India: ELP Update - The Secret Sauce That Goes Into Angel Funds

Angel funds were introduced by the Securities and Exchange Board of India (SEBI) with effect from September 16, 2013, by inserting chapter IIIA in the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 (SEBI AIF Regulations). Angel funds are a sub-category of Venture Capital Funds, one of the various types of Alternative Investment Funds (AIF) under Category I. However, angel funds are very different from not only Category II and Category III AIFs, but also from other sub-categories of Category I AIF.

The note below is a ready reckoner for understanding the scope of an angel fund and compliances involved in setting up and operating an angel fund. Additionally, the document also compares IFSCA Angel Fund Regulations with SEBI AIF Regulations .

1. Who can invest in angel funds?

The SEBI AIF Regulations provide that only an 'Angel Investor' can invest in angel funds.

Angel Investors are defined by the SEBI AIF Regulations to be individuals or body corporates who meet the following criteria:

In case of an individual, the Angel Investor must have net tangible assets of at least INR 2,00,00,000 (Indian Rupees Two Crores) excluding the value of his/her principal residence, and who:

• has early-stage investment experience¹, or
• has experience as a serial entrepreneur², or
• is a senior management professional with at least 10 (ten) years of experience.

In case of a body corporate, the Angel Investor must have a net worth of at least INR 10,00,00,000 (Indian Rupees Ten Crores).

Any AIF registered under the SEBI AIF Regulations, or a Venture Capital Fund registered under the SEBI (Venture Capital Funds) Regulations, 1996 would also be an Angel Investor.

The SEBI AIF Regulations do not contain a similar prescription regarding eligibility to invest in the case of other sub-categories of Category I AIFs or Category II or Category III AIFs.

2. Where can angel funds invest?

Regulation 19F(1) of the SEBI AIF Regulations provide that angel funds can invest only in startups. A startup has been defined as follows:

"startup" means a private limited company or a limited liability partnership which fulfills the criteria for startup as specified by the Department of Promotion of Industry and Internal Trade, Ministry of Commerce and Industry, Government of India, vide notification no. G.S.R. 127(E) dated February 19, 2019 or such other policy of the Central Government issued in this regard from time to time;

As per the aforementioned notification, an entity shall be considered as a startup only if it meets the following criteria:

• Not more than 10 (ten) years should have elapsed from the date of its incorporation registration as company or as a partnership firm or as a limited liability partnership.
• The turnover of such entity for any of the financial years since incorporation/ registration should not exceed INR 100,00,00,000 (Indian Rupees One Hundred Crores).
• The entity should be working towards innovation, development or improvement of products or processes or services, or if it is a scalable business model with a high potential of employment generation or wealth creation. An entity formed by splitting up or reconstruction of an existing business shall not be considered a 'Startup'.

The SEBI AIF Regulations further provide that an angel fund shall not invest in a startup which is:

• promoted or sponsored by or related to an industrial group³ whose group turnover⁴ exceeds INR 300,00,00,000 (Indian Rupees Three Hundred Crores); or
• a company with a family connection with any of the angel investors who are investing in the company.

Other sub-categories of Category I AIFs, Category II AIFs and Category III AIFs too have various investment restrictions. However, such restrictions are not as narrow or as strict as that applicable for angel funds. For example, venture capital funds (which are a subcategory within Category I) can invest upto 75% of their investable funds⁵ in unlisted equity shares or equity linked instruments of a venture capital undertaking⁶ or in companies listed or proposed to be listed on a SME exchange or SME segment of an exchange. Category II AIFs are required to invest primarily in unlisted companies directly or through investment in units of other AIF. The term 'primarily' has been interpreted by SEBI to mean that more than 50% of the investment by a Category II AIF has to be in unlisted entities⁷. Category III AIFs face the least amount of investment restrictions.

3. How much diversity should investments by angel funds have?

Regulation 19F(5) of the SEBI AIF Regulations provide that an angel fund shall not invest more than 25% (of the total investments under all its schemes in one venture capital undertaking⁸.

Category I AIFs and Category II AIFs also have a similar restriction. Category III AIFs cannot invest more than 10% of their investable funds in an investee company. However, if an AIF is a "large value fund for accredited investors⁹", this restriction is relaxed to 50% for Category I AIFs and Category II AIFs and to 25% for Category III AIFs. An angel fund, however, cannot be a large value fund for accredited investors and does not have any relaxation in this regard.

4. Are there minimum and maximum limits for investments by angel funds?

No investment by an angel fund can be less than INR 25,00,000 (Indian Rupees Twenty-Five Lakhs) and shall not exceed INR 10,00,00,000 (Indian Rupees Ten Crores). In the case of other categories of AIFs, there ae no such minimum or maximum limits.

5. Minimum and Maximum Fund Size for angel funds

The SEBI AIF Regulations mandate angel funds to have a corpus of at least INR 5,00,00,000 (Indian Rupees Five Crores). It is worth noting that social impact funds are also subject to a similar minimum limit. For all other categories of AIFs, the minimum corpus is INR 20,00,00,000 (Indian Rupees Twenty Crores). The SEBI AIF Regulations do not prescribe any maximum limit for any AIF in any category, including for angel funds.

6. Minimum Sponsor Commitment for angel funds

The sponsor of an angel fund is required to have a continuing interest in the angel fund of not less than 2.5% of the corpus or INR 50,00,000 (Indian Rupees Fifty Lakhs), whichever is lesser. In the case of other Category I AIFs and Category II AIFs, the sponsor's continuing interest should not be less than 2.5% of the corpus or INR 5,00,00,000 (Indian Rupees Five Crores) whichever is lower. In the case of Category III AIF, the continuing interest shall be not less than 5% of the corpus or INR 10,00,00,000 (Indian Rupees Ten Crores) whichever is lower.

7. Maximum number of investors

The SEBI AIF Regulations permit angel funds to have upto 200 (two hundred) investors whereas other categories of AIFs are permitted to have upto 1000 (thousand) investors.

8. Lock-in period for investments

The SEBI AIF Regulations require investments by angel funds to be locked-in for a period of 1 (one) year. Such a lock-in period is not imposed on investments made by other categories of AIFs.

9. Investor's Right to Opt-Out of Investments

The definition¹⁰ of an AIF given in the SEBI AIF Regulations requires the AIF to be a privately pooled investment vehicle which collects funds from investors, whether Indian or foreign, for investing it in accordance with a defined investment policy for the benefit of its investors. Therefore, once an investor invests in an AIF, such investor has no control over investments to be made by the AIF, other than to demand that investments be in accordance with the investment objectives provided in the Private Placement Memorandum ("PPM"). All investors in an AIF share the rewards and losses from investments made by the AIF in proportion to their share of the total corpus. Opting out of investments is not an option for investors in an AIF, other than in a few exceptional circumstances, as per a very recent SEBI circular¹¹, which provides that an AIF may excuse its investor from participating in a particular investment in the following circumstances:

• If the investor, based on the opinion of a legal professional/legal advisor, confirms that its participation in the investment opportunity would be in violation of an applicable law or regulation; or
• If the investor, as part of contribution agreement or any other agreement signed with the AIF, had disclosed to the manager that, participation of the investor in such investment opportunity would be in contravention to the internal policy of the investor.
• Further, an AIF may exclude an investor from participating in a particular investment opportunity, if the manager of the AIF is satisfied that the participation of such investor in the investment opportunity would lead to the scheme of the AIF being in violation of applicable law or regulation or would result in material adverse effect on the scheme of the AIF. The manager shall record the rationale for such exclusion, along with the documents relied upon, if any.
• If the investor of an AIF is also an AIF or any other investment vehicle, such investor may be partially excused or excluded from participation in an investment opportunity, to the extent of the contribution of the said fund/investment vehicle's underlying investors who are to be excused or excluded from such investment opportunity. The manager of AIF shall record the rationale for such excuse or exclusion along with the supporting documents, if any.

However, in the case of Angel Funds, Regulation 19G(3) of the SEBI AIF Regulations states as follows:

"The manager of the angel fund shall obtain an undertaking from every angle investor proposing to make investment in a venture capital undertaking, confirming his approval for such an investment, prior to making such an investment."

The impact of the aforementioned Regulation 19G(3) is that before an angel fund makes any investment, it needs to obtain the consent of each investor in the angel fund. The corollary to this is that every investor in an Angel Fund has the right to opt out of investments being made by the angel fund.

10. Impact of Investor's Opt-Out Right

Since investors have the right to opt out of investments:

• Investors can decide how much to contribute for each investment. If an Angel Fund identifies an investment of INR 2,00,00,000 (Indian Rupees Two Crores) and issues a drawdown notice to an investor (who has a 10% stake in the total commitment) for INR 20,00,000 (Indian Rupees Twenty Lakhs), such investor may refuse to agree to participate in the investment, unless that investor's contribution is reduced to INR 10,00,000 (Indian Rupees Ten Lakhs);
• It may not be possible to drawdown each investor's entire commitment amount. Thus, the Angel Fund's total corpus may also not be fully drawn down. If an Angel Fund received capital commitments for INR 20,00,00,000 (Indian Rupees Twenty Crores) and is unable to draw down more than INR 15,00,00,000 (Indian Rupees Fifteen Crores) on account of investors exercising their opt-out rights, the Angel Fund would be in breach of the requirement contained in Regulation 10(b) of the SEBI AIF Regulations that every AIF should have a minimum corpus of INR 20,00,00,000 (Indian Rupees Twenty Crores).
• Calculation of hurdle rate and the performance fee (payable to investment manager) will have to be done for each investment. Therefore, an investment manager may earn performance fee in respect of certain investments (from the investors who participated in such investment) and may not receive any performance fee from certain investors in the Angel Fund.
• Since the management fee and operating expenses paid by each investor is usually a percentage of the investor's total commitment, an investor who opts out of investments and does not allow his/her total capital commitment to be fully drawn down may pay a disproportion amount of his/her invested amount towards management fees and operating expenses.

11. Application and Registration Fees

When applying to register an AIF, all applicants, irrespective of the category being applied for, pay an application fee of INR 1,00,000 (Indian Rupees One Lakh). Once the application is approved, a registration fee becomes payable. This registration fee for angel funds is only INR 2,00,000 (India Rupees Two Lakhs), whilst it is much higher for other categories of AIFs, as shown below:

12. Angel Funds in GIFT City

The International Financial Services Centres Authority (Fund Management) Regulations, 2022 (IFSCA FM Regulations) do not provide for the formation of angel funds. However, Regulation 18 which defines Venture Capital Schemes states that- Venture Capital Schemes also includes an angel fund. A few months after the IFSCA FM Regulations came into effect, vide Circular F. No. 645/IFSCA/Angel Schemes/2022-23 dated July 1, 2022 (IFSCA Angel Fund Regulations), the IFSCA provided for the setting up of angel funds in the GIFT City. The IFSCA Angel Fund Regulations are very similar to the rules applicable to angel funds in the SEBI AIF Regulations in many respects, though on certain aspects, the IFSCA Angel Fund Regulations diverge from the SEBI AIF Regulations.

• The IFSCA Angel Fund Regulations are similar to the SEBI AIF Regulations in the following aspects:
  • Angel funds set up in GIFT City require investor consent for every investment proposed to be made by the angel fund. Investors can opt out of an investment if they so wish¹²;
  • Angel funds set up in GIFT City can invest in early-stage venture capital undertakings, which are defined in a manner which is almost identical to the definition of a startup under the SEBI AIF Regulations;
  • Maximum number of investors in an angel fund permitted under both the regimes is the same i.e., 200 (two hundred) investors;
  • Both regimes impose a maximum limit on each investment by an angel fund. However, the limit imposed under the IFSCA Angel Fund Regulations is USD 1,500,000 (US Dollars One Million Five Hundred Thousand) whereas the SEBI AIF Regulations impose a limit of INR 10,00,00,000 (Indian Rupees Ten Crores) which is approximately USD 1,200,000 (US Dollars One Million Five Hundred Thousand);
  • Each investment by an angel fund shall be locked in for 1 (one) year under both regimes;
  • The IFSCA Angel Fund Regulations mandate angel funds to have a minimum corpus of USD 1,000,000 (US Dollars One Million) whereas SEBI AIF Regulations mandate a minimum corpus of INR 5,00,00,000 (Indian Rupees Five Crore), which at current exchange rates, works out to approximately USD 600,000 (US Dollars Six Hundred Thousand);
  • Both regimes specify a minimum commitment amount for each angel investor. The IFSCA Angel Fund Regulations prescribe a minimum commitment of USD 40,000 (US Dollars Forty Thousand) whereas the SEBI AIF Regulations require at least INR 25,00,000 (Indian Rupees Twenty-Five Lakhs) which is approximately USD 30,000 (US Dollars Thirty Thousand) from every angle investor;
  • The IFSCA Angel Fund Regulations require the Fund Management Entity (FME) of an angel fund to maintain a contribution of at least 2.5% of the corpus or USD 20,000 (US Dollars Twenty Thousand) whichever is lesser. Under the SEBI AIF Reulations, the sponsor is required to have a continuing interest in the angel fund of not less than 2.5% of the corpus or INR 50,00,000 (Indian Rupees Fifty Lakh), which is approximately USD 60,000 (US Dollars Sixty Thousand), whichever is lesser.

• The IFSCA Angel Fund Regulations are different from the SEBI AIF Regulations in the following aspects:
  • Under the IFSCA Angel Fund Regulations, angel investors do not have to meet any net worth requirement. As mentioned above in Paragraph A, angel investors in a SEBI registered AIF are required to have a certain minimum net worth.
  • The SEBI AIF Regulations restrict angel funds from investing more than 25% of the total investments under all its schemes in one venture capital undertaking. Such a restriction is not present under the IFSCA Angel Fund Regulations. This is possibly because it is expected that many angel funds registered under the IFSCA Angel Fund Regulations would be feeder funds which would invest their entire corpus into a domestic AIF.
  • The SEBI AIF Regulations provide that an investment by an angel fund in any venture capital undertaking shall not be less than INR 25,00,000 (Indian Rupees Twenty-Five Lakh). The IFSCA Angel Fund Regulations do not contain any such requirement.
  • The IFSCA Angel Fund Regulations allow angel schemes to invest not only in early-stage venture capital undertakings, but also in other regulated angel schemes or angel funds set up in IFSC, India or foreign jurisdictions. The SEBI AIF Regulations permit investment by angel funds only in startups.
  • Unlike the SEBI AIF Regulations, the IFSCA Angel Fund Regulations give exemptions for accredited investors in angel funds. Though the SEBI AIF Regulations give exemptions for accredited investors in other categories, they receive no special privileges in angel funds. Under the IFSCA Angel Fund Regulations, accredited investors are exempt from meeting the minimum commitment requirement¹³.
  • The IFSCA Angel Fund Regulations in certain cases provide an exemption to the FME from maintaining a continuing interest in the angel fund. Such cases are:
• If at least 2/3^rd of the angel investors are accredited investors;
• If at least 2/3^rd of the angel investors permit waiver of such contribution; or
• If the investment made is in another regulated angel scheme or angel fund set up in IFSC, India or foreign jurisdiction which has a similar requirement.

No such exemption is provided under the SEBI AIF Regulations.

• The following provisions of the IFSCA Angel Fund Regulations do not have any equivalent in the SEBI AIF Regulations:
  • The IFSCA Angel Fund Regulations require the FME of an angel scheme to structure each investment as a close-ended segregated portfolio by issuing separate classes of units to the consenting angel investor under each segregated portfolio. Further the FME must ensure that assets and liabilities of each segregated portfolio are ring-fenced from other segregated portfolios. This condition is absent under the SEBI AIF Regulations.
  • The SEBI AIF Regulations do not permit an angel fund to exceed the maximum investment limit¹⁴ even in any subsequent round of funding. The IFSCA Angel Fund Regulations permit angel funds to invest in excess of the maximum limit USD 1,500,000 (US Dollars One Million Five Hundred Thousand) during subsequent rounds of fund raising by the venture capital undertaking upon satisfaction of the conditions mentioned below:
    • The said undertaking should continue to satisfy the definition of an "early-stage venture capital undertaking", except for the requirement of the annual turnover;
    • The Angel fund shall give the opportunity to participate in subsequent rounds to only those angel investors who have participated in previous investment rounds for the said undertaking;
    • An angel investor's percentage stake in an investee company cannot increase after participating in a subsequent round;
    • Even though an angel fund establish in GIFT city is allowed to invest its entire corpus in a single investee company, if an angel fund participates in a subsequent round of funding, the FME shall ensure that the overall exposure of the angel fund in such early stage venture capital undertaking, including investments made in subsequent rounds, does not exceed 50% of the total investments made by the angel fund under all the segregated portfolios or USD 30,000,000, (US Dollars Thirty Million) whichever is lower; and
    • The FME shall comply with all other conditions as applicable to a segregated portfolio, such as consent from the angel investor, filings with the IFSCA, lockin period, FME contribution, etc.

Footnotes

1. Early stage investment experience means prior experience in investing in start-up or emerging or early-stage ventures.

2. Serial entrepreneur means a person who has promoted or co-promoted more than one start-up venture.

3. Industrial group shall include a group of body corporates with the same promoter(s)/promoter group, a parent company and its subsidiaries, a group of body corporates in which the same person/ group of persons exercise control, and a group of body corporates comprised of associates/ subsidiaries/ holding companies.

4. Group Turnover means combined total revenue of the industrial group.

5. Investable Funds means corpus of the scheme of Alternative Investment Fund net of expenditure for administration and management of the fund estimated for the tenure of the fund.

6. venture capital undertaking means a domestic company which is not listed on a recognised stock exchange at the time of making investments.

7. SEBI Circular bearing number CIR/IMD/DF/14/2014 dated June 19, 2014

8. Even though Regulation 19F(5) uses the phrase "venture capital undertaking", Angel Funds are bound by the rule in Regulation 19F(1) of the SEBI AIF Regulations that Angel Funds can invest only in startups.

9. "large value fund for accredited investors" means an Alternative Investment Fund or scheme of an Alternative Investment Fund in which each investor (other than the Manager, Sponsor, employees or directors of the Alternative Investment Fund or employees or directors of the Manager) is an accredited investor and invests not less than seventy crore rupees

10. Regulations 2(b) of the SEBI AIF Regulations

11. SEBI circular bearing number SEBI/HO/AFD-1/PoD/P/CIR/2023/053 dated April 10, 2023.

12. Paragraph 8 of the IFSCA Angel Fund Regs

13. The minimum commitment requirement is detailed in paragraph 1608078384.o

14. The maximum investment limit is detailed in paragraph D

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.