Venture Capital

SEBI Simplifies Investment Norms for Venture Capital and Angel Funds

The Securities Exchange Board of India (SEBI) relaxed some regulations and gave venture capital and angel funds more regulatory flexibility when investing in startups. The SEBI guidelines are an effort to support the funding environment in India and aid SMEs who are struggling with financial management.

A few years ago, investing in traditional investment categories like shares, bonds, real estate, FDs, etc., was the only method to accumulate financial assets in India. There is an increasing demand for unconventional investment options due to the country’s rising high-net-worth population. Alternative Investment Funds (AIFs) are a particular category of unconventional investment options. AIF is a fund that investors can use to make investments and profit from them. 

Venture capitals are those that invest in activities based on new goods, new services, technology, intellectual property^[1] rights, or new business models, according to SEBI’s Alternative Investment Fund (AIF) Regulation. Since they are typically thought to have favourable knock-on effects on the economy, this category I Businesses also obtain tax benefits and incentives from the government.

Alternate Investment Funds

An AIF is a privately operated investment vehicle that pools investor money for investments in venture capital, hedge funds, angel funds, private equity, and other types of funds. These investments are governed by an AIF investment policy established in the investors’ best interests.

Traditional investing methods in the back centuries, such as fixed deposits, equities, and debt securities, among others, are fundamentally different from an AIF. For investors who wish to diversify their holdings, alternative investment funds are a realistic option. The funds raised will be invested in accordance with the AIF’s investment strategy.

Categories Of Alternative Investment Funds 

As per SEBI AIF Regulations, AIFs are broadly classified into the following three categories based on the type of investments they undertake: 

Category I – According to SEBI AIF Rules, based on the kinds of investments they make, AIFs can be roughly divided into the following three categories:

Investments are made in infrastructure, SMEs, social initiatives, early-stage businesses, startups, and other fields or industries that the government or regulatory bodies deem to be desirable from a social or economic standpoint. The following shall be included:

• Venture capital funds
• Angel funds
• SME funds
• Social venture funds
• Infrastructure funds 

Category II – Any funds that do not fit under Categories I or III are included in Category II AIF. It doesn’t use leverage or borrow money to meet ongoing operational needs. Private equity or debt funds that are excluded must not receive any special incentives or concessions from the government or another regulator. The following are included in Category II AIF:

• Real estate funds
• Private equity funds
• Financing for distressed assets, etc.

Category III – While investing in listed or unlisted derivatives, Category III AIFs may use leverage and adopt various trading tactics. The following shall be included in Category III AIF:

• Hedge fund
• PIPE fund

Angel Funds

Under Category I AIF, angel funds are a subcategory of venture capital funds that raise money from angel investors to invest in firms at the beginning of their development. By giving startups access to early-stage finance, management mentoring, and support throughout their journeys, angel funds aim to boost the startup ecosystem.

An angel fund invests in businesses where the investing group thinks it can accelerate the business transformation. It involves engaging in and contributing to such businesses’ growth strategies.

Venture capital

Money invested in startups or small enterprises with significant room for growth is known as venture capital (VC). These investments frequently, though not always, occur in the early stages of a company’s development, before the enterprise has a finished good or significant revenue. Usually, established companies that focus on identifying the most promising fledgling startups make the investments.

For software startups and other high-growth businesses that require finance but may not be able to obtain traditional financing, like a bank loan, venture capital is a significant source of funding. The drawbacks of this method of financing include a cost to equity and, occasionally, a loss of company control, and not all organisations are suitable candidates. Also, a domestic company not listed on a reputable stock exchange when making investments is referred to as a venture capital undertaking (VCU).

Simplified Investment Regulation

The aforementioned regulations have undergone the following modifications:

• The elimination of the list of prohibited activities or sectors from the definition of “Venture Capital Undertaking” and the addition of the definition of “Startup” has been approved by SEBI.
• AIFs, including Fund of AIFs, can hold both direct investments simultaneously in the securities of investee firms and units of other AIFs.
• Under all situations, the AIF management is obligated to ensure compliance with all applicable laws, fund documents, and investment-related conditions.
• In addition to prescribing a code of conduct for key management staff of AIF and its manager, including the investment committee members, SEBI also rationalises regulatory criteria.

Analysis of the Amended Regulations

To fulfil the long-overdue expectations of venture capitalists, fund managers, and startups. The amendment’s goal was to bring clarity and accountability regarding investments in the same, with particular attention given to alternative investment funds and their operations. It is accomplished by amending the definitions of startups and venture capital undertakings and introducing a code of conduct for fund managers.

Startup Definition – The term “Startup” has been defined in the updated regulations. According to the AIF Rules, the Venture Capital Fund (VCF) is a subcategory of a Category I AIF that includes angel funds (Angel Fund). The term “startup” is not defined in the AIF Rules, even though they permit Angel Funds to invest in “Venture Capital Undertakings” (VCUs) or “startups”.

As a result, the following startup definition was added: A private limited company or limited liability partnership that meets the requirements for startup status as laid out by the Department of Promotion of Industry and Internal Trade, Ministry of Commerce and Industry, is referred to as a startup. Also, a domestic company not listed on a reputable stock exchange when making investments is referred to as a VCUs.

Elimination of Restricted activities – The list of prohibited acts that were included in Regulation 2(1)(aa) of the AIF Regulations definition of VCU was also removed by SEBI. Non-Banking Financial Companies (NBFCs) and businesses that finance gold, among other things, are not included in the scope of VCUs under the current structure. As a result, this change should increase startup investment and increase the efficiency of Category I AIFs for managers and investors.

Simultaneous Investment in other AIFs – The AIF Rules allow funds of Category I AIFs to invest in the units of other funds of the same category and funds of Category II AIFs to do the same, provided that in every case, no investment shall be made in the units of any other Fund-of-Funds (FoFs). Additionally, subject to a few predetermined requirements, SEBI now permits AIFs, including FoFs, to simultaneously invest in the units of other AIFs and directly in the securities of investee firms.

With the prior consent of at least 75 per cent of the investors by the value of their investment in that AIF, SEBI has also permitted an AIF to invest in units of other AIF managed or sponsored by the same AIF manager or sponsor.

Responsibilities of AIFs Key Management Personnel and Code of Conduct  – The extent of the duties of the AIF Key Management People, trustee, directors of the trustee company, trustee company designated partners, or directors of the AIF have been specified by SEBI in the modified regulations. The Fourth Schedule of the AIF Regulations contains a separate Code of Conduct that has been established.

The Code of Conduct outlines the operation of AIFs. It includes codes of conduct for members of the investment committee, trustees, trustee company, directors of the trustee company, and directors or designated partners of the Alternative Investment Fund.

Conclusion

The efforts made by financial authorities to give AIF managers flexibility in managing their funds effectively while ensuring that their fiduciary duties to investors are not jeopardised are reflected in SEBI’s modification. Those changes should help AIF managers comply with the relevant rules without compromising investor protection, which is what SEBI ultimately seeks to achieve. These initiatives should also significantly contribute to expanding startups in India by increasing the financing sources accessible to these businesses and encouraging the creation of new Category I AIFs.

Also Read:
All about Angle Funds
What is Venture Capital Funding in India?
How to Raise Angel Funding in a Start-up?