VENTURE CAPITAL REGULATION IN INDIA

A Paper Submitted to Mr. M Carling as part of Credit Course on Comparative Venture Capital

Thinlay Chukki

VENTURE CAPITAL REGULATION IN INDIA

Venture Capital market in India is of recent phenomenon in comparison with the US Venture Capital market. The government backed venture capital firms 1 were established in the 1980s which marked the beginning of the venture capital market in India. Since then the market has seen upward development with increase in number of venture capital firms and increase in investment. 2 It has also attracted foreign investment in large scale with Over 44 US-based VC firms sought to invest heavily in start-ups and early-stage companies in India with an average of US $100 million each.3 The legal framework in India regulating the Venture Capital is considered, interestingly, not conducive to the growth of venture capital market.4 In India the venture capital market is regulated by the Securities Exchange Board of India (Venture Capital) Regulations, 1996 for domestic venture capital company and by the Securities Exchange Board of India (Foreign Venture Capital Investor) Regulations, 2000 for foreign investors. This researcher shall analyze the regulation regulating the domestic venture capital market. With the establishment of various government-backed venture capital firms5 in 1980s the then Controller of Capital Issues issued guidelines stipulating the framework for establishment and operation of funds/companies in 1988.6 As India embraced liberalization, privatization and globalization in 1990s, it witnessed drastic changes in the governance patterns and higher activities in the venture capital market. Securities Exchange Board of India (hereinafter referred to SEBI) was established to regulate the securities market in India in 1992 through the SEBI Act, 1992. It has framed various regulations to regulate the market and the
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For example Risk Capital and Technology Finance Corporation (RCTFC) and Industrial Development Bank of India's (IDBI) venture capital fund. 2 Mike Wright, Andy Lockett, Sarika Pruthi , Internationalization of Western Venture Capitalists into Emerging Markets: Risk Assessment and Information in India, Small Business Economics, Vol. 19, No. 1 (Aug., 2002), pp. 13-29, retrieved from http://www.jstor.org/stable/40229217 on 18/4/2012 3 Dr. Alok Aggarwal, Is the Venture Capital Market in India Getting Overheated?, retrieved from http://www.venturewoods.org/wp-content/EvalueserveIndianVCMarketAugust06.pdf on 18/4/2012 4 Supra note 2 5 Supra note 1 6 Sudip Bhattacharyya, Venture Capital Financing, Economic and Political Weekly, Vol. 24, No. 47 (Nov. 25, 1989), pp. M157-M159. Retrieved from http://www.jstor.org/stable/4395620 on 19/4/2012

SEBI (Venture Capital) Regulations, 1996 (hereinafter referred to as The Regulation) was framed to regulate the domestic venture capital market in India. The Act has undergone amendments in 2000, 2004, 2006, and April 2010, in addition to the numerous administrative circulars of SEBI. Two advisory committees were also appointed in 2000 and 2003 to identify critical areas of regulatory support. The Regulation defines a venture capital fund (herein after referred to as VCF) whereby it can only be formed as a: Trust, registered under Indian Trusts Act, 1882 or Company, registered under Companies Act, 1956 or A body corporate, set up or established under the laws of the central or state legislature7 In all forms, the main objective of the entity should be to engage in venture capital investment and the trust deed or the memorandum of articles should explicitly state this as its main objective.8 Therefore, in India the VCF cannot be formed as a Partnership Firm which is the most popular form of VCF in other jurisdiction. The VCF can invest only in Venture Capital Undertaking. Venture capital undertaking is a domestic company whose shares are not listed on a recognized stock exchange in India. It should not be involved in such activities or sectors which are specified in the negative list by the Board with the approval of the Central Government in the Third Schedule of the Regulation.9 The Negative List contains the following items: 1. Non-banking financial services excluding those Non-Banking Financial Companies which are registered with Reserve Bank of India and have been categorized as Equipment Leasing or Hire Purchase Companies. 2. Gold financing excluding those Companies which are engaged in gold financing for jewellery. 3. Activities not permitted under industrial policy of Government of India.

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Regulation 2(m) of SEBI (Venture Capital) Regulation, 1996 Regulation 4 of SEBI (Venture Capital) Regulation, 1996 9 Regulation 2(n) of SEBI (Venture Capital) Regulation, 1996

4. Any other activity which may be specified by the Board in consultation with Government of India from time to time.10 Therefore, a VCF cannot invest in any Venture Capital undertaking involved in the above mentioned activities or companies. Prior to the Venture Capital Amendment Regulation 2000 even Real Estates were put under the Negative List. This Negative List restricts the options of the VCFs. Any VCF to start its operation has to get registered with the SEBI by filing the Form A along with the registration fees mentioned in the Schedule. Separate eligibility conditions have been specified for each form of VCF whether company, trust or body corporate. Once the VCF is registered it can invite contribution to the pool either through private placement or through an agreement with investors for contribution or subscription. The minimum pool size for each investor is fixed at INR 5 lakh.11 This qualification is not applicable to employees and the principal employees or the principal officer or directors of the venture capital fund, or directors of the Trustee Company or trustees where the venture capital fund has been established as a trust and the employees of the fund manager or Asset Management Company. For the purpose generating the pool of fund for investment, a placement memorandum or contribution or subscription agreement with the investors needs to be issued, a copy of which should be filed with SEBI. The document shall contain information like, the details of the trustees, fund managers, fund size, duration of the fund, and manner of subscription, investment strategies, and tax implications to the investors. The regulation specifically states the maximum limit for the VCF while making investment decisions. It shall not invest in the associated companies. It can invest only upto 25% in any one VCU. At least 66.67% of the investible funds shall be invested in unlisted equity shares or equity linked instruments of venture capital undertaking. It also makes restriction on investment in certain kinds of companies. Therefore there is lack of flexibility to the VCF in making its investment decisions. Though it is accepted that the venture capital market is of recent phenomenon compared to other jurisdictions, it is necessary that the VCFs should be given sufficient flexibility in making
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Third Schedule, SEBI (Venture Capital) Regulation, 1996 Regulation 11(c) of SEBI (Venture Capital) Regulation, 1996

the investment decisions. The protection to the investors is necessary but it should not curb the freedom of the investors to take higher risk and earn higher profit in the name of protection.

Bibliography: 1. Dr. Alok Aggarwal, Is the Venture Capital Market in India Getting Overheated? 2. Mike Wright, Andy Lockett, Sarika Pruthi , Internationalization of Western Venture Capitalists into Emerging Markets: Risk Assessment and Information in India, Small Business Economics, Vol. 19, No. 1 (Aug., 2002 3. SEBI (Venture Capital) Regulation, 1996 4. Sudip Bhattacharyya, Venture Capital Financing, Economic and Political Weekly, Vol. 24, No. 47 (Nov. 25, 1989)