Industry wants seed culture, SEBI prefers venture capitalism
In recent years, the creation of a viable ecosystem for startups has been a key agenda of the government and the regulators alike. The notable initiatives in this regard include the framing of an umbrella regulation for alternative investment funds – the SEBI (Alternative Investment Funds) Regulations, 2012 (SEBI AIF Regulations) – aimed at providing tailor made concessions to different categories of investment funds, the grant of tax pass through status to venture capital funds (VCFs) and the recognition of contributions made by companies to certain technology incubators as corporate social responsibility expenditure under the proposed Companies Bill, 2012.
Yet the run up to the recognition of angel investors as a special class of investors has been full of surprises for the angel investor community, perhaps the biggest being the introduction of a provision in the Income Tax Act, 1961 to tax funds received by unlisted companies from residents at a premium as income from other sources, unless such funds were raised from a VCF. The intention of the provision was to curb circulation of unaccounted for money; however, the same had an unintended adverse effect on the ability of startups to raise funds from angel investors. Subsequently, it was acknowledged by the government that angel investors bring both experience and capital to new ventures and accordingly, in the budget speech of 2013-2014, it was announced by the finance minister that SEBI would prescribe requirements for angel investor pools by which they could be recognised as VCFs.
In line with such an announcement, SEBI in its board meeting on June 25, 2013, has approved amendments to the SEBI AIF Regulations, permitting the inclusion of angel funds within the definition of VCFs. This move has been largely welcomed by the investor community as a positive step towards recognising angel investors as a distinct asset class and providing them with special concessions as are available to other categories of investors, which are registered with SEBI as alternative investment funds (AIFs). However, the salient features of such amendments contained in the press release issued by SEBI suggest that it may well fall short of industry expectations, as it appears that pooling of funds by angel investors would be a pre-requisite for availing of benefits proposed by SEBI.
In this context, it may be worthwhile to point out that angel investors are generally understood to mean high net worth individuals, who provide initial capital to startups or persons with innovative business proposals and assist them in implementing their business proposals. Apart from providing the initial risk capital, the essential characteristic of an angel investor is the mentoring and guidance provided to startups, by bringing on board industry experience, domain knowledge and industry connections to help the startup mature into a viable business venture. Further, the key difference between a pooled fund and an angel investor is that the decision to invest is taken by the angel investor alone and investments are made by the angel investor solely out of its own funds.
As per the release, angel funds proposing to seek registration with SEBI, as a sub-category under Category 1- Venture Capital Funds, would be required to have a corpus of at least Rs10 crore (as against Rs 20 crore for other AIFs) and minimum investment by an investor shall be Rs 25 lakh, which may be accepted over a period of maximum three years. Since SEBI envisages a pooling of funds, like other AIFs, SEBI expects such angel fund to have a sponsor/ manager, which will have a continuing interest in the angel fund of not less than 2.5% of the corpus or Rs 50 lakh, whichever is lesser.
The release further mentions minimum qualifications and net worth requirements for individual angel investors and corporate angel investors. Individual angel investors would be required to have net tangible assets of at least Rs 2 crore, whereas corporate angel investors would be required to have a minimum net worth of Rs 10 crore or be a registered as an AIF/VCF. Further, individual angel investors would be required to have early stage investment experience, experience as a serial entrepreneur or be a senior management professional with 10 years’ experience.
Accordingly, it appears that SEBI’s intention is to limit the participation by individual angel investors and corporate angel investors in angel funds registered with SEBI, with their attendant benefits, to only those investors that fulfil the aforesaid eligibility requirements. Angel investors that do not qualify for participation in such funds may invest in startups directly without the tax and other benefits. While the intent behind drawing such distinction between different sets of angel investors seems clear, the rationale behind imposing such net worth and qualification requirements, thereby limiting access to capital, may be clarified given the (relatively smaller) minimum investment for angel investors and experienced fund managers to oversee investments by the angel fund.
Similarly, the proposed amendments place several restrictions on the nature of the investee companies in which angel funds may invest. For example, angel funds can only invest in companies, which are incorporated in India and are not more than three years old, have a turnover not exceeding Rs 25 crore and are unlisted. It is appreciated that SEBI is seeking to provide adequate safeguards to ensure that only those enterprises, which inspire growth potential but do not have easy access to capital should be permitted to raise capital from angel funds. However, certain other investment conditions and restrictions applicable to angel funds, as per the release, appear to curb the investment freedom an angel investor would reasonably expect.
To illustrate, angel funds cannot invest in companies in which they have a family connection. This requirement is somewhat flawed inasmuch as being the initial round of funding, the chief source of funding for a startup generally comprises family and friends. Furthermore, in the context of pooled funds, it may be noted that the SEBI AIF Regulations provide for restrictions on investments by AIFs in associate companies to avoid any conflict of interest vis-à-vis the investors in a particular AIF. That said, such restriction is subject to waiver by 75% of investors by value of their investment in such AIF. Hence, it is not quite clear why angel funds should be made subject to a more stringent requirement in respect of investments in related entities.
Again, the minimum investment threshold of at least Rs 50 lakh and an upper ceiling of Rs 5 crore appear to be against the investment strategy of angel investors. Angel investors typically provide initial capital to operationalise the project and not for purposes of expansion, which requirement is typically met through venture capital and private equity funding. Further, such investments are required to be held for three years, as per the proposed amendments. In this regard, it may be mentioned that often, if a startup performs well, it is in a position to access venture capital funding within one to three years of the angel investor funding and inter alia provide an exit opportunity to angel investors.
In view of the above, it is important that SEBI acknowledges that the mere ability to set up a pooling vehicle with a relatively smaller corpus and minimum investment threshold may not necessarily encourage angel investors to come forward and set up angel funds (as opposed to VCFs, for instance), particularly given the investment conditions and restrictions applicable to angel funds, including the conditions pertaining to the investment size and lock-in restrictions.
One would need to await the final text of the proposed amendments to the SEBI AIF Regulations to understand better the extent to which SEBI seeks to regulate angel investor funding. Needless to say, in the current economic situation, where the government is trying hard to push for reforms and promote a culture of entrepreneurship, it is important to appreciate the role played by angel investors in promoting such culture and to repose necessary confidence in the angel investor community, which remains the mascot of innovation, entrepreneurship and excellence for aspiring entrepreneurs.
(The authors are lawyers at Luthra & Luthra, Law Offices. Views expressed are personal.)
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