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-mjg.
India is seeing a huge inflow of foreign investment into the country and investments from private equity (PE) funds as well as venture capital (VC) funds comprise a big part of such investments. Both forms of investments, though almost interchangeable, have distinct characteristics.
The Research and Development Cess Act, introduced in India in 1986, imposed a 5% cess (tax) on all know-how import payments in order to create a pool of funds for, among other things, VC activities. Since then the Indian VC industry has flourished with the participation, first of large government controlled corporations, and eventually private and international players.
Typically, VC investments are targeted at start-up businesses or businesses that are at an early stage, where the enterprise is still unsettled and the investment, in turn, entails a degree of risk. VC investments generally aim to:
Make investments in ideas and innovations with potential for growth.
Provide management, networking and other support to an entrepreneur.
PE investments, in contrast, are generally targeted at well-established businesses and enterprises that are at an expansion stage.
The typical source of funding has traditionally been money borrowed from family members and close friends. More recently, and with globalisation, the means of funding have evolved and today multiple sources of funding are available to start-up companies, both in the form of lending from banks and financial institutions, and equity participations from VC funding. Entrepreneurs typically prefer equity participation as it involves a degree of strategic alliance, while lending requires the servicing of interest payments.
In addition, with the change in the dynamics of corporate India, high net-worth individuals have started taking a keen interest in financing and grooming young start-up entrepreneurs by making angel investments.
Typically, unlisted start-up companies attract VC investments (see above, Venture capital and private equity). The sectors that have recently been attracting VC funding include clean technology, healthcare and e-commerce.
The economic policy of 1991 aimed at liberalising the flow of funds into India and in turn, globalising the Indian economy. While this process continues, market trends have shifted, with investments, having been restricted to sectors such as information technology and telecoms, now progressing to sectors such as banking and finance, pharmaceuticals, manufacturing and e-commerce.
VC funds in India are governed mainly by the:
SEBI (Venture Capital Funds) Regulations, 1996 (VCF Regulations), regulating domestic VC funds.
SEBI (Foreign Venture Capital Investors) Regulations 2000 (FVC Regulations), regulating foreign VC funds.
These Regulations define the entities that can be set up as VC funds and set out the manner in which they are registered with the Securities and Exchange Board of India (SEBI) (the regulatory authority governing the capital markets in India). The Regulations also set out the manner and extent in which VC funds can make investments.
On 1 August 2011, SEBI proposed the SEBI (Alternative Investment Funds) Regulations 2011 (AIF Regulations), for public comments. These aim to bridge any regulatory gaps and increase the purview of the existing Regulations. Once notified, the AIF Regulations will provide a fresh framework for VC funds and alternative investment funds, although the effect of the AIF Regulations on VC funds remains to be seen.
Income derived from VC investments made in an unlisted venture capital undertaking engaged in the following industry and sectors is exempted from taxation (Income Tax Act 1961) (ITA):
The dairy or poultry industry.
Nanotechnology.
Information technology relating to hardware and software development.
Seed research and development.
Bio-technology.
Research and development of new chemical entities in the pharmaceutical sector.
Production of bio-fuels.
Building and operating composite hotel-cum-convention centres meeting certain criteria as set out under the ITA.
Developing or operating and maintaining any infrastructure facility as defined in the ITA.
High growth and a vast consumer base have fuelled investments in India and, in turn, the VC industry. Typically, domestic VC funds receive funding both from domestic sources as well as offshore funds (subject to approval from the Reserve Bank of India (RBI)), while foreign VC funds receive funding from overseas sources. In addition, recently India has seen a growing trend towards high net-worth individuals setting up VC funds with their own wealth.
While limited partnerships, limited liability partnerships and limited liability companies are favoured overseas for setting up VC funds (mainly because they limit liability) in India the structure of a domestic VC fund is determined by the VCF Regulations. These require that the fund be established and registered with SEBI in the form of a trust, a company or a body corporate. A registered company or a body corporate can float multiple investment schemes for making investments in different categories of companies and similarly a registered trust can establish one or more funds.
As regards foreign VC funds, any double taxation avoidance agreement (DTAA) signed between India and the foreign jurisdiction determines the tax-structuring and tax treatment.
In addition, under the VCF Regulations and the FVC Regulations, a VC fund can subscribe to an investee company's debt instruments only where prior equity investment has been made by the fund in the company. Hence, the manner in which the charter of a VC fund proposing to make investments in India is drafted is also important.
As a VC funding is typically aimed at start-up companies, the size of the investment is small in comparison to other investments. This usually means that there is no opportunity to co-invest. However, where the investment is for a high-risk business, multiple investors often invest together to be able to mitigate their individual investment risks.
The preferred vehicle for setting up a domestic VC fund is a trust. A VC fund set up in the form of a trust is entitled to tax pass-through status under the provisions of the ITA on the fulfilment of criteria set out under the ITA.
While the primary objectives of VC funds may be specific to each fund and are usually based on varied factors such as the fund's investment strategy, tenure and intended investment sectors, general objectives include:
Promoting innovative, emerging or frontier technologies through long-term investment.
Supporting entrepreneurs by providing market access and mentoring.
Contributing to unlocking the commercial value of inventions.
Enabling innovative start-up companies to reach a stage where they can attract follow-on investments.
Funding an entrepreneur to obtain high quality business inputs from highly successful professionals.
The VCF Regulations and FVC Regulations require only the VC fund to be registered with SEBI and no registration is required for a VC fund manager or promoter. However, SEBI has made proposals in recent years to regulate the advisors and intermediaries in relation to a fund, which are under consideration.
A VC fund is regulated by SEBI as a VC fund and not as an investment company (which is classified as a non-banking financial company (NBFC), regulated by the money market regulator, the RBI). The RBI has exempted VC funds registered with SEBI from seeking a separate and independent registration as an NBFC with the RBI. The RBI has also exempted VC funds from fulfilling other criteria applicable to an NBFC such as the maintenance of liquid assets and the creation of a special reserve fund.
The relationship between a VC fund and its investors/contributors is regulated by either a private placement memorandum or a contribution agreement. In practice, a VC fund usually executes a contribution agreement with its contributors and submits a private placement memorandum (offer document) with SEBI.
As protection for the investors or contributors, the contribution agreement generally provides them with exhaustive information rights (at regular intervals), inspection rights and exit rights (which are generally triggered only at the end of the term).
Generally, investments made by VC funds are by way of subscription to equity and/or equity-linked instruments. Equity participation includes subscription to preference shares and compulsorily or optionally convertible debentures, although a VC fund can subscribe to an investee company's debt-related instruments only if the fund already holds equity participation in the company.
VC funds value a company based on various factors such as the:
Asset value.
Earning potential of a product portfolio or business model.
Value of intellectual property rights contained in the company.
Barrier to entry in the business.
Balance sheet of the investee company, at later stage of the investment.
However, the most important factor for fetching a good valuation from any investee company is its management team, since the investment is typically made when the business or business model of the investee company is unverified. An inspiring leadership team with a past (personal) success record is usually required to induce a VC fund to invest in an unproven and untested business or business model.
Before making investments VC funds conduct exhaustive and rigorous diligence on all aspects of the investee company, including financial, legal, secretarial, technical and managerial matters. In the case of a proposed business model, VC funds also carefully analyse the model's potential as well as the appetite of the market for the business model.
Once the diligence process is concluded and the VC fund decides to invest in an investee company, the investment is usually executed by a subscription/investment agreement and shareholders' agreement.
While a subscription agreement is not required for the investment itself, it is normally executed in order to set out the terms and conditions under which the investment takes place. These terms encompass the entire commercial understanding between the parties as regards the instruments being subscribed to and also includes representations and warranties provided by the investee company (and in many cases the founders of the company) on the past and present conditions of the company and its business. The agreement also records undertakings (both positive as well as negative) provided by the company and the founders.
The shareholders' agreement is an equally important agreement, signed between the VC fund, the founders and the investee company, to set out various rights and obligations of the shareholders, post-investment, in relation to each other as well as the investee company.
Subject to the negotiations between the parties and the instrument subscribed to by the VC fund, the shareholders' agreement (see Question 15) protects the VC fund's rights in the company, both during the term of investment and on exit. The nature of protection provided to the VC fund during the term of its investment typically includes the right to:
Appoint nominee directors.
Participate in follow on issues.
Veto certain matters.
Information and access.
Participation at the time of liquidation.
The shareholders' agreement also defines the VC fund's exit options.
Under the VCF Regulations and FVC Regulations, VC funds can invest in equity and equity-linked instruments and (to a limited extent) in debt instruments of an investee company where the fund has already subscribed to equity of that company. VC funds often prefer to subscribe to preference shares as opposed to equity shares (see Question 18).
VC funds typically prefer preference shares, which carry preferential rights to dividend payments and distribution of capital in the event of winding up.
However, a foreign VC fund can subscribe only to preference shares that are fully and mandatorily convertible into equity shares, so as to qualify the investment as foreign direct investment (FDI). Subscription by a foreign VC fund to non-convertible, redeemable, optionally convertible or partially convertible preference shares is instead deemed as subscription to debt instruments and must adhere to the regulations governing external commercial borrowings.
In almost all VC investments, the VC fund(s) seek to appoint director(s) on the Board of Directors of the investee company. These directors are appointed as non-executive directors and are not required to retire by rotation, to the extent this is possible.
This presence on the Board of Directors of the investee company gives the fund access to the company's management as well as to its information and documents. It is also typical to grant veto rights to the fund's nominee director(s) on matters that are critical to the company and the fund's investment.
A VC fund's equity subscription in a listed company is subject to a statutory lock-in of one year from the date of subscription in terms of the VCF Regulations or the FVC Regulations (as the case may be) as well as under the SEBI (Issue of Capital and Disclosure requirements) Regulations, 2009 (ICDR Regulations), which govern further issue of securities by a listed company, among other things.
While this statutory lock-in is applicable to listed securities subscribed to by the VC fund, it is also very common to subject the founders of the investee company to a contractual lock-in. As the founders are critical to any business, they are often contractually restricted from entirely or partly diluting their stake in the company during the term of the investment. Whether this restriction is partial or full and whether it applies to their entire shareholding or a substantial portion of the shareholding is usually a point of discussion and negotiation.
The investor usually seeks a tag-along right, and often a right of first exit, to cover the situation where the investee company is sold during the term of investment. These ensure that the investor has priority on exit and that the exit of any other shareholder is made subject to the exit of the investor.
While the investor's desired percentage of participation in the share capital of the company may be fixed, it is probable that the company will need additional funds during the lifetime of the investment, leading to a fresh issue, which may dilute the investor's shareholding. While the investor is usually granted a veto on whether or not the company can issue fresh shares, the investor is also often granted a right to participate in the fresh issue at the same price and on the same terms offered to any third party. If the third party is offered greater rights than the investor, it is common for the investor to seek such additional rights as well.
In an issuance of shares by a private limited company, the company's Board of Directors must authorise the issue and the terms of issue as well as approve the investment documentation. In an issuance of shares by a public company (listed as well as unlisted), the issuance and its terms must be authorised by the company shareholders in addition to the Board of Directors.
In addition to these corporate approvals, foreign investments may require approval by the RBI or the Foreign Investment Promotion Board (as the case may be), in terms of the extant foreign exchange laws of India.
The fund's costs are generally subject to negotiation. However, in general the cost of the VC investment, including towards execution and stamping of investment documents, is borne by the investee company.
The founders and key employees of an investee company are usually incentivised through:
Shares.
Share option plans. These are given to the directors, officers or employees of a company allowing them, at a future date, to receive or to purchase or subscribe to the securities of the investee company at a predetermined price. Share options in the case of listed companies are governed by specific regulations issued by SEBI
Performance bonuses. These are variable salary components which are linked to the fulfilment of certain key performance targets by the investee company.
Performance bonuses form a part of the employee's salary. Any benefit derived from share options are taxed as an employee perquisite.
One of the critical factors in an investment is the commitment of the founders and management team towards the investee company and investors seek protection in this regard. Investment documents therefore often provide for rights such as:
Non-compete agreements. To ensure the dedication of the founders, the investment documents typically require them to devote substantial time towards the business of the company and restrict them from initiating any venture or participating in any venture which competes with the business of the investee company.
Management agreements. Before an investment being made (particularly in the case of private companies), it is typically witnessed that there are no formal contracts entered between the company and its management. As part of the investment process therefore, it is ensured that the management enters formal management contracts with the company, defining their role and duties towards the management of the company as well as their compensation package.
Employment contracts. As with management agreements, key employees are made to sign employment contracts with the investee company in order to provide clear terms as regards their employment.
In unlisted companies, the preferred form of exit for an investor is an initial public offer (IPO), thereby creating a market for the investor's shares. However, in an unsuccessful or underperforming company, this exit is less probable and the investor is forced to look at alternative exist mechanisms. These exits are often in the form of a:
Strategic sale. In this scenario the investor sells all its shares, and forces the founders to sell their shares, to a strategic buyer (often a competitor). The investor aims to receive a price higher than the valuation of the company to at least recoup the investment amount, if not the assured returns. However, this may become a challenge for a foreign investor, where shares are proposed to be sold to a domestic purchaser as the sale of shares by a foreign investor to a domestic purchaser cannot take place at a price higher than the valuation of the company, under the foreign exchange laws of India.
Liquidation. In cases where the business or an enterprise is asset rich, the parties may opt for liquidation.
Put option. An investor may also seek to force the founders to purchase the shares held by the investor, However, it is always a challenge for the founders to raise the funds for such a purchase under these conditions. In addition, where the price of purchase is fixed beforehand (such as at the time of grant of the option), the execution may be challenged by the authorities.
In a successful company, the preferred exit route for a VC fund is an IPO, where the fund may also seek the right to offer some of its shares in the offering.
VC funds seek to enforce exit modes through various rights built-in in the investment documents. Therefore, not only the time of exit but also the modes of exit are typically well defined in the investment documents and most often provide the investor with multiple alternate exit rights.
T +91 22 4096 1000
F +91 22 4096 1010
E purvi@rajaniassociates.net
W www.rajaniassociates.net
Qualified. Bar Council of Maharashtra & Goa, India, 2002
Areas of practice. Private equity and venture capital.
T +91 22 4096 1000
F +91 22 4096 1010
E poorvi@rajaniassociates.net
W www.rajaniassociates.net
Qualified. Bar Council of Maharashtra & Goa, India, 2003
Areas of practice. Private equity and venture capital.
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