7.0 FLEXIBILITY IN INVESTMENT AND EXIT

7.1 Allowing Flexible Structure

7.1.1 The venture capital fund is a high risk and reward activity. The investments are made by high networth individuals and institutions to reap high returns. The investor in venture capital funds does not involve himself in day-to-day management of the fund and the activities of the funds are managed by professionals. The investor therefore likes to keep their liability limited to the contribution committed by them to the fund and are not willing to take on any other liability. The venture capital funds are set up for a limited life and on maturity, the returns are distributed amongst the investors. The structure of venture capital funds should therefore protect the interest of investors and the liquidation process should be simple. Limited Partnership(LP), Limited Liability Partnership(LLP) and the Limited Liability Company(LLC) are commonly used and widely accepted structures internationally especially in USA which has an active venture capital industry. These structures limit the liability of investors to the extent of funds committed, at the same time they can be structured to become pass through vehicles for the purpose of income tax. The legal structure of LP, LLP and LLC is enclosed as Annexure to the Report.

7.1.2 For venture capital funds which deal in high risk investments structuring flexibility is very important to meet their business strategies. In India, such structures like LP, LLP and LLC are not recognised under the Indian Partnership Act and the Indian Companies Act. For development of VC industry in India on global lines and also to facilitate and attract the foreign investment in venture capital industry, such alternative structures need to be provided by bringing appropriate changes in legislation.

7.1.3 Under the SEBI Regulations a VCF can be registered in the form of a Trust, a Company or a Body Corporate(with a recent amendment dated November 17, 1999 under the Regulations). A company or a body corporate registered with SEBI may float multiple schemes for investment in different categories of companies and the fund set up as trust may also establish one or more funds under it. SEBI Regulations however, do not specifically provide for registration of a scheme floated by a body corporate or a company, as like mutual fund schemes and multiple funds set up by a venture capital fund incorporated as a trust. At present, the LP, LLP and LLC structure are also not permitted under the statutes ie. the Indian Partnership Act and the Indian Companies Act However, as and when permitted, these should be eligible to be registered under the SEBI Regulations. The SEBI regulation therefore needs to be amended to provide for registration of other entities such as LP, LLP, LLC, etc as well as the scheme floated by or the fund setup by a Trust, Body Corporate, Company and other entities.

7.1.4 Recommendations

In view of the above background the following recommendations are proposed:-

1. The necessary legislative provisions for incorporation of entities such as Limited Partnership(LP), Limited Liability Partnership(LLP), Limited Liability Company(LLC) may be made by way of enactment of separate Act or by way of amending the existing Indian Partnership Act and Indian Companies Act.
2. SEBI Regulations should be amended to include the eligibility for registration of other entities such as LP, LLP, LLC, etc. as and when permitted to be incorporated under the respective statutes.
3. SEBI Regulation should be amended to include a provision for registration of scheme floated or funds set up by a Trust, Company, Body Corporate or any other entity.
4. The Indian Companies Act be amended so as to permit issue of shares by unlisted limited companies with differential right in regard to voting and dividend. Such a flexibility already exists under the Companies Act in the case of private companies which are not subsidiary of public limited companies.

7.2 Flexibility in the matter of investment ceilings and sectoral restrictions

7.2.1 Venture capital Investments falls under high risk category of investment and typically it comes from high networth sophisticated and long term investors and institutions. The basic dictum in VC investments therefore is that "Money finds its best use" as the investors and fund managers are expected to be expert, sophisticated and fully aware of the risk / return potentials. Unlike several other type of investments, venture capitalists provide fund to build up resources and enterprises. Because of the very nature of VC investment and type of investors involved, a high degree of flexibility in terms of selection of investment, instruments and terms of investment is required. Internationally also, venture capital industry has developed in an environment which provides such investment flexibilities.

7.2.2 In the present regulatory requirements, there are sectoral restrictions as well as various types of investment ceilings. Sectoral restrictions for investment by VCFs are not consistent with the very concept of venture in promotion of innovation and technology as innovation and technology based ideas could emerge in any area of business, manufacturing or services. The function of VCFs is to provide risk capital and support idea based enterprises. All over the world, specially in countries like USA, Israel, Taiwan, Malaysia, Australia, etc venture capital funding has gone to business, service as well as manufacturing and helped the growth in all these sectors. Selectivity comes in the very nature of VC funding which comes from high networth, sophisticated individual and institutional investors who know where to put their money to its best use. It is therefore strongly believed that sectoral restrictions crate unnecessary obstacles and hamper the growth of VC activity. However, certain restrictions could be put by specifying a negative list which could include areas like real estate, finance companies, activities not legally permitted and any other sectors which could be notified with SEBI in consultation with the Government. Infact, the present SEBI regulations as well as Government of India Guidelines do not have any such restrictions and restrictions have been put under the Income Tax Act for tax exemption purposes only. However in view of the discussion in the earlier chapter and the proposed recommendation therein that as in the case of mutual funds, once registered with SEBI, VCF could be automatically entitled to tax exemption and no separate rules under the Income Tax Act would be required.

7.2.3 The investment criteria under the SEBI regulations prescribe that at least 80% of the funds raised by VCF should be invested in unlisted or financially weak sick companies. The Income Tax Rules and the Government of India Guidelines for overseas venture capital investment until recently prescribe a ceiling of 40% of paid up capital of an investee company and not beyond 20% of the corpus of the fund. These investment restrictions can seriously affect the flexibility in operation of venture capital fund. The venture funds may engineer a turnabout by increasing their stake in an investee firm and restructuring the management. During these times, the restriction of investing only upto 40% of the paid up capital of the company will be a major constraint. Similarly, if the performance of investee companies are below expectation, the VCF may choose to withhold further release of funds into the investee companies which may violate the minimum 80% investment limit under SEBI Regulation. It is therefore felt that VCFs should have flexibility of investment depending upon the business requirement in start up companies. Further, the ceiling of investment of not more than 25% of the corpus of the VCF in one single investee company would meet the requirement of diversification of risk of VCFs. Here it may be noted that globally VCFs invest in sufficient number of investments which is part of the investment strategy. However in the Indian context and since VC industry is still in the evolutionary stage, it would be desirable to keep the ceiling of 25% of the corpus for investment in single VCU. Further, VCF should not be permitted to invest in associated companies. No other investment ceilings including 80% limit for investment as provided in SEBI Regulations are appropriate in VC operations. Manner and nature of investments should be disclosed by VCFs as a part of their investment strategy statement.

7.2.4 The SEBI Regulation restricts the investment by VCF in unlisted equity or equity related instruments and listed securities of financially weak or sick companies. The Government of India Guidelines and the Income Tax Rules restrict the investment only in unlisted equity of the investee company. The venture capital fund need to enter into structured deals and the deals may also include the options for venture capital funds to buy or sell the equity of the investee company on occurrence of particular event. Sometimes, the VCFs require to invest partly in debt also. Such flexibilities of investment instruments are not available to VCF in India in view of the Government of India Guidelines and CBDT Guidelines as well as to some extent under SEBI Regulations also. Therefore, while primarily the VCFs should be investing in unlisted equity only, there should be flexibility to invest in listed equity though with a reasonable ceiling. Further, the investment in listed equity should be restricted through the initial public offer of a company whose shares are proposed to be listed or through a preferential offer in the case of a company which is already listed. Similarly, in certain situations, VCFs are required to provide debt also to the undertakings where they have already made VC investment. Thus the investment other than unlisted equity may be permitted within the overall ceiling of 30% of the investible fund and atleast 70% should be invested in unlisted equity, equity related instruments or other instruments convertible into equity. This is keeping in tune with the funding patterns of VCFs globally.

7.2.5 In USA, the investment by VCFs are done as subscription to preferred stock (similar to preference share in terms of dividend and liquidation) with preferential voting /veto rights in respect of key decisions like modification in the Memorandum and Article of Association, expansion or sale of whole or part of business, merger or acquisition, etc. The preferred stock is convertible into equity shares at the option of venture capital investors. In order to facilitate investment by VCF in new enterprises, the Companies Act may be amended so as to permit issue of shares by unlisted public companies with a differential right in regard to voting and dividend. Such a flexibility already exists under the Indian Companies Act in the case of private companies which are not subsidiaries of public limited companies.

7.2.6 The venture capitalists invest into long term high risk portfolios to create wealth. FIIs invest money with a shorter outlook and time frame which may add to speculation and volatility in the capital market. On the other hand, investment by venture capitalists are long term investments and contribute to the building of enterprises and promotion of industrial and business activity. The venture capital investors therefore in no way should be put to more restrictions as compared to FIIs. On the contrary, such investment should be encouraged and facilitated through regulatory support. The FVCI needs to obtain approval for pricing from RBI at the time of investment as well as disinvestment. However, when FIIs invest in unlisted equity stocks, they are not required to obtain such approvals. In addition to this, the formula applied for arriving at the prices of unlisted securities based on book value and PE multiples of BSE National Index are extremely restrictive and not in tune with the valuations relevant to the new generation enterprises which typically obtain VC funding like in infotech, bio-tech, service industries, etc. Such enterprises especially start up enterprises do not have tangible assets but the stock of the same may obtain high valuations due to their intangible assets like human resources, growth prospects, etc. Therefore, once foreign venture capital investor either coming through 100% funding in a domestic VCF or otherwise registered with SEBI should not be subjected to such requirements.

7.2.7 Recommendations:

In the above background, the following recommendations are proposed:

• Investments by VCFs in VCUs should not be subject to any sectoral restrictions except those to be specified as a negative list by SEBI in consultation with the Government which may include areas like real estate, finance companies and activities prohibited by Law.
• There is no need for any ceiling of investment in equity of a company. It is understood that the investment ceiling of 40% of paid up capital of VCU under the Income tax Act has already been removed. As a prudential norm, the investment in one VCU should not exceed 25% of the corpus of VCF..
• The investment criteria needs to be amended to provide for investment criteria whereby VCF invest primarily in unlisted equity and partly in listed equity, structured instruments or debts also. The investment in listed equity shall be through IPO or preferential offer and not through the secondary market route. The VCF shall invest atleast 70% of the investible funds in unlisted equity of VCU and 30%of investible funds may be used for investment through IPO, preferential offer, debt, etc. The investible funds would be net of expenditure incurred for administration and management of the funds. The present requirement of investment of atleast 80% of the funds raised by the VCF under the SEBI Regulations needs to be replaced by the criteria as under:

1. The VCF will disclose the investment strategy at the time of application for registration.
2. The VCF shall not invest more than 25% of the corpus in one VCU and shall not invest in an associated concern.
3. The VCF will make investment in the venture capital undertakings as enumerated below :

1.    atleast 70% of the investible funds shall be invested in unlisted equity shares or equity related instruments or other instruments convertible into equity;

2.    not more than 30% of the investible funds may be invested by way of -

• subscription to the initial public offer of a VCU whose shares are proposed to be listed subject to lock in period of one year;
• preferential allotment of equity of a listed VCU subject to lock in period of one year;
• debt / debt instrument to a venture capital undertaking in which VCF has already made investments by way of equity.

4. The existing provisions under the SEBI regulations for investment in listed securities of financially weak or sick companies may be dispensed with as such investments would get covered under the 30% limit.
5. The existing provisions under SEBI regulations permitting financial assistance in any other manner, to companies in whose equity shares venture capital fund has invested, needs to be dispensed with as this also gets covered in 30% limit.

4. The registered FVCI should be permitted to invest and exit in a hassle free automatic route as permitted to FIIs without requirement of approval of pricing by RBI.
5. The provisions under Section 370 & 372 under the Companies Act relating to Inter-corporate Investment and Inter-corporate Loan should be relaxed in the case of venture capital funds incorporated as Companies.
6. In order to facilitate investment by VCF in new enterprises, the Companies Act may be amended so as to permit issue of shares by unlisted public companies with a differential right in regard to voting and dividend. Such a flexibility already exists under the Indian Companies Act in the case of private companies which are not subsidiaries of public limited companies.

7.3 Flexibility in Exit

7.3.1 Venture capital funds are set up to make investment in venture capital undertakings for a defined timeframe say 8-12 years. As and when investment matures, the investors are paid back the returns and on expiry of the timeframe, the funds are liquidated. The structure of VCF therefore should be such that its liquidation is simpler. In India, a VCF can be incorporated as a trust, a company or a body corporate. The liquidation of trust is comparatively easier as compared to that of a company or a body corporate. The guidelines for buyback of shares by the company are not adequate to facilitate the liquidation process and distribution of capital among the shareholders. Because of cumbersome liquidation procedure to be followed in the case of a company, most of the funds in India had been set up as a trust. Structures such as LP, LLP and LLC (which have been discussed in the Report earlier) are popular amongst international venture capitalists because of their easy liquidation procedure. This is one of the main reasons the Committee has recommended necessary amendments in the statutes to permit incorporation of LP, LLP and LLC in India.

7.3.2 In the case of a VCF constituted as a company, the existing guidelines for buyback of shares should be relaxed to permit them to buyback the shares out of the sale proceeds of investments and assets instead of reserves, share premiums and fresh issue proceeds. The buyback relaxation should also be extended to a VCU which proposes to buyback the equity from the VCF. This would provide an exit opportunity to the VCF. The existing conditions for buyback of equity shares by an unlisted company prohibit the company from making a fresh issue of capital for a period of 24 months. This has been a major constraining factor for growth oriented companies, to buyback their shares, even if they have a cash surplus. The prohibition period for fresh issue of capital may be reduced to a period of six months as VCUs are typically growing companies and they may need financing and should not be debarred from making fresh issue of capital for a longer period of time. The existing guidelines also do not permit the negotiated deal even in unlisted equity. The provision may be suitably relaxed in the case of transaction where VCF is one of the parties.

7.3.3 A VCF gets an opportunity to exit from the investment when VCU shares are listed on a recognised stock exchange. The present IPO guidelines of SEBI requires a three years track record of profit for a company to float a public issue. However, some of the companies operating in emerging areas such as internet and e-commerce may not be in a position to generate profits yet they have adequate market share in business to justify a significant market capitalisation. Also these type of companies are at present seeking listing outside country. This deprives domestic venture capital funds of an exit on listing of stock of VCU. The IPO norms and listing requirements need to be reviewed in the cases of companies funded by VCFs to facilitate early exit for them. The present benefit of project apprised and funded by Bank/Financial Institution should also be extended to project financed by the registered venture capital funds. The revised IPO criteria would be either companies having three years track record of profitability or the project is funded to the extent of 10% by Banks, Financial Institutions or registered venture capital fund. The participation of the venture capital fund to the extent of 10% of the project cost however should be locked in for a period of one year. Those companies which are funded by Venture capitalists and their securities are listed on the stock exchanges outside the country, these companies should be permitted to list their shares on the Indian stock exchanges.

7.3.4 The VCF enter into an agreement with the VCU at the time of commitment for participation in the venture which inter alia includes an option to the VCF to buy or sell the securities from / to the promoters. The legality of such an agreement is not clear in the light of Circular issued by Government of India 1969 under Section 16 of SC(R)A when the share of the VCU are listed on the stock exchange. Further, in the event of shares being listed on the stock exchange, the exercising of the right by VCF may trigger off SEBI Takeover Code. The necessary exemptions may be granted to VCF to enable them to exercise their contractual rights within the framework of law.

7.3.5 The trading in unlisted securities are not held in an organised manner in India. The transaction in unlisted securities are primarily bi-lateral contracts among the buyer and seller. SEBI has permitted OTCEI to develop a platform where it will facilitate trading in unlisted equities between qualified investors. This would help in arriving at the prices of unlisted securities as per the market forces. The VCF and FVCI registered with SEBI should be considered eligible for qualified investor and at the same time the joint promoters of the ventures should also be eligible to be qualified investors.

7.3.6 If FVCI disinvest and transfer its holding in VCU in favour of any other person, it is required by RBI to obtain a NOC from the joint venture partner and other shareholders. The process of obtaining NOC is time consuming and cause uncertainty about the transaction for a FVCI as joint venture partners may create obstacle in the exit route for VCFs. The requirement for obtaining NOC should be dispensed with.

7.3.7 RECOMMENDATIONS

In view of the above background, the following recommendations are proposed:

1. Relaxing buyback requirements : The provisions under the Companies Act for buyback of securities needs to be amended as under :

• 24 months prohibition period for fresh issue of capital to be reduced to 6 months in the case of unlisted companies where the buyback of shares is from the VC investors ;
• negotiated deals be permitted in unlisted companies where one of the party to the deal is venture capital investor;
• permit VCC / VCU to redeem their equity shares / preference shares to an extent of 100% of their paid up capital out of sale proceeds of investment and assets and not necessarily out of free reserves, securities premium account or the proceed of fresh issue should apply to them.

2. Relaxing Takeover Code : The venture capital fund while exercising its call or put option as per the terms of agreement should be exempt from applicability of takeover code and 1969 circular under section 16 of SC(R)A issued by the Government of India.
3. Relaxing the IPO norms :The existing requirement under the SEBI (Initial Public Offer) Guidelines for three years track record of profit should be relaxed in the case of companies funded by VCFs. Further, the companies whose shares are already listed on stock exchanges outside India, the listing rules should be relaxed to permit the listing of shares of these companies on Indian Stock exchanges. Those companies which are funded by Venture capitalists and their securities are listed on the stock exchanges outside the country, these companies should be permitted to list their shares on the Indian stock exchanges.
4. QIB market for unlisted securities : The market for trading in unlisted securities should be promoted. The VCF / joint promoters should be eligible as qualified investor to participate in the unlisted equity segment of OTCEI or any other stock exchange permitted by SEBI.
5. NOC requirement : In the case of transfer of securities by FVCIs to any another person, the RBI requirement of obtaining NOC from joint venture partner or other shareholders should be dispensed with.
6. RBI pricing norms : The FVCI should be permitted to invest and exit from any investment as like FIIs without any requirement of prior approval of the pricing of securities by RBI.