Venture Capital — Bull-dozing a reluctant market regulator

The crux of the problem is simple. The Finance Minister in his budget speech promised a hassle-free environment for investment and disinvestment by Foreign Venture Capital Investors in India, and a total tax pass-through for SEBI registered Venture Capital Funds (VCFs). The guidelines now cleared by SEBI, however, say that VCFs who want to avail of tax benefits will have to off-load their holding within a year of listing.

The ridiculous linkage of tax benefits to exit norms takes away a benefit granted by Parliament through the Finance Bill, and also contradicts another SEBI rule which imposes a 12 month post-public offer lock-in on VCFs and other promoters. Under SEBI’s primary market rules, VCFs are forced to hold on to their investment for one year; if they follow that rule, they lose out on tax benefits because of the CBDT requirement that they divest their holding within a year. Nobody is quite sure when and how a VCF will haveto divest to get the tax concessions. Also, VCFs as well as companies will have little leeway to make their public offering in a buoyant stock market. The CBDT’s suggestion was apparently even more ridiculous. Sometime in August it suggested that VCFs should exit a company in six months of listing. After SEBI pointed out the contradiction with the lock-in rule, it extended this to one-year, even though it does not resolve the problem.

SEBI officials have repeatedly told Finance Ministry officials that the exit rule was absurd, illogical and inconsistent with the Finance Bill, but they were overruled. That the SEBI board was also induced to clear the guidelines is a great example of how much the finance ministry’s unthinking writ dictates the decision of the allegedly independent capital market regulator. It also demonstrates the utter contempt that the babus in CBDT and the Ministry have for all the long deliberations by Indian and foreign experts on creating a badly needed market for venture capital funding in India. Thursday’s meeting had only one agenda – to pass the venture capital guidelines, and the meeting opened with Kumar Mangalam Birla opposing the tax provisions. He was supported by Dr P L Sanjeeva Reddy, Secretary of the Department of Company Affairs, who is at other times is a fairly severe critic of SEBI. SP Talwar, Deputy Governor the Reserve Bank of India also supported Reddy’s views and Dr J R Varma, Member SEBI, went sofar as to ask for his dissent to be recorded.

Then the Finance Ministry representative conveyed to the group that the Government would like the guidelines cleared without unnecessary debate about the CBDT’s tax suggestions. It silenced the SEBI Board and the guidelines were cleared on the tacit understanding that if there is enough of an uproar they will be open to tinkering. In fact, the SEBI press release says – ‘some of the members of the Board felt that the mandated post listing exit time frame of one year for availing tax pass through by a domestic Venture Capital Fund could be reconsidered by the Government in the light of international experience and the need to avoid operational restrictions and optimise inflow of venture capital in the country’. In other words – prove our foolishness and we will change the rules. Venture capitalists are furious at this attitude. They say that already one of the biggest hurdles in raising venture funds overseas is the perceived “policy risk†in India – or the tendency of our policy-makers to force frequentchanges in the rules after the game has begun, which perverts investment planning. The Federation of Indian Chambers of Commerce and Industry (FICCI) has already kicked off the attack by calling the guidelines “retrogradeâ€. FICCI is not lobbying for VCFs, it is worried about the impact of the guideline on entrepreneurs.

Let us look at an example. Over 60 per cent of Portal X’s equity is held by VCFs. To avail of tax benefits the VCFs will have to dump the stock a year after listing and this is bound to send the price of this popular portal crashing. In fact, from now on it will be impossible for VC-funded company to be priced correctly at IPO because investors will know that the clock is ticking towards the 12 month deadline for VCFs to exit. Knowing this, investors are unlikely to buy the stock until the VCFs have exited.

On the one hand, when SEBI allowed IT, communications and entertainment companies to get listed by offering only 10 per cent of their equity capital, the low floating stock allowed them to extract higher value from the market. Now the exit clause for VCFs will force them to make a commitment about their holding period or the stock will lose their attraction. No VC would want to make such a commitment.

If a company cannot realise full market value, it will also make its Employee Stock Options unattractive. One venture fund manager says that he will simply not invest in companies incorporated in India anymore. Another plans to figure out ways of staying outside the SEBI framework. Some are looking at transferring their holding to other subsidiaries in order to avoid tax, but are not clear if this is workable. But everybody agrees that the guidelines will impact the flow of venture funds into the country. This is bad news for investors.

Today, every primary market is forced to be a venture capitalist because there aren’t enough of expert risk-takers doing the job. But then, the rule-making in India is unconcerned with what is good for the market and not decided by the experts. It is no wonder that Bill Gates after all the hype promised nothing more than a piffling investment of $ 50 million.

Author’s email: suchetadalal@yahoo.com