This AZB Practice Guide intends to provide a high level overview of the venture capital market, including key sectors, preferred investment structures, regulatory approval requirements, legal restrictions on investment, investor protection, preferred structures for investment in venture capital deals, rights available to venture capital investors in public companies, etc.
1. In India, which sectors do venture capital funds typically invest in?
Key sectors attracting venture capital (VC) investments in India include information technology, e-commerce, healthcare, consumer, financial services (including mobile wallets and digital payment solutions), education
2. Do venture capital funds require any approvals before investing in India?
Foreign Venture Capital Investors (FVCI) are required to obtain a one-time registration under the FVCI Regulations with the Securities Exchange Board of India (SEBI). Investments under the Foreign Direct Investment (FDI) route do not require any registration but may require prior government approval depending on the sector in which the investment is being made.
3. Are there any legal limitations to an offshore venture capital fund acquiring control or influencing the business, operations, or governance of an investee entity?
There are no restrictions on a foreign VC acquiring control or influencing operations of a private company.
In case of a listed target, however, a first-time investor (together with persons acting in concert) cannot acquire 25% or more of the voting rights or control unless it makes a mandatory tender offer to acquire an
additional 26% of the capital from public shareholders of the target. A mandatory tender offer requirement is also triggered where an investor holding 25% or more voting interest seeks to acquire control, or additional
shares or voting rights exceeding 5-10% (depending on certain regulatory conditions) in a financial year.
4. Would an investor be required to undertake an antitrust analysis prior to investment? When would such a requirement be triggered?
Generally, early-stage VC transactions in India rely on a statutory exemption from mandatory pre-merger notification requirements under the merger control regime. Currently, merger control regulations allow for an exemption from notification where the target either has assets not exceeding INR 3.5 billion (approx. USD 54.17 million) in India, or has a turnover not exceeding INR 10 billion (approx. USD 154.77 million) in India. This exemption is currently available until March 29, 2022.
5. What are the preferred structures for investment in venture capital deals? What are the primary drivers for each of these structures?
Typically, VCs acquire a minority stake of 10-15% in early-stage investments by way of compulsorily convertible preference shares (CCPS) or a combination of equity shares and CCPS. CCPS rank in priority to equity shares on dividend distribution and repayment of capital on liquidation. CCPS also allow the investor to link the ratio of conversion to pre-agreed valuation expectations.
FVCIs looking to invest in start-ups can also subscribe to convertible notes. The primary advantage of a convertible note is that it allows an investor the flexibility to determine, within a five-year period, whether the money invested should be repaid or be converted into equity shares on terms and conditions agreed upon
with the target.
While determining the preferred structure, other considerations which play a key role include tax implications, exchange control considerations relating to the sector of investment, as well as antitrust and other regulatory analysis.
6. Is there any restriction on rights available to venture capital investors in public companies?
No. Securities regulations in India apply uniformly to all investors and shareholders of a public company, regardless of domicile.
Unlike private equity, VCs typically do not to invest in the listed space. An acquisition of control or 25% or more of voting rights in a listed company would trigger mandatory tender offer obligation. Financial investors are also generally cautious of not wanting to be categorized as ‘promoters’ of a listed company, on account of attendant legal and regulatory implications.
7. What protections are generally available to venture capital investors in India?
Aside from standard contractual protections, transaction documents can also provide for a return on capital invested, provided this does not exceed the fair market value of the investment made by the investor in the target. Typically, we have seen investors opt for the higher of 1x their investment amount or the fair market value of their investment.
In addition, statutory protections available to minority shareholders include, (a) the right to make an application with the national company law tribunal in case of mismanagement or where the company’s affairs have been conducted in a manner that is oppressive to the interests of the members; (b) the right to file a
class-action suit; and (c) the right of minority shareholders to appoint a director.
8. Is warranty and indemnity insurance common in India? Are there any legal or
practical challenges associated with obtaining such insurance?
Traditionally, investors in the Indian context rely on contractual indemnities and the right to claim damages and specific relief in law. However, in recent years, we have seen investors increasingly opt for warranty and
indemnity insurance in India. It is generally preferred in high value transactions where founders are exiting the company and the incoming investor would have to rely on personal guarantees of the promoters for
performance of conditions under the transaction documents.
The exclusion of known risks, high premiums and a limited market of insurance brokers offering warranty and indemnity insurance in India is likely to pose some practical challenges in obtaining such insurance.
9. What are common exit mechanisms adopted in venture capital transactions, and what, if any, are the risks or challenges associated with such exits?
In a typical venture capital deal, investors opt for a waterfall exit mechanism with multiple exit options. This usually includes exit through an initial public offering (IPO), a put option on the founders and buyback of capital. If the company/founders are unable to provide an exit through any of these mechanisms, as a last
resort, investors reserve the right to sell their investment to a third-party buyer along with the founders’ stake in the entity by exercising a drag right.
Implementing each of these exit mechanisms is not without its challenges. The difficulties in achieving a successful IPO have been discussed in our response below. While exercising a put option on the resident founders, an investor is permitted to do so only after having held the security for a period of one year. Further, the sale price of the investor’s securities cannot exceed fair market value.
For implementing a buyback, Indian company law imposes certain limitations such as: (a) it should be permitted under the articles of association of the target; (b) funds used for buyback should be out of free reserves, securities premium or proceeds from issue of any shares or other specified securities; (c) the buyback cannot exceed 25% of the aggregate of paid-up capital and free reserves of the company; and (d) the ratio of the aggregate of secured and unsecured debts owed by the company after buyback should not be more than
twice its paid-up capital and free reserves. A subsequent offer of buyback cannot be made within a period of one year reckoned from the date of the closure of the preceding offer of buyback, if any.
10. Do investors typically opt for a public market exit via an IPO? Are there any specific public market challenges that need to be addressed?
While it is common for most VC deals to provide an exit via an IPO, a successful public market exit depends significantly on external factors such as market conditions and regulatory and political climate, which are beyond the control of exiting investors. This provides a very narrow timeframe during which the exit can be
achieved. Public market exits are highly regulated, and managing and implementing an IPO is a long, drawnout process typically taking a year to complete. It is also a promoter-driven process, with the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (ICDR Regulations) imposing several eligibility
conditions on the issuer company, such as having net tangible assets of INR 30 million, operating profits of INR 150 million and a net worth criterion of at least INR 10 million in each of the three years preceding the IPO.
Other key challenges include: (a) in an offer for sale to the public, ICDR Regulations impose a lock-in on the sellers’ shareholding for a period of one year prior to filing the draft offer document with SEBI; and (b) the post-issue capital should account for a minimum contribution from promoters of 20% and will be locked in for a period of three years.