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Legal Aspects of Venture Capital Funding

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Venture capital is a type of financing or private equity that investors provide to start-up companies and small businesses that are believed to have long-term growth potential. Venture capital is usually provided by well-known investors and wealthy individuals. To promote innovations, enterprise, and conversion of scientific technology and knowledge-based ideas into commercial production, it is very important to promote venture capital activity in India.

India is fast catching up with the West in the field of venture capital and several venture capital funds have a presence in the country (IVCA). In 2006, the total amount of private equity and venture capital in India reached $7.5 billion across 299 deals. In the Indian context, venture capital consists of investing in equity, quasi-equity, or conditional loans to promote unlisted, high-risk, or high-tech firms driven by technically or professionally qualified entrepreneurs. It is also used to refer to investors “providing seed”, “start-up and first-stage financing”, or financing companies that have demonstrated extraordinary business potential. Venture capital refers to capital investment; equity and debt; both of which carry indubitable risk. The risk anticipated is very high. The venture capital industry follows the concept of “high risk, high return”, innovative entrepreneurship, knowledge-based ideas, and human capital intensive enterprises have taken the front seat as venture capitalists invest in risky finance to encourage innovation.

Meaning 

Venture capital (VC) is a form of private equity financing that is provided by venture capital firms or funds to start-ups, early-stage, and emerging companies that have been deemed to have high growth potential or which have demonstrated high growth (in terms of several employees, annual revenue, the scale of operations, etc). Venture capital firms or funds invest in these early-stage companies in exchange for equity, or an ownership stake. Venture capitalists take on the risk of financing risky start-ups in the hopes that some of the firms they support will become successful. Because start-ups face high uncertainty, VC investments have high rates of failure. The start-ups are usually based on an innovative technology or business model and they are usually from the high technology industries, such as information technology (IT), clean technology, or biotechnology.

Multiplicity of Regulations

At present, the Venture Capital activity in India comes under the purview of different sets of regulations namely:

  • The SEBI (Venture Capital Funds) Regulation, 1996[Regulations] lays down the overall regulatory framework for the registration and operations of venture capital funds in India.
  • Overseas venture capital investments are subject to the Government of India Guidelines for Overseas Venture Capital Investment in India dated September 20, 1995.
  • For tax exemptions purposes venture capital funds also need to comply with the Income Tax Rules made under Section 10(23FA) of the Income Tax Act. 

In addition to the above, offshore funds also require FIPB/RBI approval for investment in domestic funds as well as in Venture Capital Undertakings (VCU). Domestic funds with offshore contributions also require RBI approval for the pricing of securities to be purchased in VCU likewise, at the time of disinvestment, RBI approval is required for the pricing of the securities.

The Income Tax act provides tax exemptions to the VCFs under section 10 (23FA) subject to compliance with income tax rules. The Income Tax inter alia provides that to avail their exemption under section 10(23FA), VCFs need to make an application to the director of income tax (exemptions) for approval. One of the conditions for approval is that the fund should be registered with SEBI. Rule 2D also lays down conditions for investments and section 10(23FA) lays down sectors in which VCF can invest to avail tax exemptions. Once a VCF is registered with SEBI, there should be no separate requirement of approval under the Income Tax Act for availing of tax exemptions. This is already in practice in the case of mutual funds.

Important Regulations Laid Down By SEBI For Venture Capital Funds

  1. VCF is a fund established in the form of a trust/a company including a body corporate and registered with SEBI. It has a dedicated pool of capital, raised in a specified manner, and invested in VCUs following the regulations. VCU is a domestic company whose shares are not listed on a stock exchange and is engaged in the specified business.
  2. The minimum investment in a VCF from an investor would not be less than Rs. 5 lakh and the minimum corpus of the fund before it could start activities should be at least Rs. 5 crores.
  3. The norms of investment were modified. A VCF seeking to avail benefit under the relevant provisions of the Income Tax Act will be required to divest from the investment within one year from the listing of the VCU.
  4. The VCF will be eligible to participate in the IPO through the book building route as a Qualified Institutional Buyer.
  5. The mandatory exit requirement by VCF from the investment within one year of the listing of the shares of VCUs to seek tax pass-through was removed under the SEBI (VCF) Regulation to provide for flexibility in exit to VCFs.
  6. The VCFs were directed to provide information about their venture capital activity for every quarter starting from the quarter ending December 31, 2000.
  7. An automatic exemption was granted from the applicability of open offer requirements in case of transfer of shares from VCFs in Foreign Venture Capital Investors (FVCIs) to promoters of a VCU. 

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