The Legal Framework Of Venture Capital Investment In India - Financial Services

Introduction

Venture Capital in India refers to the funding supplied by venture capitalists in India, who make investments in startups or relatively young, high-growth businesses with the potential to become very successful businesses. It has both high-risk and high-return features. As a result, it serves as a crucial source of funding for business owners with innovative ideas. It is the best type of financing for organisations and businesses with significant upfront cash needs and no other affordable alternatives.

India currently boasts one of the world's fastest expanding economies. Strong demographic changes are being fuelled by the nation's fast growing young labour force. India's governance has improved steadily over time, which has strengthened its competitiveness and raised its appeal to foreign investors. India has become a desirable venture capital investment destination as a result of the permanent cash flowing into the country in the form of foreign direct investment (FDI) from all over the world.

Venture capital investments are made in early-stage startups by individual or institutional investors. The money is used to invest in small firms or those that are just getting started but have a lot of potential to expand. Venture capitalists are those who make these investments. When venture capitalist purchases stock in a start-up company, they are making an investment by joining the company as a financial partner. The risk of losing money if the enterprise fails is what is known as the “large capital risk” or “patient risk” component of venture capital. Due to this being a huge risk, a proper medium for regulation and Venture Capital Laws is essential.

Due to the extreme complexity of venture capital law, careful strategic planning is necessary. A venture capital lawyer can provide venture capitalists with access to a wide range of information, including but not limited to securities legislation, licencing issues, mergers and acquisitions deals, and intellectual property rights and protections.

Development trends in venture capital investment in India

The first study on venture capital in India was published in 1983. It showed that new businesses frequently encounter obstacles when trying to access the capital market and raise equity financing, which hinders their ability to expand and thrive in the future. Additionally, it suggested that in order to evaluate the equity cult generally, a competitive return on equity investment is required. All of this manifested as institutional shortcomings and led to the development of venture capital investments.

Since the ecosystem has changed dramatically over the last ten years, from computer games to consumer media tech to health tech to financial services, etc., almost every industry is now served by these new start-ups. This paradigm change has been substantially facilitated by effective governmental initiatives and the confidence of venture capitalists. According to a survey by Bain & Company¹, the number of start-ups in India expanded by 17% annually between 2012 and 2020 and approximately 9% of the 110,000 start-ups in India at this time have funding, indicating that there is a considerable need for additional investments.

India as of 2021 has 73 unicorns, 2021 witnessed the creation of 44 new unicorns, which puts it in third place among nations with the most unicorns, behind China and the United States. In the first quarter of the year, venture capital funds with an emphasis on India raised around US$10 billion as startup money, continuing the momentum from 2021.

The market for venture capital investments is expected to change and grow in 2023 as a result of equity crowdsourcing, large deals creating more "unicorns," and a further shift of venture capital to international markets. During the late-stage phase, investors diverted their attention away from early-stage company campaigns and put more money into long-term chances. Conducting thorough research and being up to date on current events is crucial if one wants to uncover the finest investing opportunities.

Key considerations in structuring venture capital funds in India

The Indian government occasionally introduces regulations for the sake of investment. Before building a VCF, a number of factors had to be taken into account that could be confusing and led to the VCF being utilised by many other investment funds because the person creating the fund first had to pick which kind of investment funds it desired. The government found it difficult to encourage innovation, entrepreneurship, developing businesses, and the start-up ecosystem as a result. In light of this, regulations were deemed necessary to be implemented in 2012. As a result, SEBI adopted the SEBI (Alternative Investment Funds) Regulations 2012 (the AIF Regulations), which recognised VCFs as separate asset classes.

It adopted modifications as part of its effort to make investing simpler, which were crucial to the development of the AIF as one of the favoured investment vehicles. These reforms included-

“Exempting AIFs from a lock-in of shares during an initial public offering (IPO);”
“Increasing clarity regarding the taxation classification of AIFs;”
“Allowing the foreign capital received for the AIF to be classified as domestic capital in situations where the fund manager is domestically controlled and owned”, meaning the AIF is exempt from pricing guidelines and sectoral caps under FDI norms.

A single firm may receive a maximum investment of 25% of the investable funds.
Borrowing is only permitted for a maximum of 30 days to address short-term funding needs. There are a total of four borrowing opportunities per year. No more than 10% of the investable funds may be borrowed.

Private equity funds and debt funds are included in a Category II AIF, which is distinct from a Category I or Category III AIF. It has the same requirements as Category I as well as-

The entity may operate in hedge funds subject to SEBI regulation.
Under Chapter XB of the SEBI (Issuance of Capital and Disclosure Requirements) Regulations 2018, the entity and a merchant banker may decide to subscribe to the portion of the issue that has not yet been fully subscribed or to receive or deliver securities in the course of market making if the entity invests in firms listed on the SME Exchange, it is free from the SEBI (Prohibition of Insider Trading) Regulations, 1932.

A Category III AIF uses numerous or intricate trading techniques, may use leverage and may invest in listed or unlisted derivatives. It stipulates:

A single firm may receive a maximum investment of 10% of the investable funds.
The entity may invest in derivatives, sophisticated or structured products, listed or unlisted investee company securities, or other financial instruments.
The company is permitted to transact in delivered items in exchange for the physical settlement of commodity derivatives.
Investments in fund-of-funds units cannot be made by the entity.
Subject to investor permission and within the maximum amount set by SEBI, the firm may use leverage or borrow.

The biggest challenges faced by venture capital investors

Venture capital investments are not for the timid. The VC sector is rife with competition as investors vie for the next unicorn startup. The stakes have never been higher given the industry average of three out of every four venture-backed startups failing.

Practically in every business, competition is a continual factor, and venture capital is no exception. The feeling that they are rarely the first choice in comparison to the main players in the business is a typical complaint among venture capitalists.

Start-up overvaluation as a notion is no longer as uncommon as it once was. The number of emerging start-ups and prospective unicorns has increased exponentially along with the world of technology. Many people are beginning to realise that these fictitious unicorn start-ups are unreal, just like their mythological counterparts. After entering the intensely competitive market, these companies frequently fall short of their exorbitant values. Overvaluation presents a major danger to prospective revenue, which should be avoided.

The lack of information regarding portfolio performance is one of the main problems faced by venture capital organisations. Numerous software programmes have started to address the issue of portfolio reporting, but the solution is still far from perfect. Venture Capital Investments also face other difficulties, such as the need to raise additional funds and keep landing lucrative agreements.

Conclusion

As global marketplaces become extensively competitive, it is important to choose the appropriate human capital to direct and oversee new projects as well as the necessary funding. Indian venture capitalists have made sure that there are more opportunities for growth. A significant portion of the economy, including the pharmaceutical, information technology, and other service sectors, is ready for venture capital investors. Therefore, venture capitalists are responding favourably to business opportunities and have established themselves as the primary source of funding for creative entrepreneurs, thereby offering the necessary solution.

FAQ's

Which is the regulatory body for venture capital funding in India?

It is governed by the Securities Exchange Board of India (referred to as "SEBI").

What are the SEBI guidelines for venture capital?

The types of AIF that an organisation can register for and acquire a certificate of registration under are categorised under Regulation 3(4) of the AIF Regulations. Investments in start-ups, early-stage businesses, social ventures, small and medium-sized enterprises (SMEs), and other infrastructure are all eligible for Category I AIFs. Private equity funds and debt funds are included in a Category II AIF. A Category III AIF uses numerous or intricate trading techniques, may use leverage, and may invest in listed or unlisted derivatives

How is venture capital regulated by the Indian government?

Venture capital funds in India are subject to regulation under the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 ("AIF Regulations"). It is acknowledged as a Category I Alternative Investment Fund that functions as a middleman in the financial sector, providing cash to small businesses and developing start-ups with strong development prospects.

Footnote

1 IVCA & Bain & Company, 'India Venture Capital Report 2021' (March 2021).

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.

India: The Legal Framework Of Venture Capital Investment In India