-Yash Sheth & Gayatri Bajaj
Introduction
In today’s day and age along with booming startups and entrepreneurial business ventures comes a difficulty that every entrepreneur must face. Where must they get their funding from? Venture Capital Funds (“VCF”) are an essential part of the startup ecosystem. These funds provide capital to startups, which they can use to grow and expand their businesses. In return, the venture capitalists expect a significant return on their investment when the startup either goes public or gets acquired by another company. These funds have become a popular option to scale quickly. They provide funding to early-stage companies that have high growth potential in exchange for equity in the company. In addition to financial support, venture capital funds also provide guidance and mentorship to help these companies succeed. In the past few years, India has seen a boom in Emerging Companies and Startups which in turn has resulted in a rapid increase in the number of Venture Capital Funds in the Country.
One of the key benefits of venture capital funding is that it allows startups to access larger amounts of capital than they might be able to obtain through traditional financing methods. These funds typically invest in companies that have innovative products or services, a strong management team, and a solid business plan. They also require a significant return on their investment, which means that companies must be able to generate substantial revenue and profits in a comparatively shorter period of time.
Role of Venture Capital Funds in the Start Up Ecosystem
Venture capital funds work by investing in startups in exchange for equity in the company. It is essentially a pool of money that is raised. These funds are then managed by experienced professionals. The amount of equity that the venture capital fund receives is proportional to the amount of capital that they invest. This means that the venture capital fund becomes a shareholder in the company, with the right to participate in the company's management and decision-making processes. These funds are usually structured in the form of a partnership, where the venture capital firm (and its principals) serve as the general partners and the investors as the limited partners that contribute the capital. Limited partners may include the insurance companies, pension funds, university endowment funds, and wealthy individuals, among others. [1]
These funds typically have a specific investment mandate, which outlines the types of companies and industries that they are interested in investing in. This mandate may also specify the stage of the company's development that the fund is interested in investing in, such as seed-stage or early-stage companies. A VCF works in a way where every VCF has certain ideologies and they would only invest in the businesses that look favorable, profitable and align with their ideologies. For example, if a VCF has invested in 7 startups out of which 2 are loss making businesses. The VCs will make an overall profit as the profits of the other 5 companies might outweigh the losses and the balance profit will be divided amongst all the investors.
The investment process for venture capital funds typically involves several stages, starting with the screening of potential investments and the due diligence process, where the fund evaluates the company's business model, market potential, and management team. Once the fund has decided to invest, they will negotiate the terms of the investment with the company and provide the capital needed to fund the company's growth.
The way venture capital funds work is by raising money from institutional investors, such as pension funds, university endowments, and wealthy individuals. The fund managers then use this capital to invest in a portfolio of a company that they believe have the potential to generate significant returns. The funds typically have a fixed lifespan of around 10 years, during which time they invest in different companies. The fund managers will work closely with the companies to help them grow and develop.
Venture capital funds are known for taking on a high level of risk, as many of the companies they invest in may fail. However, the potential rewards can be substantial if one or more of the portfolio companies becomes a success. As a result, venture capital funds are often seen as a key driver of innovation and economic growth.
Legal Framework
Venture Capital firms in India are regulated by SEBI (AIF) Regulations 2012 and are classified as Alternative Investment Funds. VCFs can raise funds from any investor whether Indian, foreign or non-resident Indians ("NRI") by way of issue of units, however, any investment in VCF by a person resident outside India (including a NRI) is governed by Foreign Exchange Management (Non-debt Instruments) Rules, 2019.
“Alternative Investment Fund” means any fund established or incorporated in India in the form of a trust or a company or a limited liability partnership or a body corporate which,-
(i) is a privately pooled investment vehicle which collects funds from investors, whether Indian or foreign, for investing it in accordance with a defined investment policy for the benefit of its investors;
Alternative Investment Funds will seek registration under one of the following categories:
Category I – These AIFs strictly invest in startups, social ventures, early stage ventures, SMEs, infrastructure or any other area which the government considers as socially or economically desirable and shall include VCFs.
Category II – Funds not included in Category I and III and which do not undertake leverage or borrowings other than to meet day-to-day operational requirements and as permitted in these regulations.
Category III – These provide diverse or complex trading strategies and include investments in listed and unlisted derivatives.
According to the criteria’s given hereinabove VCFs must fall under Category I Alternative Investment Funds and must register themselves abiding the Rules and Conditions prescribed in the Regulation.
Setting Up of a Venture Capital Fund
In relation to the Categories given hereinabove VCFs fall under “”Category I” Alternative Investment Fund. Thus, during registration they must follow any Regulation related to “Category I” Alternative Investment Fund. The VCF must make an application for grant of certification under its Category. Upon perusal of the application, if the Board is satisfied that the applicant fulfills all the criteria’s laid down in the Regulations applicable to their Category and Sub-Category, the certificate is granted. The certificate shall remain valid until the VCF winds up. A VCF, once registered cannot change its Category.
Only once the VCF has been granted registration, can it accept any money from its investors. A VCF must raise a minimum of Rs. 20 Crore with every investor pooling in a minimum of Rs. 1 Crore [Employees and Directors of the VCF can invest a minimum of Rs. 25 Lakhs]. A VCF can have a maximum of 1000 Investors. Manager/ Sponsor of the VCF have a continuing interest in the VCF of not less than 2.5% or Rs. 5 Crore, whichever is lower.
While raising funds or whilst launching schemes, VCFs are required to do so by issue of information memorandum or placement memorandum. The information memorandum or placement memorandum must contain all the information of the VCF including its investment strategies, schemes, targeted investors, about the manager, fees and all expenses that will be charged, tenure, risk management tools, winding up, etc.
Apart from the conditions prescribed in the Regulation under “Category I” Alternative Investment Fund, the Regulation also provides exclusive conditions that VCFs must fulfill:
§ The VCF is required to invest not less than 75% of its investible funds in unlisted equity shares or equity linked instruments of a VC undertaking or in companies listed or proposed to be listed on a SME segment of an exchange.
§ VCFs are allowed to enter into an agreement with a merchant banker to subscribe to the unsubscribed portion of the issue or to receive or deliver securities.
§ VCFs are exempted from sub-regulations (1) & (2) of regulation 3 and sub-regulation (1) of regulation 4 of the SEBI (Prohibition of Insider Trading) Regulations, 2015 in respect of the investment in companies listed on the SME exchange or SME segment of an exchange after due diligence of such companies subject to certain conditions prescribed under the Regulation.
Conclusion
The growing Indian Economy is indirectly aided by Venture Capital Funds since entrepreneurs don’t have to face cumbersome traditional financing methods. Venture capitalists have today emerged as the mainstream source of finance for the innovative entrepreneurs thereby providing the requisite solution.
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