Is there an alternative to the current VC model?

As the traditional Venture Capital model falters, with both the GPs and LPs questioning if this is worth their time, maybe it is time to think if we can do this differently

A couple of seemingly unconnected trends can point us towards a format:

1. Emergence of angels/ Limited Partners who are keen to evaluate each investment opportunity separately
2. Technology platforms showcasing possible investment opportunities to investors, reaching out to a larger group through the platform. These entities aim to not just showcase projects but also provide in-depth benchmarking and analytics for informed investment decisions
3. The increasing blurring of responsibilities between an investment bank, whose responsibility used to end once the deal is done, and the venture capital fund who gets the carriage fees only on successful exits in its portfolio

Lets look at a new entity that enables investors to take individual calls on each investment, instead of pledging to a common fund, combining several roles currently played by different entities

How will the revenue and fee work for this combined entity?

Key to this model will be building of a strong technology platform that will allow disintermediation of these roles and also allow the new entity to engage with all stakeholders: owners, investors and eco-system players on a continued basis

We already see the emergence of several angel investment platforms in various classes of assets as a precursor towards this new entity. While all players are trying to figure the various aspects of the business, I see most of them morphing into some format of the new entity I mentioned above

What policy initiative would boost angel investing in India?

In absence of tax rebates for angel investments, capital gains tax parity with listed stock, is a key policy change that will help boost angel investments in new ventures in India

The recent Budget has mentioned that angel investor pools will now be able to organize themselves as a Category I Alternate Investment Fund.

As I had mentioned in an earlier post Angels can organize themselves in Category I AIF Fund, this measure looks set to be a non-starter because of limited applicability of the framework to individual angel investments

What are other countries doing?

Various countries primarily offer tax rebates or credits for angel investors who invest in start-ups and new ventures under varied formats

What could we do?

In India, we face a dichotomy as the government is currently tackling larger issues of tax compliance and non-reporting of wealth and income, so a rebate or a credit looks counter intuitive

A start could be made through capital gains tax parity

1.     Making capital gains tax on angel investments at par with capital gains tax on investments in listed companies or mutual funds

2.     Ability to set off profits from one investment with losses from another

Key is to differentiate between tax evasion and new venture funding 

The government’s concern that angel investments should not become another format for unaccounted money flowing into questionable companies is valid.

However, the key here will be to differentiate between investments made in small enterprises for the purpose of tax evasion and smart money invested in new ventures by angels who invest to grow fledgling ideas into companies

Defining new ventures and angel investments

The policy will require a robust definition for both new ventures and angel investments.

Some thoughts on this are:

Define new ventures as:

A company registered in the past 5 years

A company not promoted by another company/ group of companies with more than INR 25 crore annual revenue

Set limits for tax parity on angel investments as:

Maximum limit of INR 1 crore of investment per annum per individual

Investment to be done only as an individual and not as a company

Some more debate is required on how we could make both these definition more robust, do respond with your comments on this

Will more angels start investing only because of the capital gains parity?

Angels will not invest in riskier start-ups purely because of the parity, but this will ensure they are not deterred by the higher tax they will otherwise pay on their profitable investments

A stock market investor in India today expects a minimum of 15% on his investments, as opposed to a developed market where they might be happier with a lower rate.   

A new venture has to be able to provide at least 30% returns to to attract investments. This number actually gets compounded when one factors in the high rate of failures of new ventures and the lack of exit options for the investor.

Moreover, angels take a portfolio approach in their investments, expecting only 20-30% of their investments to make up for the losses of the rest of the companies.

Both the capital gains parity and a set off feature will better the investors’ chances of improving returns on new venture investment.

This will also ensure the angel investor is not getting discouraged by adverse taxation while deciding on an already risky investment option.

In conclusion

If the government is unable to look at these two measures currently, in my view it is best that angel investments be left to evolve on its own without too many policy frameworks.

Without a detailed thinking through, wrong policy making might actually become a hindrance to a fledgling source of clean and smart money flowing to new ventures.

Budget 2013: Angels can organize into Category I AIF Funds

The Budget 2013 proposes to allow angel investor pools to organize themselves into Category I Alternate Investment Funds (AIF). So how will this benefit the new venture ecosystem?

What does this mean? How is it different from current scenario?

Angel investors, who are currently investing into new ventures directly, will now be able to invest as a part of a single entity structured as a Category I Alternate Investment Fund (AIF). A Category I AIF Fund is a common classification for funds that invest in start-up or early stage ventures

How does it benefit angel investors?

Angel investors currently organize themselves into networks, take their individual calls on investment and then invest directly into companies as individual shareholders.

While we still need to see the details of this change, no major benefits or incentive seem to accrue to angel investors with this change.

A minor benefit will be the ability to invest as a single entity in new ventures instead of individual investors, which will facilitate monitoring, company interface and exits

A critical change for the VC funds investing in start-ups

The current AIF regulations require each investor to commit to a minimum investment size of INR  1 crore. This is a severe limitation for funds operating in the seed, angel and Series A stage investments for three reasons:

Most investors look at much smaller amounts at the initial venture stage, between INR 25-50 lakhs every year

This minimum size restriction inhibits the basic spirit of angel investing where the investor looks to invest smaller amounts in risky businesses, deploying not just money but also expertise and networks to help build new ventures into large companies

The seed stage ecosystem itself is evolving and might not be able to absorb large amounts of capital at once

The SEBI guidelines will however have to tackle some key points mentioned in the AIF Regulations to make this effective:

 Minimum investment of INR 1 Crore: If current minimum amount of INR 1crore is maintained, this move will fail to take off. The move will benefit only if the combined pool is treated as a single investor and there a minimum cap of INR 1 crore for each investment can be applied

Minimum corpus size issues: The rules have to address the two points of minimum corpus size of INR 20 crores and the management commitment of 2.5% of the corpus. Both these are not applicable in an angel network investment as there is no defined corpus and no management since members make their own investment choices

Separate Entity for each investment: The structure will work only if investors are allowed to form a separate legal entity for each investment they make. If the guidelines require the network to form a common corporate structure for all their investments, this will fail to take off as only some, and not all, of the angels invest in each specific venture. This will also need provisions for easy dissolution of the entity once the angel group exits the investment

Taxation Pass through: The Budget also mentions that new tax pass-through change for the Category I AIF fund will also apply to angel investors. This will be critical as currently angel investors do not have to tackle this issue as they invest directly into the companies

In conclusion, while this change might not directly benefit angel investors, if implemented properly will help remove several hurdles for the early stage VC Funds, enabling more India registered funds to power the funding requirement for the seed, start-up and early stage ventures.