Why Venture Capital

The venture capital industry in India is still at a nascent stage. With a view to promote innovation, 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's recent success story in the area of information technology has shown that there is a tremendous potential for growth of knowledge based industries. This potential is not only confined to information technology but is equally relevant in several areas such as bio-technology, pharmaceuticals and drugs, agriculture, food processing, telecommunications, services, etc. Given the inherent strength by way of its skilled and cost competitive manpower, technology, research and entrepreneurship, with proper environment and policy support, India can achieve rapid economic growth and competitive global strength in a sustainable manner.

A flourishing venture capital industry in India will fill the gap between the capital requirements of technology and knowledge based startup enterprises and funding available from traditional institutional lenders such as banks. The gap exists because such startups are necessarily based on intangible assets such as human capital and on a technology-enabled mission, often with the hope of changing the world. Very often, they use technology developed in university and government research laboratories that would otherwise not be converted to commercial use. However, from the viewpoint of a traditional banker, they have neither physical assets nor a low-risk business plan. Not surprisingly, companies such as Apple, Exodus, Hotmail and Yahoo, to mention a few of the many successful multinational venture-capital funded companies, initially failed to get capital as startups when they approached traditional lenders. However, they were able to obtain finance from independently managed venture capital funds that focus on equity or equity-linked investments in privately held, high-growth companies. Along with this finance came smart advice, hand-on management support and other skills that helped the entrepreneurial vision to be converted to marketable products.

Beginning with a consideration of the wide role of venture capital to encompass not just information technology, but all high-growth technology and knowledge-based enterprises, the endeavor of the Committee has been to make recommendations that will facilitate the growth of a vibrant venture capital industry in India.

The report examines-

1. the vision for venture capital

2. strategies for its growth and

3. how to bridge the gap between traditional means of finance and the capital needs of high growth startups.

While making the recommendations the Committee felt that the following factors are critical for the success of the VC industry in India:

1. The regulatory, tax and legal environment should play an enabling role. Internationally, venture funds have evolved in an atmosphere of structural flexibility, fiscal neutrality and operational adaptability.

2. Resource raising, investment, management and exit should be as simple and flexible as needed and driven by global trends

3. Venture capital should become an institutionalized industry that protects investors and investee firms, operating in an environment suitable for raising the large amounts of risk capital needed and for spurring innovation through startup firms in a wide range of high growth areas.

4. In view of increasing global integration and mobility of capital it is important that Indian venture capital funds as well as venture finance enterprises are able to have global exposure and investment opportunities.

5. Infrastructure in the form of incubators and R&D need to be promoted using Government support and private management as has successfully been done by countries such as the US, Israel and Taiwan. This is necessary for faster conversion of R & D and technological innovation into commercial products.

Multiplicity of Regulations - Need for Harmonisation and Nodal Regulator

Presently there are three set of Regulations dealing with venture capital activity i.e. SEBI (Venture Capital Regulations) 1996, Guidelines for Overseas Venture Capital Investments issued by Department of Economic Affairs in the MOF in the year 1995 and CBDT Guidelines for Venture Capital Companies in 1995 which was modified in 1999. The need is to consolidate and substitute all these with one single regulation of SEBI to provide for uniformity, hassle free single window clearance. There is already a pattern available in this regard; the mutual funds have only one set of regulations and once a mutual fund is registered with SEBI, the tax exemption by CBDT and inflow of funds from abroad is available automatically. Similarly, in the case of FIIs, tax benefits and foreign inflows/outflows are automatically available once these entities are registered with SEBI. Therefore, SEBI should be the nodal regulator for VCFs to provide uniform, hassle free, single window regulatory framework. On the pattern of FIIs, Foreign Venture Capital Investors (FVCIs) also need to be registered with SEBI.

Tax pass through for Venture Capital Funds

VCFs are a dedicated pool of capital and therefore operates in fiscal neutrality and are treated as pass through vehicles. In any case, the investors of VCFs are subjected to tax. Similarly, the investee companies pay taxes on their earnings. There is a well established successful precedent in the case of Mutual Funds which once registered with SEBI are automatically entitled to tax exemption at pool level. It is an established principle that taxation should be only at one level and therefore taxation at the level of VCFs as well as investors amount to double taxation. Since like mutual funds VCF is also a pool of capital of investors, it needs to be treated as a tax pass through. Once registered with SEBI, it should be entitled to automatic tax pass through at the pool level while maintaining taxation at the investor level without any other requirement under Income Tax Act.

1. Foreign Venture Capital Investors (FVCIs)

   Presently, FIIs registered with SEBI can freely invest and disinvest without taking FIPB/RBI approvals. This has brought positive investments of more than US $10 billion. At present, foreign venture capital investors can make direct investment in venture capital undertakings or through a domestic venture capital fund by taking FIPB / RBI approvals. This investment being long term and in the nature of risk finance for start-up enterprises, needs to be encouraged. Therefore, atleast on par with FIIs, FVCIs should be registered with SEBI and having once registered, they should have the same facility of hassle free investments and disinvestments without any requirement for approval from FIPB / RBI. This is in line with the present policy of automatic approvals followed by the Government.

   Further, generally foreign investors invest through the Mauritius-route and do not pay tax in India under a tax treaty. FVCIs therefore should be provided tax exemption. This provision will put all FVCIs, whether investing through the Mauritius route or not, on the same footing. This will help the development of a vibrant India-based venture capital industry with the advantage of best international practices, thus enabling a jump-starting of the process of innovation.

   The hassle free entry of such FVCIs on the pattern of FIIs is even more necessary because of the following factors:

   1. Venture capital is a high risk area. In out of 10 projects, 8 either fails or yield negligible returns. It is therefore in the interest of the country that FVCIs bear such a risk.

   2. For venture capital activity, high capitalisation of venture capital companies is essential to withstand the losses in 80% of the projects. In India, we do not have such strong companies.

   3. The FVCIs are also more experienced in providing the needed managerial expertise and other supports.

2. Augmenting the Domestic Pool of Resources

   The present pool of funds available for venture capital is very limited and is predominantly contributed by foreign funds to the extent of 80 percent. The pool of domestic venture capital needs to be augmented by increasing the list of sophisticated institutional investors permitted to invest in venture capital funds. This should include banks, mutual funds and insurance companies upto prudential limits. Later, as expertise grows and the venture capital industry matures, other institutional investors, such as pension funds, should also be permitted. The venture capital funding is high-risk investment and should be restricted to sophisticated investors. However, investing in venture capital funds can be a valuable return-enhancing tool for such investors while the increase in risk at the portfolio level would be minimal. Internationally, over 50% of venture capital comes from pension funds, banks, mutual funds, insurance funds and charitable institutions.