Disclaimer: This is an Investor education initiative by YourNest. For specific information on related laws, rules, regulations, guidelines and directives framed there under, please refer and study details on the website of SEBI (Securities Exchange Board of India), The Companies Act'2013 (Ministry of Corporate Affairs), The Income Tax Act'1961, RBI (Reserve Bank of India), Press notes of Ministry of Finance (MoF) & the Ministry of Commerce (MoC).
What is Venture Capital?
Venture Capital is a term used for the money, or capital, provided to early-stage, high-potential, high-risk start-ups. The Venture Capital Fund (VCF) gets an equity stake in the start-up, in lieu of the funds it provides. These start-ups, usually own a novel technology or choose to operate in high technology industries, such as biotechnology, IT, mobile, internet and software.
Venture Capital investment, mostly, takes place after the seed or angel funding. It is considered growth funding because it generates a return, when the start-up goes for an IPO, trade sale, strategic investment etc.
Who is Venture Capitalist?
The general partners and other investment professionals of the venture capital firm are often called “venture capitalists” or “VCs”. Broadly speaking, VCs either have an operational or a finance background, though there is no hard and fast rule.
What are the funding options available to a start-up?
The types of financing options roughly correspond to the stage of a start-ups' development and amount of risk capital required.
- Seed funding : Small funding given to prove a new idea, often provided by angel investors, incubators or accelerators. Crowd funding is also emerging as an option for seed funding.
- Start-up funding: Early-stage ventures need funding for expenses associated with marketing and product development. It is normally provided by early stage venture funds, like YourNest, or angel funds.
- Early Stage (Series A): At this stage some of the risks associated with a start-up have been negated or refuted, the market has validated the concept and its value proposition to some extent. Normally known as Series A funding, it continues to be an early stage funding but for growth. YourNest normally participates in such subsequent round of funding, also.
- Growth Stage funds: These Venture Funds provide growth capital to established businesses who are now ready to scale-up, on the back of significant brand building, or ramping the manufacturing or production capabilities.
- Bridge Round: Working capital for early stage companies that are selling their products or services however, are not showing cash profits, yet. These funds are intended to finance the process to “go public” or a “private equity” round.
Who can be an Angel Investor?
An Angel Investor is an individual who believes in entrepreneurship, can create value for the economy and has allocated part of his investible surplus for supporting start-ups or investing in a Venture Capital Fund.
Recently, SEBI (Securities and Exchange Board of India) has defined Angel Investor as a person who proposes to invest in an Angel Fund and who has net tangible assets of at least two crore rupees, in individual capacity, excluding value of his principal residence, and who:
- has early stage investment experience, or
- has experience as a serial entrepreneur, or
- is a senior management professional with at least ten years of experience;
‘Early stage investment experience’ means prior experience of investing in a start-up or emerging or early-stage ventures. ‘Serial entrepreneur’ means a person who has promoted or co- promoted more than one start-up venture.
The definition of investors, who can invest in certain types of higher risk investments including seed money, hedge funds, private placements and angel investor networks, is different in each country. The term generally includes wealthy individuals known as accredited investors.
For example in the United States, an individual is considered an accredited investor, if his net worth is at least one million US dollars, not including the value of one’s primary residence or has an income of at least $200,000 a year for the last two years (or $300,000 together with his or her spouse if married) and expects to make the same amount this year.
How does Angel Investing differ from Venture Capital?
Venture capital firms are professional investors who dedicate 100% of their time to investing and building innovative companies on behalf of third party investors or their limited partners. The angel investment community is a more informal network of investors who invest in companies for their own interests. Typically, angel investors invest less than $1 million in any particular company, whereas venture capitalists usually invest from small cheques to say up to $20 million.
How are Venture Capitalists different from other Investors?
Venture Capitalists are long-term investors who take a very active role in their portfolio companies. They invest with a horizon of 5-8 years, on an average. The initial investment is just the beginning of a productive relationship between the venture capitalist and entrepreneur. Venture capitalists bring value by providing capital and management expertise. Venture capitalists often are invaluable in building strong management teams, managing rapid growth and facilitating strategic partnerships.
Why Invest in Venture Capital in India?
The nature of Venture Capital is such that it offers an opportunity for wealth creation- by investing in entrepreneurs driven by high growth aspirations. The Indian scenario offers:
- An attractive high-growth opportunity.
- Strong entrepreneurial spirit taking root in Young India.
- Unique business ideas offered by Indian start-ups that fulfil the unmet needs of the target segment.
- Vibrant environment for sharing gains with co-founder, equity participation and strategic exits for appropriate returns.
- Significant value creation by first generation entrepreneurs in recent years energizing early stage opportunities.
- Limited availability of early stage funding in India.
What benefits does a start-up derive from Venture Capitalist?
The resource and expertise of a Venture Capitalist not only provides funds, without the regular repayment liability, to a start-up but also provides several other less tangible benefits such as handholding and coaching. The VCs share a common desire of succeeding with the entrepreneuer. A start-ups success or failure is the VC’s success or failure. VCs bring expertise, experience, contacts and discipline, to the table. The presence of a venture capitalist also lends credibility to the company.
What impact does Venture Capital have on the economy?
Venture Capital has a positive spillover impact on the economy. It is a catalyst for job creation, innovation, technology advancement, international competitiveness and increased tax revenues.
How do Venture Capitalists realize a return on their investment?
Venture Capitalists invest in private enterprises and get return on investment as and when they dispose-off their shareholding to another investor. “Exit” is a crucial moment for any VC. Typically, an “Exit” could be achieved when the portfolio company goes public (IPO) or merged or purchased by another company.
How does an investor in a Venture Capital Fund (VCF) get return on Investment?
A VCF's lifespan is 8-12 years. It normally has an investment holding period of 4-6 years in each portfolio company. When the shareholding in the portfolio company is disposed-off the VCF realizes cash against the original investment. The “sales proceeds” are distributed among all, in proportion of their contribution to the fund. An individual investor does not have a say in the liquidation of the investments in the portfolio company. He or she gets a return only on “Exit“ by the VCF along with all other investors.
What is Private Placement Memorandum (PPM)?
Private placement (or non-public offering) is a funding round through sale of shares, which are not sold through a public offering, but through a private offering, mostly to a small number of chosen investors. The PPM is a legal document stating the objectives, risks and terms of investment of the private placement. This includes financial statements, management biographies, detailed description of the business, etc. An offer memorandum provides buyers with information on the offering and protects the sellers from the liability associated with selling unlisted securities. The contents of the document are governed by the securities regulator i.e. SEBI in India.
How does a Venture Capitalist get paid for the services offered?
Venture capitalists are compensated through a combination of management fees and carried interest (often referred to as a “2 and 20” arrangement):
- Management fees – Annual payment is made by the investors (in the VCF) to the Fund manager for carrying out the operations. In a typical Fund, the general partners receive an annual management fee up to 2% of the committed capital.
- Carried interest – This is a share of the profits of the Fund (typically 20%), which is paid to the VCF’s management company as a performance incentive. The remaining 80% of the profits are paid to the investors. Strong limited partners, in top-tier venture firms, have commanded a carried interest of 25% to 30% of the profits, in the recent past.
What will be the tax liability on realised profit from Investments made in Indian VCF?
Dec'13 Indian Tax laws allow a pass through benefit, so that income is only taxed in the hand of the investor and not taxed at the VCF level. However, It is advisable to consult a tax expert because every exit has its own nuances. The main tax implications for the beneficiaries of the fund are -
- Exit gains on sale / buy back of securities – The gains arising from the sale of shares held in the Portfolio Companies may be treated either as “capital gains” or as “business income” for Indian tax purposes. In case of “capital gains” –
- The short term capital gains are taxed at the marginal rate of tax that is full tax rate applicable to the investor e.g. an individual resident in India is taxed at 30.90%.
- Long term capital gains: There will be no tax on Resident/ Non Residents in case shares are listed in India and the sale is subject to Securities Transaction Tax (STT) or in the case of sale of unlisted equity shares under an offer for sale to the public included in an initial public offer and the sale is subject to STT. Otherwise, for unlisted shares –
- For Resident in India after considering indexation
- if beneficiary is a Domestic Company, it is 21.63%.
- if beneficiary is any other assessee, it is 20.60%
- For Resident in India without indexation benefit or sale not subjected to STT (i.e. off market transactions)
- if beneficiary is a Domestic Company, it is 10.82%.
- if beneficiary is other assessee, it is 10.30%.
- For Non Resident :
- if beneficiary is a Foreign Company, it is 10.51%.
- if beneficiary is any other assessee, it is 10.30%.
What is the difference between Venture Capital (VC) and Private Equity (PE)?
Venture Capital is a subset of Private Equity. Therefore, all Venture Capital is Private Equity, but not all Private Equity is Venture Capital. Both PE firms and VCs invest in companies and make money by exiting – selling their investments. The key difference is that PE firms buy mature companies whereas VCs invest, mostly, in early-stage companies.
How does a Venture Capital Fund mitigate “high-risk” involved in early stage companies?
The risk associated with early stage investments is expected to be high due to a variety of reasons. The portfolio company may be less than 3 years old, promoted by first generation entrepreneurs, offering a service or product for the first time in a market. In some cases, they may have revenue, but may not have achieved break-even. Most VCF exercise risk mitigation through –
- Time & Portfolio Diversification – Investment is spread over 3-5 years so that all investments are not made at the peak of a economic cycle. Moreover, 10-15 start-ups are nurtured so that the risk is balanced across the portfolio.
- Milestone based disbursements – Investment tranches are linked to realistic milestones so that capital is optimally utilized.
- Effective deal structuring & investor protection – This is ensured with measures such as founder vesting, founder lock-in, pre-emptive right, liquidation preference, information rights, right of first refusal, valuation protection, tag along, drag along, special rights to exit etc.