Key parameters of fundraising by startups in India

June 2016 | SPOTLIGHT | FINANCE & INVESTMENT

Financier Worldwide Magazine

Fundraising is critical to provide a boost to any startup. Most startups cannot rely on traditional methods of financing due to their limited liability and risk aversion approach. Startups require long-term and high-risk capital at all stages of their evolution and such risk capital can be made available by alternative investment funds (AIFs). They help incubate innovative ideas and invest in a broad array of sectors ranging from e-commerce, hospitals, tech ventures, education ventures, and industrial and infrastructure projects.

In view of stimulating the startup ecosystem in India, the government has proposed to set up a fund in the nature of a ‘fund of funds’ with an initial corpus of INR 2500 crore and a total corpus of INR 10,000 crore over a period four years (i.e., Rs 2500 crore per year). Further, the government has, from time to time, brought about various regulatory and tax reforms to promote the raising of risk capital in a prudent manner.

AIF regulations

The Securities and Exchange Board of India (SEBI), through a notification dated 21 May 2012, issued the SEBI (Alternative Investment Funds) Regulations, 2012 (AIF Regulations) toward regulating investments by pooling vehicles. The AIF Regulations classified AIFs into three categories based on the investment objectives of the AIF: (i) category I AIFs, which includes investment in sectors that are perceived to have positive spill-over effects on the economy and includes venture capital funds, social venture funds, infrastructure funds, small medium enterprise funds and angel funds; (ii) category II AIFs, which includes funds that are not classified as category I AIF or category III AIF and include private equity funds and debt funds; and (iii) category III AIFs, which include funds such as hedge funds that employ complex diverse strategies and leveraging.

The AIF Regulations permit AIFs to be structured as a trust, LLP or company. In view of ensuring their ‘skin in the game’, AIF Regulations provide for mandatory sponsor/manager commitment of 2.5 percent of the corpus or INR 5 crores (whichever is lower) for category I AIF and category II AIF and 5 percent of the corpus or INR 10 crore (whichever is lower) for category III AIF. Further, the minimum ticket size for investment is INR 1 crore with a maximum of 1000 investors in a scheme. AIF Regulations prescribe investment conditions and restrictions for each of the categories of AIFs. A detailed procedure for registration of AIFs or schemes launched under the AIFs has been prescribed. The AIF Regulations further stipulate comprehensive reporting requirements, depending upon the category of AIF.

FDI investments

In order to attract offshore funds and allow managers to tap into the offshore fund market, the government has allowed 100 percent foreign investments under the automatic route in AIFs subject to certain conditions. Thus, non-residents, foreign portfolio investors (FPIs) and non-resident Indians can invest directly in AIFs without floating complex structures. However, FPIs cannot hold more than a 25 percent stake in category III AIFs.

ODI investment

In order to widen the ambit of investments by AIFs, the government has permitted AIFs to invest in offshore venture capital undertakings, subject to an overall cap of $500m with prior SEBI approval. The investments shall only be made in companies which have an Indian connection, subject to an overall cap of 25 percent of the investible funds of the scheme of AIF.

Trust taxation

The extant tax regime under the Income Tax Act, 1961 imposes various ambiguities in relation to taxation of trusts, indirect transfer of Indian assets, applicability of general anti-avoidance rules, making the Indian marketplace less conducive for the AIF industry. Pursuant to the Finance Act, 2015 and subject to certain conditions, the government has granted a tax pass-through status to category I AIFs and category II AIFs, which is a major boost for the AIF industry.

Further, the Central Board of Direct Taxes released a notification dated 15 March 2016 which introduced the much liberalised ‘safe harbour rules’ to mitigate the exposure of offshore funds to the intricate income tax regime in India. Among other relaxations, the new rules prescribe a ‘look-through status’ in determining the number of investors and participation interest in the fund to qualify for availing safe harbour benefits. The primary objective of streamlining the safe harbour laws is to curtail the flipping of base structures by offshore funds to tax efficient jurisdictions.

Even though a lot of work has been done to liberalise the AIF industry, some finer aspects still need to be ironed out to further boost investor sentiment. The Alternative Investment Policy Advisory Committee, constituted by SEBI and led by Narayan Murthy, has also made several recommendations to promote AIFs, such as unlocking a diverse domestic capital pool which includes pension funds, insurance companies, banks and charitable endowments funds, among others. Furthermore, the report also proposed a robust tax regime to promote onshore fund management.

Thus, it is imperative for the government to fast-track the reforms to promote AIFs as they can significantly increase the steady source of long-term risk capital – a prerequisite for the startup industry. A flourishing AIF industry will bring more vibrancy in to the startup ecosystem and in turn will positively impact government startups and the ‘Make in India’ initiative.

Rajesh Begur is the managing partner of ARA LAW. He can be contacted on +91 22 6619 9800 or by email: rajesh.begur@aralaw.com.

Rajesh Begur

ARA LAW