rei daar-la insolvency: \ rie! ree feet ae challenges at mi aad ned! oe ee ad ee atl ete eon enue ose sage ae ae Saeda eae EUN egal r one Seeded Co) og tse ent Rote Pre tacosLegal and regulatory aspects for private equity and venture capital in India 8Y KARTIK GANAPATHY AND RAJESH PATHANIA, he frst three quarters of 2007 witnessed venture capital fonding of more than 777m in $7 deals in India. This was a fivefold increase over the previous year. In addition, 386 private equity deals were stack at @ total value of approximately $17.Ldba, Tndia has been witnessing substantial growth, year ‘on year, in both venture capital funding’ and privare equity financing. Indian regulstions do ‘not differentiate between veature capital aad private equity, and the terms are often used synonymously. Regulations governi vestment In 1973 the Government of India set up a committee on Development of Small and Me- dium Enterprises. The committee higiighted the urgent need to promote venture capital as source of funding aew entrepreneurs and venture capital in- technology. The Government of India in 1988 framed guidelines for venture capital funds Which were considered restrictive, with provi- sions limiting the seting up of venture capital funds by persons other than banks and finan cial instutions. Further regulations were intro- duced by way of an additional set of guidelines issued by the Government of India for regulat- ing foreign venture capital investment in In- cla, With a view to inceativise venture capital » swwlisaciveiecon | Opportunities in Emerging Marks 2008 FW | 9funding the Government of India, through the Contral Board of Direct Taxes, issued guie- Tines which exempted venture capital funded ‘companies from certain taxes Significartly, in addition to the Reserve ‘Bank of India (RBD, which regulates the flow ‘of money into India (SEBI). the Sevvrities Exchange Board of India is a key regulstor ‘of venture capital in India. SEBL. pursuant to the SEBLAct, 1992, framed the SEBI (Venture Capital Funds) Regulations, 1996 (VCF Regu- Jations), Following recommendations made by the K-B, Chandrasekhar Committee (1999. 2000) SEBI was made the nodal regulator for ‘venture capital funds ‘Until September 2000, India did not regulate ‘or monitor foreign venture capital or private equity investors, whereas regulations existed for domestic VCES. With foreign investment in mast sectors being allowed under the au tomatic route (i.e, without the need for prior regulatory approvals). the government also felt the need fo monitor (i wot regulate) foreign vestment coming into the venture capital sec- tor. In September 2000, in addition to majoc reforms tothe existing VCF Regulations, SEBI also introduced a set of regulations applicable to offshore funds, called the SEBT (Foreign ‘Venture Capital Investors) Regulations, 2000 (CEVCT Regulations ‘The approach SEBI adopted whilst introdue- ing the FVCI Regulations was to monitor and fot regulate foreign investment. The FVCT Regulations do not make it mandatory for an offshore fund to register itell with SEBI. To bring parity between domestic VCFs and FV- (Cs, ihe investment restrictions laid down in both sets of regulations are simular Implications of registration Registered EVCT's are exempr from bath the entry an exit pricing regulations that other- ‘wise govern foreign investors. This isa signiti- cant benefit especially when FVCIs are look- ing to exit from unlisted companies through a strategie sale or through a buy-back arrange- ‘ment with Indian promoters. Rewistered FV- (Cis have been accorded “qualified insiutional buyer” status and would accordingly be eli- sible for subseribing in an IPO to securities of ‘Venture Capital Undortaking (VCU) through the book-building rout, Registered FVCIs are exempt from the one-year lock-in of shares pst IPO, for shares purchased prior t the IPO, subject ro cerain qualifications; exempt from the SEBI takeover regulations foe sales to promoters pursuant 10 the IPO of a WCU and ‘ae wot automatically treated as promoters in an IPO of VCU. However es a consequence of registration a least 66.67 percent of the investible funds should be invested in unlisted equity shares or equity inked instruments of VCUs. Further, 00 ‘mote than 33.33 percent ofthe investible funds may be invested by way of (@ subscription to inital public offer of a VCU: (il) debt or debt instruments of a VCU in which an investment by way of equity has already’ been made:(i) preferential allotment of equity shares of it~ ced company, subject to lock in period of one year: (iv) equity or equity linked instruments of financially weak company ora sick indus- ‘rial company whose shares are liste: and (¥) special purpose vehicles created for the pur pose of facilitating or promoting investment in sccordance with the relevant regulations. Fur ther, an FVCI cannot make any investments in companies, which are in de sectors mentioned inthe ‘negative is’ specified by SEBI. ‘Types of instruments Historically investment in VCUs has been a imix of equity shares and preference shares. Redeemable, optionally convertible and non- convertible preference shares and debentures ware also used, but these instruments now fall under the External Commercial Borrow Ing Guldelines (ECB) of the RBI, snd are not curently in vogue. Compulsorily convertible preference shares ane compulsorily coavert- ible debentures romain outside the purview of the ECB, Consequently, equity shares, com- pulsorily convertible preference shares and/or compulsorily convertible debentures are the primary investment instruments Frquiry shares. Equity is the simplest and most direct route of investing into @ VCU. Eq tity could be of separate classes, and subject to differential sights asco voting and dividend, Dividends diseibured from an Indian company to the foreign holder attract a dividend distr bution tax of 16.995 percent, payable by the Indian company making the dividend payout ‘Subsequent receipt of dividend is exempt in the hands ofthe shareholder. Buy-back of eq tity shares of a company are subject to certain restitions, Significantly only 25 percent of the equity shares can be bought back in any ‘financial year. Capital gains ax is payable on the sale of shares in India and the rates are pri- marily dependent upon the period of holding (short term capital gains orlong term capi- tl gains), ube status of the entity (resident or non-resident) andthe availabilty of tax treaty benefits. Preference shares. Under Taian lain order fora share to be considered a preference share, ‘and not an equity share it must cary 2 prefer ‘ential right be paid a fixed amount as divi- dendscaery a preferential right to repayment of capital, vis--vis the equity shareholders, in the event of winding-up or arrangement to re- pay capital, and have voting rights only with respect to matters which affect the rights of the 10 | FW Opportunies in Emerging Makes 2008 | weiner cm, asic preference sharcholders as a class, Other pref ftental rights like the right to be paid arrears of dividend, payment of fixed premium etc ‘may be contractually provided. Equity share ‘buy-back caps do not apply to the buy-back Of preference shares. Premium received on redemption of redeemable preference shares is treated a capital gains. The tax treatment ‘of dividend and capital guns for preference shares is similiar to equity shares ‘Debentures, Debentures are debt instra- _ments unless compulsorily convertible subject to ECB, Debentures do not have any voting rights, Interest paid to a foreign holder by an Thuan company’ on debentures is subject 10 & ‘withholding tax. Interest payable on deben tures could be tax deductible for the Indian company. Debentures when used as invest ‘meat instruments are normally structured as compulsorily convertible debentures to avoid attracting the restrictions under the ECB. There fare no tax implications at the time of conver sion of debentures into equity shares; however at the time of sale of the shares following con version the period of holding is counted from the date of conversion of the debentures into equity shares Investment terms Internationally acceptable investment terms are found in Indian term shects. Term sheets run the gannut of brit descriptions of the Bead- ings to mini agreements, and are usually nego~ tiated, Its normal for investment documento ‘contain standard rights including right of first ‘offer for fresh issues, and restrictions on share transfer such as the right of fist refuse, te- along rights and drag-along rights. Affirmative votes are used to control critical decisions, ‘and rights to appoint directors to the board are commonplace. The two critical thresholds in India with respect to voting are SI percent (for ‘ordinary resolutions) and 75 percent (for spe- cial resolutions). Law prescribes that certain matters require either ordinary or special reso lations, Regalatory intricacies need to be care- fully dealt within investment documentation, Case law in India as lead to the convention of inserting as much as possible of he sharehold- ers agreement into the Amticles of Association Ge, by-laws) of companies, It remains to be seen whether the newly set up Competition ‘Commission of India cass its gaze upon ven- ‘re capital and private equity transactions and the extent to which the newly enacted compe- tition laws affect such transactions Exit mechanisms dia has seen exits of private equity and ven- ture capital firms by way of IPOs, share sales and mergers Indian law providesthat an Indian ‘company should go public in India prior to or