sc-largeSome shrewd, backroom lobbying over the past 15-odd months played a critical role in last week’s unveiling of the much awaitedinvestment framework for angel investors by SEBI. Yet, the framework, though ground breaking in several ways, doesn’t quite solve the original problem that led to its making. In fact, it leaves the country’s real angels — family members and friends, usually the first source of capital for an entrepreneur — a bit in the lurch.

Angel investments made by family, friends or any individual not investing through a SEBI-registered angel fund, will still be subject to be taxed as income at the hands of the investee company. While that doesn’t spell the death of grassroots angel investing in the country, it certainly makes life that much more difficult for both entrepreneurs and their most genuine benefactors.

There are ways around the problem and we’ll dwell on those in a bit. First, let’s talk about the events in the last 15 months that led to last Tuesday’s announcement.

Making angels and startups part of the government’s lexicon

Soon after the government announced in its March 2012 Union Budget that angel investments would be taxed, professional angel investor groups, in a rare display of solidarity, closed ranks to work around the problem. Several venture capital firms, who depend on these angel investor groups for deal flow, and a couple of industry representative bodies also threw their hats into the ring. Leveraging the public outcry that erupted following the Budget proposal, this lobby was able to get the then finance minister, Pranab Mukherjee, to amend the original proposal. In May 2012, Mukherjee said that capital raised from notified angel investors would not be taxed as income.

While the finer details of how ‘notified angel investors’ would be defined were yet to be worked out, the lobby kept up the pressure on the government. In August, a special Planning Commission committee rolled out a roadmap that detailed a number of initiatives to promote the development of a healthy angel and venture capital industry. The committee consisted of key actors from the entrepreneurial and investor communities, including professional angel investor groups. The underlying objective in getting the Planning Commission involved in the discourse was clearly to ensure that entrepreneurship and early stage investing remained a priority on the government’s agenda.

The persistence paid off. In March this year, in its 2013 Union Budget, the government announced that SEBI would prescribe requirements for angel investor pools by which they could be recognized as Category I AIF venture capital funds. Investments made by these SEBI-recognized angel funds would not be taxed as income at the hands of the investee company.

Finally, last week, in a well deserved victory for the lobby, SEBI followed through with the approval of amendments to its AIF (Alternative Investment Funds) Regulations, 2012, providing a framework for registration and regulation of angel pools under the sub-category ‘Angel Funds’ under Category I Venture Capital Funds.

SEBI sets the ground for a more stable angel investing environment

Overall, there’s little doubt that SEBI’s move is ground breaking. In recognizing angel funds as a distinct asset class, the regulator has legitimized angel investing in India. This is a big step. It will go a long way in fostering a stable and sustainable professional angel investing environment and encourage more angel investors to get into the system.

Let’s explore how that could happen:

  • More angels, better angels: The framework stipulates that individuals who invest in angel funds must invest a minimum of Rs 25 lakh over a three-year period and must have net tangible assets of at least Rs 2 crore. There are conflicting views on the Rs 25 lakh criteria. “This excludes lots of people who may want to invest a lower amount. If a fresh engineer wants to invest even Rs 1 lakh, as long as the angel fund is willing to accommodate, it should be fine,” says K Ganesh, serial entrepreneur and prolific angel investor. On the other hand, Ravi Kiran, founder of Mumbai-base startup accelerator VentureNursery says, “Rs 25 lakh over a three-year period is quite low. If you don’t have Rs 25-30 lakh, it is a disaster to expose yourself to such investments.” The minimum investment criteria helps with accountability but we agree with Ganesh on the prescribed amount being too high.
  • Many more angel funds: SEBI has set the minimum corpus of an angel fund at Rs 10 crore, which is small enough to enable more people to set up funds and large enough to ensure stability. This is very, very good news for entrepreneurs. SEBI has opened the doors for accelerators like VentureNursery and professional angel investor networks such as IAN and Mumbai Angels to set up their own angel funds. “Get ready for a few dozen such funds in the next few years,” says Anand Lunia, founder of early stage venture capital fund India Quotient, who has made several angel investments in the past. Angel funds set up by entities like IAN and Mumbai Angels will be particularly beneficial for startups. Currently, these entities operate as aggregators of HNIs, help them to source deals and advise them on transactions for a fee. The actual investments are made individually by each investor which means that the startup has to cope with 5-6 investors at a time, which can often be a really messy and exasperating affair.

Government and regulators should bat for all stakeholders equally

Despite the obvious benefits, SEBI’s moves largely benefit professional angel investors, specifically HNIs. Such investors represent less than 10 per cent of the overall angel investing activity in the country. Consider the facts. Delhi-based IAN, the country’s largest organized pool of professional angel investors, had invested only $19 million in 47-odd companies till December 2012, out of 18,000-plus applications reviewed. This is over a seven year period (IAN was born in 2006) and from capital pooled from more than 200 investors within the network. The ratios for other angel networks are not too different.

The vast population of Indian startups that are unable to pass muster with organized networks such as IAN, Mumbai Angels and Hyderabad Angels or other angel funds, still depend on individuals within their personal networks to bring in the first Rs 10-30-odd lakh. As mentioned earlier, capital raised through such sources continues to be subject to being taxed as income. Of course, there are ways around that problem. You can either raise the capital as convertible debt or make the uncle or friend from who you are raising capital an initial shareholder in the company. The other solution is to ‘convince’ the Income Tax officials that the premium at which you issued shares to the angel investor is justified.

But the really damaging stipulation that SEBI lays down, and which could negate all its good intentions, is that registered angel funds cannot invest less than Rs 50 lakh in a startup. The assumption is that the first Rs 50 lakh will come from the entrepreneur’s own resources, which would typically be family and friends and that brings us back to the income tax problem. SEBI cannot address the income tax issue but in preventing angel funds from investing less than Rs 50 lakh, the regulator is choking capital supply at the most critical stage of a startup’s life. Neither does it make it easy for small investors to invest through registered angel funds (because of the Rs 25 lakh minimum investment and Rs 2 crore net assets requirements).

Such requirements suggest that either the regulator is being naive or has been led to bat for professional angels groups and in turn larger venture capital firms. If SEBI’s and the government’s intention is to strengthen and foster angel investing in the long term — and we believe that to be the case — then they must take into account the interests of all stakeholders equally in the ecosystem. Entrepreneurs and small angel investors form the core of this ecosystem and it may be time for this constituency to flex some lobbying muscle of its own.

The original post was published here.

(c) StartupCentral 2013