an angel fund must invest in an undertaking which:
Has been incorporated during the preceding three years from the date of investment.
Has not been promoted or sponsored by or related to an "industrial group" whose group turnover exceeds INR3 billion.
Has a turnover of less than INR200 million.
Has no connection with the investors of the angel fund or in which the director, trustee, partner, sponsor, manager, director or partner of the sponsor or manager, of the angel fund, holds, individually or collectively, more than 15% interest.
The following requirements also apply to angel funds:
An angel fund can make an investment of between INR5 million and INR50 million in an investee company.
Angel funds cannot invest more than 25% of their investable funds in an investee company (AIF Regulations).
All investments of angel funds in an investee company are locked-in for a three-year period. Angel funds cannot make offshore investments.
The angel fund manager must obtain confirmation from every investor proposing to make an investment in an investee company. Additional qualifying thresholds apply to angel fund investors (AIF Regulations). Angel fund units and shares cannot be listed on a stock exchange.
Fund life cycle
Venture capital and angel funds must be closed-ended funds with a minimum tenure of three years (AIF Regulations). Domestic venture capital and angel funds generally have a life cycle of four to seven years. The fund's life can be extended by a maximum period of two years with the consent of two-thirds of the investors by value of their investment.
Fund regulation and licensing
Domestic venture capital and angel funds require a certificate of registration from the Securities and Exchange Board of India (SEBI) (Alternative Investment Funds Regulations).
Offshore funds intending to benefit from the foreign exchange regime prescribed by the foreign direct investment policy of the Government of India (FDI Policy) require a certificate of registration from SEBI (SEBI (Foreign Venture Capital Investor) Regulations 1993 (FVCI Regulations)).
The promoters, managers and principals do not require any specific licence to engage in domestic venture capital and angel funding activities.
All domestic venture capital funds and offshore funds must be registered with the Securities and Exchange Board of India (SEBI). Any offshore funds intending to benefit from India's Foreign Direct Investment (FDI) Policy must also register with SEBI. There are no available exemptions.
The following legislation governs venture capital and angel funds:
Foreign Venture Capital Investor Regulations (FVCI Regulations).
Alternative Investment Funds Regulations (AIF Regulations).
Venture Capital Funds Regulations (VCF Regulations).
Offshore venture capital funds can register with SEBI as "foreign venture capital investors" (FVCIs) to avoid certain Foreign Direct Investment (FDI) Policy requirements (for example, FVCIs can enter and exit without having to comply with the pricing guidelines of the FDI Policy). Under the pricing guideline, a non-resident investor cannot:
Purchase shares of a company at a price below fair market value.
Sell such shares at a price above fair market value.
The AIF Regulations were notified by SEBI on May 2012, which repealed the previous VCF Regulations. The AIF Regulations come into force in 2012. Funds registered under the old VCF Regulations were allowed to continue as such until the end of their existing life cycle.
The AIF Regulations provide the statutory guidelines for setting up the following domestic funds:
Venture capital funds. These are close-ended funds which must primarily invest in unlisted venture capital undertakings (see Question 8, Venture capital funds). A venture capital fund can have up to 1,000 investors.
Angel funds. These are a sub-set of venture capital funds which are used to enable smaller venture capital undertakings to gain access to capital (see Question 8, Angel funds). Angel funds are therefore exempt from certain requirements of the AIF Regulations (such as the requirement to pay fees for filing placement memorandums for schemes). Angel funds are limited to a maximum of 49 investors. In addition, the minimum investment size by individual investors is set at a lower threshold, and the minimum corpus size and the mandated sponsor or manager interest are smaller than other kinds of funds.
Domestic venture capital and angel funds must raise funds on a "private placement basis". Although the AIF Regulations do not define the term, practitioners have adopted the Companies Act 2013 definition (an offer of securities or invitation to subscribe to securities to a select group by a company (other than by way of public offer) through issue of a private placement offer letter).
The contents of the marketing document issued to prospective investors must comply with the AIF Regulations. The marketing document must contain all the material information in relation to the fund (among others):
Details of the fund manager (his background, qualifications and so on).
Details manager's key investment team.
Fee and expenses proposed to be charged to the investors.
Tenure of the fund.
Investment objectives and strategy.
Fund accounting methodology.
Risk management tools.
Key service providers.
Conflict of interest and procedures to identify and address them.
Terms and conditions on which the manager offers investment services.
Manager's affiliations with other market intermediaries.
Manner of winding-up the fund.
The relationship between an investor and the fund is governed by the Alternative Investment Funds Regulations (AIF Regulations) and the contribution agreement entered between them.
The AIF Regulations provide the following protections for investors of venture capital and angel funds:
No material alteration to the fund strategy can be made without the consent of at least two-thirds of the investors by value of their investment.
The manager or sponsor of the fund must have a continuing interest in the fund of the lower of:
2.5% of the corpus of the fund; or
INR50 million for venture capital funds and INR5 million for angel fund.
The manager and sponsor must disclose their investment in the fund to the investors.
An extension of the fund's life for up to two years is only permitted with the consent of at least two-thirds of the investors by value of their investment.
Co-investment in an investee company by the manager or sponsor must not be on terms more favourable than those offered to the fund.
The fund must not invest more than 25% of the investible funds in one investee company.
For venture capital funds, investment must not be made in any associates of the manager or the sponsor of the fund, except with the consent of 75% of investors by value of their investment in the fund.
For angel funds, investment must not be made in any associates of the manager or sponsor of the fund. In addition, angel investors are also not permitted to invest in a company in which such angel investor has "family connections".
The fund must inform the Securities and Exchange Board of India (SEBI) of any changes to the sponsor, manager, designated partners or any other material change in the information provided by the fund at the time of application for registration.
There must be no change of control of the fund, sponsor or manager without the prior approval of the fund. The fund must disclose any change of control of any of the investee companies to the investors.
The sponsor and manager must act in a fiduciary capacity to its investors and disclose all actual or potential conflicts of interests.
The manager must establish and implement written policies and procedures to identify, monitor and appropriately mitigate conflicts of interest.
Financial, risk management, operational, portfolio and transactional information regarding fund investment must be periodically disclosed to the investors.
Any fees ascribed to the manager or sponsor and any fees charged to the fund or any investee company by an associate of the manager or sponsor must be periodically disclosed to the investors.
Any legal inquires or actions by legal or regulatory bodies in any jurisdiction must be disclosed to the investors as and when such inquires or actions occur.
Any material liability arising during the tenure of the fund must be disclosed as and when such liability arises.
Any breach of a provision of the placement memorandum (that is, the marketing document) or agreement made with the investor or any other fund document must be disclosed as and when such breach occurs.
Books of accounts of the fund must be audited annually.
The fund must provide, at least on an annual basis, the following reports to the investors:
financial information to the investee companies;
material risks and how they are to be managed including concentration risk at fund level, foreign exchange risk at fund level;
leverage risk at fund and investee company levels;
realisation risk at fund and investee company levels;
strategy risk at investee company level;
reputation risk at the investee company level;
extra-financial risks, including environmental, social and corporate governance risks, at fund and investee company level.
The fund must, at least once every six months, provide a description of its valuation procedure and methodology of valuing assets and undertake valuation of their investments by an independent valuer.
The fund must lay down the procedure for resolving disputes between the investors, the fund, manager or sponsor through arbitration or any such mechanism mutually decided between the investors and the fund.
The fund must wind-up in the event 75% of the investors by value of their investment in the fund pass a resolution at a meeting of the investors.
Subject to negotiation between the investors and the funds, investors generally require rights similar to the best practice recommended by Institutional Limited Partners Association – Private Equity Principles.
Interests in investee companies and securities regulation
Forms of interest
Venture capital funds must invest at least two-thirds of their investible funds in unlisted equity shares or equity linked instruments of venture capital undertakings (Alternative Investment Funds Regulation (AIF Regulations)). The remaining investible funds can be invested in the following:
Initial public offerings of venture capital undertakings.
Debt or debt instruments of venture capital undertakings in which the fund has equity interest.
Preferential allotment of listed companies subject to a one year lock in period.
Equity shares or equity linked instruments of a financially weak or a sick companies whose shares are listed.
However, angel funds are given greater freedom and must "primarily" invest in the unlisted shares of domestic venture capital undertakings (AIF Regulations). SEBI has clarified that the word "primarily" indicates that investments in unlisted shares must be more than the aggregate investments in all other instruments.
Restrictions on direct investment
Foreign venture capital funds can invest in equity securities of investee companies in all sectors except those in which foreign investment is prohibited or in which the amount of foreign investment is capped. Foreign venture capital funds (except FVCIs) also need to comply with pricing guidelines and certain other restrictions under the foreign exchange laws of India.
The offer and sale of securities is governed by the Companies Act 2013 which venture capital investors must comply with. They must also comply with the Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations 2009 when exiting an investment at the time of an initial public offer of the investee company. The foreign exchange laws of India restrict the transfer of securities in certain cases. For example, optionality clauses on shares can only be exercised after a lock-in period of one year from the date of investment.
Valuing and investigating investee companies
Offshore and domestic venture capital funds and angel funds value investee companies on the basis of internationally accepted pricing methodologies which take into account the investee company's:
Assets, including intellectual property.
Potential for growth of its product.
The most commonly used valuation methodology is the "discounted cash flow method".
Since funds are typically established as trusts, the usual documentation includes a:
Investment management agreement.
Venture capital and angel investment documentation
The typical documentation in a venture capital and angel funding includes a:
Venture capital and angel funds also typically negotiate the following with the investee company:
The form of the employment agreement of the founder.
The form of any issue of employee stock options proposed by the investee company.
Protection of the fund as investor
When venture capital or angel funds invest in an investee company, they generally enter into a shareholders' agreement and a share subscription agreement.
The share subscription agreement details the terms on which the investor fund agrees to invest in the shares of the investee company. The following are the most critical provisions from an investor protection point of view:
Indemnity which is linked to the representations and warranties provided by the investee company and, generally, its founders.
The shareholders' agreement details the contractual rights of the investor fund over and above the statutory rights of a shareholder and the mechanism by which the investee company is to be governed. From an investor protection point of view, the following are the most critical provisions:
A corporate governance mechanism including:
affirmative rights of the investor fund;
right to nominate directors on the board or board committees of the investee company;
quorum rights in the board, board committees and shareholders meetings.
Transfer restrictions on the shares of the founders of the investee company.
Exit rights of the investor fund, where the right to initiate investor exit generally shifts with time or achievement of performance targets by the investee company from the investee company or founders to the investor fund.
Liquidation preference of the investor fund.
Founder and key management non-compete and non-solicit clauses.
Other contractual rights such as:
use of proceeds to be only for approved activities such as approved business plan;
right to conduct independent audit of the investee company;
right of the investor fund to have the most favourable terms of investment over any other future investor;
obligation of the investee company to procure insurance;
obligation of the investee company and founders that the investor fund is a financial investor and will never be named the "promoter" or "founder" in any governmental filings.
The terms of the shareholders' agreement are generally incorporated in the investee company's articles of association.
Forms of equity interest
Domestic and offshore venture capital funds and domestic angel funds generally subscribe to token equity shares so that they have the statutory right to receive all notices of, and to attend, all shareholders' meetings. The remaining stake is taken in the form of preference shares with a contractual right to vote on an "as if converted basis", and a right convert to equity shares, generally at conversion ratio of 1:1 (at the time of issuance), subject to anti-dilution protection.
Venture capital funds and angel funds prefer to hold preference shares because holders of preference shares have the following rights:
Statutory right of preference in payment of dividend, whether as a fixed amount or an amount calculated at a fixed rate, over the equity shareholders of an investee company.
Liquidation preference over the equity shareholders of an investee company.
Venture capital and angel funds negotiate the following to have a level of management control over the activities of an investee company:
The right to nominate a director on the board of the investee company.
A contractual requirement:
for the presence of a director or representative of the fund to form quorum in board or shareholders' meeting;
on all shareholders of the investee company to not discuss and approve any matters which are listed in the shareholders' agreement and require the consent of the nominee director, at the board level, and representative of the fund, at the shareholders' meeting level.
Certain "reserve matters" or "affirmative vote items" on which the fund has veto rights, including:
amendment to the charter documents of the investee company;
changes to the terms of any securities;
approval of the annual business plan;
appointment or removal of the statutory auditors;
appointment or removal of key management employees of the investee company.
Share transfer restrictions
Venture capital and angel funds generally invest in unlisted private companies.
The private company's board of directors must approve any transfer of its shares (Companies Act 2013). This gives the investor funds (through their nominee directors) a right to restrict transfer of shares without their approval or consent.
The shareholders' agreement generally provides the founder and employees with stock option shares which they cannot transfer without affirmative consent of the investor fund. The investor funds are usually free to transfer their shares at any time.
Angel fund investments must be locked-in for a period of three years from the date of investment (Alternative Investment Funds Regulations).
Venture capital and angel funds generally require a covenant from the investee company to provide the fund an exit before four to five years from the date of investment. The shareholders' agreement can provide a range of options for an including the following:
An initial public offering.
A strategic or third-party sale (the most common option).
Buy-back by the investee company or the promoters.
The fund usually also has the right to:
Drag the shares of the other shareholders of the investee company in a drag sale.
Tag along in a sale by the promoters/founders.
However, despite the standard options , funds generally exit when market conditions are favourable because during such times early-stage companies are typically accorded higher valuations. For example, there were fewer per capita venture capital exits during 2009 to 2013 than between 2014 to 2015 because the prevailing market conditions in India were not favourable during that time.
In an exit by way of a strategic or third party sale, investor funds have several contractual protections to safeguard them. All strategic or third-party sales require an affirmative vote from the investor funds. If a strategic or third-party sale is approved by the investor funds, the shareholders' agreement will usually state that either:
A strategic or third party sale is a sale of 100% of the shares of the investee company to the third party.
The investor funds will have a priority over all the other shareholders of the investee company to sell their shares.
A "strategic or third-party sale" is generally considered a "liquidation event" (that is, an event which triggers the liquidation preference of the investor funds over the other shareholders of the investee company).
The investee company requires an approval from its board and shareholders to issue and allot shares, negotiate and enter into the various agreements in relation to the investment, and to do all other ancillary acts required to consummate the investment (see Question 16).
If required by their limited partnership or contribution agreement, the offshore and domestic venture capital may need the approval of their investment committees to approve investment documentation. The investment funds must also obtain:
Board approval of their managers, to negotiate the investment documents.
Board approval of the trustee, to execute the investment documentation (usually delegated to the manager by way of a power of attorney).
Founder and employee incentivisation
The founders are usually the initial subscribers of the company and generally hold the vast majority of the equity shares of the company which they subscribe to at par value. The venture capital funds and angel funds usually subscribe for preference shares at a premium. Those preference shares dilute the equity shares held by the founders when converted.
Where the founder is in a particularly strong position, he may negotiate that the equity shares he holds should be of a class that does not get diluted below a certain percentage. However, this is rare.
The founders do sometimes negotiate a bonus in the event the investor funds are provided an exit option (or transfer a part of their investment) at a price which is higher than the pre-determined exit price.
"Promoters" cannot be granted employee stock options. A "promoter" is a person who has control over the affairs of the investee company or, in accordance with whose advice, direction or instructions the board of the investee company is accustomed to act (Companies Act 2013).
Key employees of the investee company are generally incentivised by a grant of shares through employee stock option plans.
The difference between the price paid by an employee upon exercise of stock option and the fair market value of the share is taxable as a perquisite or as part of the employee's salary of the employee on the date of allotment of the shares. When an employee sells such shares, the difference between the fair market value on the date of allotment and the date of sale will be subject to capital gains tax.
Investor funds ensure that the founders are committed to the venture by building the following contractual safeguards into the shareholders' agreement:
Restricting the right to transfer the shares issued to the founders by the investee.
Forcing the founders to a non-compete and non-solicit.
The founders are permitted to transfer their shares only with the prior consent of the investor funds. If the investor funds consent to the founders' transferring their shares, the funds are given the:
"Right of first refusal" over such shares.
Right to "tag along" their shares, in priority to the founders' shares, to the third party purchaser, if they do not exercise the "right of first refusal".
If the founders are no longer committed to the investee company (because of termination of their employment or otherwise), it can contractually oblige them to transfer their shares to the investor funds (by way of a buy-back) at a discount to the fair market value of the shares.
After efforts are made to revive unsuccessful investee companies (including, by infusing additional capital), investor funds typically attempt to either:
Compel (usually through a drag mechanism) the sale of the investee company to a third-party purchaser (usually a competitor of the investee company).
Force the founder to purchase the shares of the investor fund for nominal value.
If the investors are unable to exit by either of the above means, they can write-off the investment and cause the company file for liquidation.
Third-party sale is generally the best option for investor funds because competitors value an investee company more than other non-competitor purchasers. However, it might be a challenge to find a competitor in a bad market or, if the investee company has little to offer by way of assets, customer base or intellectual property. A share sale to the founders is unlikely to get an investor fund good value and is, therefore, the last resort short of liquidation. While liquidation may provide investor funds with some returns, the process is time consuming. The time-value of continuing to wait for the investee company to complete the liquidation process reduces its attraction as an exit option.
The exit strategy is documented in detail in the shareholders' agreement and incorporated in the articles of the investee company. The exit strategy includes the:
The time and flow of exit options.
The procedure to be followed during conduct of each exit option, such as:
the contents of notices to be issued;
the response time to such notices;
the consequences of no-response.
Securities and Exchange Board of India
Description. The official website of the securities market regulator in India. The website is updated on a daily basis and all the documents are in English. The website contains all the statutes and regulations relating to securities laws. The website also contains AIF Regulations.
Reserve Bank of India
Description. he official website of the central bank of India. The website is updated on a daily basis and all the documents are in English.The website contains all the regulations governing foreign exchange laws of India.
Wadia Ghandy & Co
T +91 22 4073 5600
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Professional qualifications. LLB, University of Cambridge
Areas of practice. Investment funds, private equity, venture capital, mergers & acquisitions, joint ventures, securities law.
Non-professional qualifications. BA in Anthropology (summa cum laude), Cornell University; MSc in Developmental Studies, London School of Economics.
Languages. English, Hindi, Gujarati
Professional associations/memberships. Member of the Bar Council of Maharashtra & Goa.