New ‘license raj’ regime proposed for VCs - What entrepreneurs need to know from a funding perspective
This post analyzes the impact of the draft guidelines for alternative investment funds on funding options available to startups. If the Alternative Investment Funds Guidelines are passed, will it help startups in any way? Will VCs find it easier to invest? Will VCs retain complete autonomy over their investment strategy?
SEBI’s effort to regulate investment structures in a catch-all manner may spell trouble for many so-called VC and angel funds inIndia. It may prevent seed funds and smaller precision venture capitalists from pooling capital, if the proposals in the discussion paper go through in the current form. In regulating alternative investment structures, SEBI may have gone beyond its original mandate to protect 'investor interest'. Its draft guidelines may be retrogressive, as compared to the recentUSlegislation (passed on November 3) that permits crowd-funding of startup companies.
Some of the key issues that arise from SEBI's move, from the perspective of VCs and startups are:
1. High registration fees
SEBI has imposed high registration fees of Rs. 6 lakhs on all alternate investment funds. Investing in startups is amongst the riskiest forms of investment, with no predictable indicator to anticipate success. Investors do elaborate planning and adopt strategies that minimize the impact of government charges and taxation. Some of it may be necessary to render investment in sunrise sectors and startup industries economically viable. SEBI's exorbitant registration fees will add to the costs these funds face, and may come in the way of setting up smaller seed-funds.
2. Suffocating VC’s investment strategy?
SEBI has sought to comprehensively restrict the ‘business model’ of the funds, which can prevent fund infusion into high-risk industries and micro and small enterprises and startups.This has been done through the following measures:
a) Minimum and maximum limits on fund size
SEBI has imposed a maximum fund size of 250 crores for venture capital funds. This makes it more difficult for VC funds to invest in new and risky technologies, which have no ‘predictable’ or ‘charted’ path to success. These technologies can often lead to groundbreaking innovations, and these are the technologies which need VC investment most.
This can be understood better in light of the business model of VC funds. Statistically, a majority of VC investments fail, but the amount of returns on the investments that succeed far outweigh the amount lost out of failed investments, which enables VC funds to make significant profits. In order to make profits by investing in riskier and technology intensive developments, VC funds shall:
i. Need to invest more funds per venture;
ii. Require a huge capital base to ‘pool’ their funds over more ventures, so that success in some ‘risky’ ventures can outweigh the failure in others.
The cap of 250 crores might prevent funds from investing in some potentially useful technologies. It does not provide them the vast capital base that they need to pool their investments in the riskier ventures.
Note that the issue is not whether the cap should have been higher, but that determination of a cap is a subjective issue, and that the cap should be determined on the basis of the business model and the investment strategy of the fund. Can we imagine a limit being imposed on the maximum capital of a company? Isn’t the optimum amount of capital determined by economic indicators and the business model? SEBI’s limit on the maximum size of alternative investment funds is very similar to this.
In addition, SEBI has introduced a minimum size of any alternate investment fund to be Rs. 20 cr. Hence, smaller players cannot source money from high networth individuals or financial institutions. If we apply SEBI’s rationale of containing systemic risk and fraud to the minimum limits it has imposed, we see peculiar results - why would the small size of a financial entity add to the element of risk it poses to a financial system?
b) Requirement of high minimum contribution by fund sponsors
SEBI has required fund managers to themselves invest 5% of the total fund amount. For large funds, this can be a significant amount. For example, a fund with a size of Rs. 200 crore will require the sponsor to put in at least Rs. 10 crores of his own money! It seems that SEBI has given preference to richer managers, and not to the brightest or smartest managers.
This may be justified by SEBI on two grounds:
i. When people invest their own money into a venture, they are likely to be more careful with it, and it can avoid reckless and excessively risky decision making.
ii. The tendency to make short term gains with disregard to long-term gains is lower, when the fund manager’s own money is involved.
c) SMEs and Micro-Enterprises may be excluded from funding
SEBI has imposed a minimum investment limit of Rs. 1 crore, or 0.1% of the fund size, whichever is higher. Thus, a fund with a size of Rs. 2000 crore needs to have a minimum investment of Rs. 2 crore. This may prevent seed funding, and funding of micro and small entreprises in their initial phases. This will also completely block startups from accessing some of the most reputed and larger funds.
The reason that SEBI has sought to regulate various kinds of investment vehicles now is because if they are unregulated, they may pose risk to the financial system of the country in general, that is, the risk out of failure of the institution can affect other parties in the financial system. In that regard, some guidance should be taken on how the Reserve Bank ofIndiahas regulated important financial sector entities. RBI uses minimum net-worth requirements to determine whether a large entity in the financial sector, or a large holding company must be regulated. Similarly, SEBI could have used net-worth requirements as a criterion to impose more regulation on larger funds, instead of imposing limits on investment and fund-size.
3. Why govern seed stage and angel investors?
SEBI has the power to pass regulations to protect investor’s interest, and hence its regulation of investments by VC funds may be justifiable. However, seed stage and angel investors stand on a different footing from other funds. They may operate with a smaller pool of capital as compared to a traditional VC fund, but they are very sophisticated, and invest in industries that the investors themselves closely follow and understand, as opposed to investors in VC and PE funds, who may rely completely on the expertise and judgment of the fund managers for investing their funds. While regulation of VC and PE Funds to protect investor interest may be justified, regulation of seed stage and angel funds for the same reason is not needed. It is simply a restriction on their scope of operation and limits their freedom to do business, with no purported benefit to any party.
What startups need to know?
The Alternative Investment Fund Guidelines are still in draft format and will be finalized based on public comments received by SEBI. If they are passed in their current state, then startups need to know the following:
1. Startups would have to conduct some sort of preliminary diligence on the fund to understand the risk-taking appetite and the minimum amount the fund needs to invest, as the law has imposed severe restrictions on the autonomy and investment strategy. A startup seeking lower than the minimum amount investable by a particular fund need not approach that fund. Private funds would now be governed by external regulatory factors as well, apart from their internal investment strategies. This would reduce the funding options available to startups, and imposes additional costs (of a preliminary due diligence) for them. The cost of preliminary diligence would get reduced if SEBI maintains a list of investment funds and their fund size which is publicly accessible.
2. The Alternative Investment Fund Guidelines are intended to apply to angel and seed 'funds', that is, investors who manage other people's money (pool of capital), and not to investors who invest their own money. Startups seeking initial stage funding could identify such investors and approach them.
iPleaders was born out of an idea, and a realization. The realization came while attempting to help a few entrepreneur friends with legal work - there is no proper, insightful and affordable legal service offered to startup companies on the growth track. Law firms largely focus on international and blue-chip clients, and litigators who go to Court do not have a strong grasp of business law. Therefore, startups are unable to hire quality business lawyers. The idea was to find solutions through technology and products (law is so far only a service industry inIndia). iPleaders has worked on developing resources to make law accessible - through blogging, educational products and interactive softwares. At present, it offers super-cheap incorporation, trademark registration and a diploma course (jointly offered with a top law school in the country, NUJS) that teaches entrepreneurs how they can handle legal issues affecting their business by themselves. iPleaders is launching do-it-yourself kits for startup entrepreneurs at E-Sparks 2011, inBangalore, which will simplify various legal processes for them - such as incorporation (LLP / Company), trademark registration, etc.
Want to make your startup journey smooth? YS Education brings a comprehensive Funding Course, where you also get a chance to pitch your business plan to top investors. Click here to know more.