Legal Framework of Venture Capital Investment in India

Swetha Dhinesh

02 May, 2023

Venture capital funds (VCFs) are governed by the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 (the “AIF Regulations”). A Category I Alternative Investment Fund serves as a financial middleman to finance rising start-ups and small enterprises with promising futures. The majority of a VCF’s investments are in unlisted stocks of emerging or early-stage Indian businesses, limited liability partnerships working in the fields of new products, new services, technology, or businesses based on intellectual property rights.

Funding for Venture Capital

A venture capital fund is defined as a fund established in the form of a trust, including a body corporate, and registered with SEBI that has a dedicated pool of raised capital in a manner specified in the regulations and invests in venture capital undertakings (VCUs) in accordance with these regulations, as per section 2(m) of the SEBI Venture Capital Funds (VCFs) Regulations, 1996.

Investment vehicles known as venture capital funds (VCFs) enable people to invest money in newly founded start-ups as well as small and medium-sized enterprises in exchange for ownership interests in those companies. These are investment funds that frequently invest in businesses that have the potential to generate substantial rewards but also pose a significant risk.

Investments in venture capital are private equity in the sense that they are not offered on the open market. A venture capital firm manages the fund, while investment banks, high-net-worth individuals, and other financial institutions are typically the investors. 

Venture capital (VC) is a type of private equity financing offered by venture capital firms or funds to start-ups, early-stage, and emerging businesses that have shown high growth (in terms of the number of employees, annual revenue, scale of operations, etc.) or have a high growth potential. Venture capital firms or funds fund these early-stage businesses in exchange for equity or ownership stakes. In the hopes that some of the businesses they support will succeed, venture capitalists take on the risk of financing hazardous start-ups. VC investments frequently fail because start-ups experience significant levels of uncertainty. 

Establishment of Venture Capital Funds

Three types of structured or institutional venture capital funds are private venture capital firms/funds, venture capital subsidiaries of businesses, and venture capital funds established by high-net-worth individuals. India’s different types of promoters can be used to segment venture capital funds.

• Venture capital funds promoted by development financial institutions under the Central government’s jurisdiction, such as TDICI, ICICI, Risk Capital and Technology Finance Corporation Limited (RCTFC), Industrial Finance Corporation of India (IFCI), and Risk Capital Fund, IDBI.
• It is pushed by state government-controlled development finance organisations like Gujarat Venture Finance Company Limited (GVCFL) and Andhra Pradesh Venture Capital Limited (APVCL), both of which are owned by the State Industrial Investment Corporation.
• Public sector banks like Canfina and SBI-Cap are also promoting this.
• Investment funds for venture capital that are supported by international banks, private sector businesses, or financial organisations, like Grindlay’s India Development Fund and Indus Venture Fund.

Regulatory Framework of Venture Capital in India

The SEBI Act of 1992^[1]and the SEBI (Venture Capital Fund) Regulations of 1996 control venture capital in India, which states that any business or trust wishing to engage in venture capital fund activity must obtain a certificate from SEBI. The FVCI regulations, however, do not require foreign venture capital investors (FVCI) to register. The Securities Contract (Regulation) Act of 1956, the SEBI (Substantial Acquisition of Shares & Takeover) Regulations of 1997, and the SEBI (Disclosure of Investor Protection) Guidelines of 2000 also cover venture capital funds and foreign venture capital investors.

Important SEBI Regulations for Venture Capital Funds: 

• A Venture Capital Fund (VCF) is a fund that is registered with SEBI in the form of a trust or a corporation with a body corporate. It has a designated fund that was raised in a specific way and invested in VCUs in accordance with the rules. VCU is a domestic corporation that conducts the stated business but does not have its shares listed on a stock exchange.
• Investors must make a minimum investment of Rs. 5 lahks in a VCF, and the fund must have a minimum corpus of Rs. 5 crores before it can begin operations.
• Investment standards were altered. Within one year of the VCU’s listing, a VCF that wants to take advantage of the applicable provisions of the Income Tax Act must sell their stake.
• As a Qualified Institutional Buyer, the VCF will be qualified to participate in the IPO via the book-building approach.
• To allow for flexibility in exit to VCFs, the SEBI (VCF) Regulation abolished the required exit requirement by VCF from the investment within one year of the listing of the shares of VCUs.
• The VCFs were instructed to disclose each quarter’s venture capital activity information.
• When shares are transferred from VCFs in Foreign Venture Capital Investors (FVCIs) to promoters of a VCU, an automatic exemption from the open offer rules is given. 

Obligation of Venture Capital Fund

Venture capital fund obligations include the following: 

• Venture capital fund shall not engage in any activity other than that of venture capital fund.
• Venture capital shall disclose the investment strategy at the time of making investments.
• Venture capital shall disclose the life cycle of the fund.
• Venture capital shall not list its units in any listed stock exchange until the expiration of three years from the date of issuance of units by venture capital.
• It shall not solicit offers from the general public to subscribe to its units and may only receive money through a private placement of the units.
• VFC must enter into a placement memorandum and subscription agreement that contains the terms and conditions under which money is proposed to be raised from investors. A copy of the subscription agreement and placement memorandum will be filed with the Board along with the actual money paid in.
• VCF must keep all of its financial records and books for at least eight years.

Challenges Faced by Venture Capital Firms

We all know what a venture capitalist is and how they work, let us examine some of the biggest issues that venture capitalist firms are facing:

• Investments should target businesses that can withstand ups and downs. Countercyclical tactics have been successful in the past when applied to uncertain situations. 
• The funds need to have operational knowledge. They can take the wheel to handle troublesome ones if the need arises. Despite having strong financial standing, funds attempting to turn around an invested company frequently lack operational capabilities. Realising the lack of operational expertise frequently happens after the agreement is closed and the company is unable to fulfil its obligations. Some of the underperforming businesses are in the infrastructure and textiles industries. 
• During a challenging economic moment, some assets may go wrong and make an exit nearly impossible. The growing mistrust between funders and promoters as a result of the investee companies’ poor financial health was a direct result. Therefore, funds must regularly conduct due diligence and, when necessary, retain forensic experts to monitor the financial statements of promoter-led companies, related party transactions, and promoters’ political connections. In order to stop the value of their investments from depreciating, funds must take timely follow-up action based on forensic findings.
• It might be difficult for venture capitalists to invest in start-up businesses because of the lengthy gestation time and considerable risk involved. Until shares are listed, they should be able to support and monitor for an extended period of time.
• Nowadays, the majority of venture capitalists (VCs) spend more than 50% of their corpus in internet-based businesses. These venture-backed businesses depend on the newest technology, but there is a severe lack of qualified technology talent. Additionally, regulations governing internet-backed ventures are not clearly defined, which will affect the value of investee companies.
• One of the most challenging problems that businesses, particularly venture capital firms, face today is earning a customer’s trust. Venture capital firms must put in a lot of effort to create a customer-centric working environment if they want to win customers’ trust and loyalty in order for them to be successful in their pursuit of the highest level of sustainable growth and progress imaginable in this business environment that is both tech-savvy and cutthroat.
• Adherence to CBDT requirements, FDI regulations, FEMA regulations, and local SEBI regulations in order for VCs to claim tax benefits are one of the challenges.
• Cyber Security – In recent years, cybercrime has become more commonplace. Hackers are pervasive and will take advantage of any weakness in a fledgling company’s system deployment.Venture capital firms are subject to online security issues. They run the risk of being endangered by unauthorised access to private data, such as employment records, banking information, or any other pertinent information.
• It is impossible to view portfolio performance. Lack of knowledge about portfolio performance is one of the biggest problems that venture capital organisations face. It is gradually improving as various software solutions attempt to address the problem of portfolio reporting, but there is still room for improvement. Incomplete, inaccurate, or missing data may also make performance visibility difficult. 

Conclusion

Positioning of the legal system is intended to encourage innovation and fresh ideas. Venture capital will soon be the leading source of funding for the emerging business community. A sizeable segment of the economy, including the pharmaceutical, information technology, and other services sectors, is ready for venture capital investors. In order to provide the essential solution, venture capitalists are receptive to company prospects and have established themselves as the primary source of finance for innovative entrepreneurs.

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