Startups are turning to an alternative source of venture capital

Nishchal Joshipura, who leads the private equity and M&A practice at an India-focused global law firm, Nishith Desai Associates elaborates and highlights key areas of concern and possible strengths to guide the startup ecosystem towards large-scale capital creation and economic success

To unleash India’s potential that resides in the startup ecosystem, systems and regulations are needed to review procedures and laws. The VC and PE segment strongly regrets that the critical guidelines are simplified and enforceable.

1. Funds appear to be largely sourced or stored with family offices or PEs in India. Do you see this changing as India matures as a startup/entrepreneurship market?

Family and friends, angel investors, family offices, and VCs will continue to remain important sources of funding for early-stage startups due to their easy accessibility to founders.

In recent years, startups have turned to another source of capital: venture capital debt. As markets around the world face a shortage of liquidity, debt financing has become crucial to meet working capital needs and capital expenditures. Notably, the “India Venture Debt Report 2022” reports that funding for startups through venture capital debt has nearly doubled in the past year.

According to Invest India, as of June 29, 2022, India is home to 103 unicorns with a total value of $335.80 billion. Given India’s promising growth and the rate at which India is adding unicorns every year, there will be a quantum leap in investments by venture capitalists and venture debt funds over the next few years. .

2. The government introduced a model, the Fund of Funds (FOF), which strengthened the domestic capital pool. How does this help the ecosystem in the long term?

Historically, foreign capital invested in Indian portfolio companies has been at least 3-4 times greater than domestic capital. This signifies the heavy reliance of the Indian PE/VC industry on foreign capital for the growth of Indian businesses. There is an urgent need to reduce reliance on foreign capital by encouraging new sources of domestic capital to invest in Indian holding companies. In this regard, the FOF is a commendable initiative that will enable other national funds in India to deploy capital for Indian business start-ups, and such capital deployed by the national funds can be leveraged to raise additional funds from Indian companies. other sources such as banks and NBFCs.

3. The past year has seen many profitable releases. Will this continue and how do you see exit strategies changing over the coming year?

After a long dry spell, Walmart’s acquisition of Flipkart was India’s biggest private equity outflow, instilling confidence among Indian and foreign PE/VC players in India as a destination. attractive investment. Since then, there has been an increase in the number of expensive private equity outflows in India. In 2021, India recorded the highest number of IPOs (65) of Indian holding companies on the main market and around 60 IPOs on the SME exchange. While IPOs declined in 2022 due to global developments, India will continue to see robust exits through secondary sales and commercial sales going forward.

4. Government and other governing bodies such as IVCA have been deeply involved in streamlining the segment. What is your opinion on the work done so far and your advice on what more can be done?

Since its inception, the IVCA has been very active in representing the Indian PE/VC industry and has been instrumental in liaising with government agencies to iron out creases and streamline the segment. In fact, multiple legal and tax changes have been introduced by the government due to the timely intervention of the IVCA.

The next major initiatives that the government can take vis-à-vis the PE/VC industry are:

1. Spot the potential pool of domestic capital: The government must allow provident funds and insurance companies to deploy more capital from their mammoth balance sheets for the growth of Indian businesses. Internationally, the main sources of capital for local businesses have been pension funds, sovereign wealth funds and insurance companies.

2. Ease of Doing Business: Like the “Ease of Doing Business” initiative, to shorten the time to do business, the government should introduce the “Ease of Doing Business” as the next initiative. As part of this initiative, the government should focus on removing barriers such as extensive compliance requirements and the long wait process for obtaining regulatory approvals. In this regard, the time has come for important regulators such as RBI, SEBI, CCI and IRDAI to re-examine the entire approval process which will ensure that transactions are completed in the shortest possible time.

3. Tax parity between foreign and domestic investors: Currently, Long Term Capital Gains (LTCG) realized by foreign investors on the sale of Indian private company shares are taxed at around 10%, while domestic investors are taxed at around 20%. . Steps should be taken to bring parity so that domestic investors have a level playing field vis-à-vis their foreign counterparts.

4. Tax security for foreign and domestic PE/VC investors: Over the past few years, the Indian Revenue Service has issued a number of tax opinions questioning treaty benefits and imposing GST on investment income. deferred interest. This has led to a lot of ambiguity and uncertainty among domestic and foreign PE/VC actors. For matters like these, it is absolutely important that the tax laws in India are completely clear and unambiguous.

5. India being strong in international investment and foreign capital available, what are the challenges faced by Indian VCs?

For Indian fund managers, the biggest challenge is the availability of large domestic pools of capital. As a result, unlike their foreign counterparts, Indian fund managers have not been able to acquire large companies on their own. Indian fund managers have to pay almost twice as much capital gains tax on outflows of domestic capital they have raised compared to foreign capital. Moreover, since the Indian rupee is not fully convertible into capital, Indian fund managers also have limited flexibility to invest overseas in lucrative global ventures that their overseas counterparts have been able to benefit from.

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John A. Bogar