In order to give flexibility to venture capital funds (“VCFs”), the Securities and Exchange Board of India (“SEBI”) amended the definition of venture capital undertaking (“VCU”) via a notification dated May 5, 2021.[1] Thereafter, via a circular issued on May 21, 2021, SEBI doubled the overseas investment limit for VCFs registered as AIF – Category 1 investment funds, from USD 750 million to USD 1500 million.[2] With the recent notifications and circulars, the regulators seem to open doors and ease funding of early stage ventures by VCFs and angel funds.

VCFs and angel funds are alternate investment funds (“AIFs”) regulated under the SEBI (Alternative Investment Funds) Regulations, 2012 (“AIF Regulations”). AIF Regulations were notified to regulate funds privately pooled by the investors (both Indian and foreign) and used for making further investments. Prior to AIF Regulations, VCFs were regulated under the Securities and Exchange Board of India (Venture Capital Funds) Regulations, 1996.

AIFs AND ITS CATEGORIES

AIFs may be a trust or a company or a limited liability partnership or any other corporate body (except certain investment pooling entities exempt from the purview of AIF Regulations like mutual funds, collective investment schemes, family trusts, employee welfare trusts etc.).[3] These exempt category of entities is regulated by one or more other regulations/ laws, as applicable.

AIF Regulations categorize AIFs into 3 (three) categories basis the anticipated impact of their investment activities at a macro-economic level.

Types of AIF AIF – Category I AIF – Category II AIF – Category III
Where to invest[4] – start-up
– early stage ventures
– social ventures
– small and medium enterprises (“SMEs”)
– infrastructure		 – whatever does not fall in Category I and III
– cannot undertake leverage or borrowing		 – can employ diverse or complex trading strategies
– can employ leverage including through investment in listed or unlisted derivatives  
Types of Funds[5] – VCFs
– SME funds
– social venture funds
– infrastructure funds		 – private equity funds
– debt funds for which no specific incentives or concessions are given		 – hedge funds
– funds which trade with a view to make short term returns
– funds which are open ended and for which no specific incentives or concessions are given  
Tenure[6] – close ended
– tenure determined at the time of application
– a minimum tenure of 3 years		 – close ended
– tenure determined at the time of application
– a minimum tenure of 3 years		 – may be open ended or close ended
Investment Limitations[7] – cannot invest more than 25% funds in the same Company, directly or indirectly – cannot invest more than 25% funds in the same Company, directly or indirectly – cannot invest more than 10% funds in the same Company, directly or indirectly

IDENTIFIED EARLY STAGE VENTURES

AIF Regulations specifically define certain early stage ventures like VCUs, start-ups and social ventures. It also provides a framework for investing in such early stage ventures and for setting up AIF – Category I funds (like VCFs, SME Funds, infrastructure funds, angel funds and social venture funds) for making such investments.

VCUs: Earlier, VCU was defined as a domestic company, engaged in the business for providing services, production or manufacture of things and did not include activities or sectors like non-banking financial companies, gold financing etc. SEBI removed the list of restricted activities or sectors from the definition of venture capital undertaking such that VCU means a domestic company which is not listed on a recognized stock exchange at the time of making investments.[8]

Start-ups: AIF Regulations incorporated the definition of “start-up” and aligned with the Department for Promotion of Industry and Internal Trade, Ministry of Commerce and Industry, Government of India (“DPIIT”).[9] Accordingly, “startup” means a private limited company or a limited liability partnership which fulfills the criteria for startup as specified by DPIIT.[10]

Social Ventures: Social ventures are corporate bodies (like trust, society, company, VCU, limited liability partnership etc.) formed with the purpose of promoting social welfare or solving social problems or providing social benefits.[11] Start-ups and VCUs which satisfy the social purpose theme may qualify as social ventures. The AIF Regulations also provide for setting up a theme based fund – social venture fund, under AIF Category – I, to focus on such theme based ventures.

CRITERIA FOR AN EARLY STAGE FUND

General Criteria for AIFs

Fit and Proper Criteria: The applicant, sponsor and manager should qualify as “fit and proper” persons by fulfilling the requirements of (a) integrity, reputation and character; (b) absence of convictions and restraint orders; (c) competence including financial solvency and net-worth; and (d) absence of categorization as a wilful defaulter.[12]

Key Investment Team: The key investment team of the manager should have at least (i) one key personnel with 5 (five) years (or more) of relevant investment experience; and (ii) one key personnel with adequate professional qualification. Both such requirements may also be fulfilled by the same key personnel.[13]

Investors of AIF: AIF may raise funds from any investor (whether Indian, foreign or non-resident Indians) by way of issue of units on a private placement basis. AIF is required to have a minimum corpus of Rs 20,00,00,000/- (Rupees Twenty Crore only), and it cannot accept an investment of less than Rs 1,00,00,000/- (Rupees One Crore only) from each of its investor.[14] These minimum corpus and minimum investment requirements do not apply to angel funds. Specific criteria for angel funds has been stated below.

Additional Criterial for AIF Category – I

AIFs which are generally perceived to have positive spillover effects on the economy and for which the Government may consider providing incentives or concessions are included in AIF Category – I. AIF Category – I funds have such features as have been elaborated in “Categories of AIF” section above. Further:

Tax Exemption: Funds which are formed as trusts or companies are construed as “venture capital company” or “venture capital fund” under the tax regime. In computing the total income of a previous year of such entities, any income from investment in a VCU is not be included.[15]

Investments by AIF: AIF Category – I cannot invest more than 25% (twenty five per cent) of the investable funds in an investee company directly or through investment in the units of other Alternative Investment Funds.[16]

Borrowing Conditions: AIF Category – I cannot borrow funds directly or indirectly or engage in any leverage except for meeting temporary funding requirements for not more than 30 (thirty) days, on not more than 4 (four) occasions in a year. Such borrowed funds should not be more than 10% (ten percent) of the investable funds.

Additional Criteria for Theme Specific AIFs

AIF – Category I funds may be set up as VCFs, SME funds, infrastructure funds or social venture funds under the AIF Regulations and subject to its own investment thesis. Following example:

VCFs: At least 2/3rd (two-thirds) of the investable funds of a VCF are required to be invested in unlisted equity shares or equity linked instruments of a VCU or in companies listed or proposed to be listed on a SME exchange or SME segment of an exchange.[17] At the same time, not more than 1/3rd (one-third) of the investable funds of the VCF can be invested in (among other things): (A) subscription to initial public offer of a VCU whose shares are proposed to be listed; or (b) debt or debt instrument of a VCU in which the fund has already made an investment by way of equity or contribution towards partnership interest.[18]

SME Funds: At least 75% (seventy five percent) of the investable funds of an SME Fund are required to be invested in unlisted securities or partnership interest of VCUs or investee companies which are SMEs or in companies listed or proposed to be listed on SME exchange or SME segment of an exchange.[19]

Infrastructure Funds: At least 75% (seventy five percent) of the investable funds of an infrastructure fund are required to be invested in unlisted securities or units or partnership interest of VCU or investee companies or special purpose vehicles, which are engaged in or formed for the purpose of operating, developing or holding infrastructure projects.[20]

Social Venture Funds: At least 75% (seventy five percent) of the investable funds of a social venture fund are required to be invested in unlisted securities or partnership interest of ‘social ventures’.[21] Such funds may (a) accept muted returns for their investors (i.e. returns lower than prevailing returns for similar investments)[22]; and (b) accept grants[23]; and (c) give grants subject to appropriate disclosures[24].

Specific Criteria for VCFs set up as Angel Funds

An angel fund is a sub-category of a VCF (under AIF Category – I) that raises funds from ‘angel investors’ and invests as per the provisions carved out for specifically for angel funds under the AIF Regulations.[25]

Angel Investor: In order to qualify as an angel investor, following conditions are required to be fulfilled[26]:

(a) For an individual investor:

  • Net tangible assets of at least Rs 2,00,00,000/- (Rupees Two Crore only) excluding the value of principal residence; and
  • Such person is (i) an early stage investment experience, or (ii) has experience as a serial entrepreneur, or (iii) a senior management professional with at least 10 (ten) years of experience.

(b) For a body corporate, a net worth of at least Rs 10,00,00,000/- (Rupees Ten Crore only).

Financial Specifications

Minimum corpus: Rs 5,00,00,000/- (Rupees Five Crore only)

Minimum investment from an angel investor: Rs 25,00,000/- (Rupees Twenty Five Lakh only)

Maximum period of investment from an angel investor: 5 (five) years

Further, the units of an angel fund cannot be listed on any recognised stock exchange. Such funds are required to raise funds through private placement only.

Investments by Angel Funds: Angel funds may invest in startups which are not promoted or sponsored by or related to an industrial group whose group turnover exceeds Rs 300,00,00,000/- (Rupees Three Hundred Crore only). Further, investment by an angel fund in any VCU is required to be[27]:

  • a minimum of Rs 25,00,000/- (Rupees Twenty Five Lakh only) and a maximum of Rs 10,00,00,000/- (Rupees Ten Crores only); and
  • locked-in for a period of 1 (one) year.

Angel funds cannot invest more than 25% (twenty-five per cent) of the total investments under all its schemes in one VCU.[28]

SEBI’s amendments to the AIF Regulations reflect the efforts undertaken by the financial regulators to not only provide flexibility to the AIF managers in running their fund operations effectively but at the same time ensure that their fiduciary obligations towards the investors are not compromised with.[29] In addition to clarifying the definitions to provide flexibility, the amendments also specify a code of conduct for AIF managers, trustees, investment committees and AIF itself. These efforts should play a key role in the growth of start-ups in India by expanding the available pool of capital as well as catalyse the formation of new Category I AIFs.[30] For example, structuring of ‘fund of funds’ pursuant to clarity on inter se investments by different AIFs.

[1] Inserted by the SEBI (Alternative Investment Funds) (Second Amendment) Regulations, 2021, w.e.f. 05-05-2021.

[2] Please see SEBI circular number SEBI/HO/IMD/DF6/CIR/P/2021/565 dated May 21, 2021.

[3] Regulation 2(1)(b) of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.

[4] Regulation 3(4) of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.

[5] Please see regulation 3(4) of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.

[6] Regulation 13 of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.

[7] Regulation 15(c)-(d) of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.

[8] Clause 3I(2) of the SEBI (Alternative Investment Funds) (Second Amendment) Regulations, 2021, w.e.f. 05-05-2021.

[9] See Clause 3I(i), SEBI (Alternative Investment Funds) (Second Amendment) Regulations, 2021, dated 05-05-2021.

[10] Regulation 2(1)(wa) of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.

[11] Regulation 2(1)(u) of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.

[12] Regulation 4(f) of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 read with Schedule II of the Securities and Exchange Board of India (Intermediaries) Regulations, 2008.

[13] Regulation 4(g) of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.

[14] Regulation 10(b)-(c) of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.

[15] Please see Section 10(23FB) of the Income Tax Act, 1961.

[16] Regulation 15(1)(c) of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.

[17] Regulation 16(2)(a) of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.

[18] Regulation 16(2)(b) of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.

[19] Regulation 16(3)(a) of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.

[20] Regulation 16(5) of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.

[21] Regulation 16(4)(a) of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.

[22] Regulation 16(4)(d) of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.

[23] Regulation 16(4)(b) of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.

[24] Regulation 16(4)(c) of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.

[25] Regulation 19A(1) of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.

[26] Regulation 19A(1) of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.

[27] Regulation 19F(2) & (3) of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.

[28] Regulation 19F(5) of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.

[29] “2021 Q1 Amendments to Alternative Investment Funds Framework” by National Law Review (25.05.2021).

[30] “2021 Q1 Amendments to Alternative Investment Funds Framework” National Law Review (25.05.2021).