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INDIA PRIVATE EQUITY AND VENTURE CAPITAL

LANDSCAPE 2016-17

ACCESSIBLE I RESPONSIVE I ADAPTABLE

INDIA PRIVATE EQUITY AND VENTURE CAPITAL LANDSCAPE 2016-17

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NOTE FROM RAJESH BEGUR 05

PE & VC 2016: THE YEAR IN FOCUS

INVESTMENT TRENDS: SECTORAL AND QUANTITATIVE ANALYSIS 07

REPRESENTATIVE DEALS OF 2016 16

DEVELOPMENTS IN THE REGULATORY LANDSCAPE 19

PE & VC SECTOR : KEY ISSUES, IN PERSPECTIVE

I. FUNDRAISING FOR STARTUPS: IS YOUR HOUSE IN ORDER? 34

II. LISTING VENUE FOR STARTUPS: ISSUES AND WAY FORWARD 36

III. FIVE EXIT CHALLENGES FOR VC AND PE INVESTORS 38

IV. KEY ASPECTS OF INTELLECTUAL PROPERTY RIGHTS FOR STARTUP'S 40

V. EMPLOYEE STOCK OPTIONS IN STARTUPS: ALL YOU NEED TO KNOW 42

VI. OPTION CONTRACTS: ENFORCEABILITY ISSUES 44

VII. NON-CONVERTIBLE DEBENTURES: ISSUES IN PRIVATE PLACEMENT 46

VIII. REAL ESTATE INVESTMENT TRUSTS (REITS) REGULATORY & TAXATION ASPECTS 48

IX. BRIEF OVERVIEW OF AIF REGULATIONS 52

X. IS DUMPING OF FOREIGN CAPITAL TO OFFER DISCOUNTS “ANTI COMPETITIVE”? 54

XI. PHARMACY - LEGAL SANCTITY? 57

INVESTOR SPEAK 61

SECTOR VIEWS & WISH-LIST FOR 2017 67

PE & VC SECTOR VIEW - 2017 68

POLICY & REGULATORY WISHLIST FOR 2017 72

TABLE OF CONTENTS

RAJESH N. BEGUR

FOUNDER & MANAGING PARTNERARA LAW


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“2016 HAS BEEN AN EVENTFUL YEAR WITH ANUNPRECEDENTED NUMBER OF EVENTS FROM BREXIT TOTRUMP’S VICTORY TO INDIA’S DEMONETIZATION. THESE

EVENTSHAVE CONTRIBUTED TO MARKET VOLATILITY AND ITS IMPACTHAS BEEN SEEN ACROSS ALL ASSET CLASSES,

MAKING THEINVESTING ENVIRONMENT MORE CHALLENGING. GIVEN THECHALLENGES AND RISKS THAT

EMERGE FROM 2016 ANDMOVE INTO 2017 THERE CAN BE NO BETTER TIME TOCAPITALIZE ON THE VALUE BASED INVESTMENT WHICH ISWHAT PE & VC IS ALL ABOUT!”

2016

Private equity deal volume and valueduring Q3 CY2016 declined 45%and 63% respectively, compared toQ3 FY2015, which is evident fromthe statistics provided under thesection on Investments by PE & VCin 2016. The sharp decline ininvestments can be attributed to thedeclining interest of investors inonline and e-commerce businessmodels, unstable valuations, lessthan expected improvement in easeof doing business and a challengingenvironment for exits due to lowervaluations.

RAJESH N. BEGUR

FOUNDER & MANAGING PARTNERARA LAW


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has been an eventful year with an unprecedented number ofevents from Brexit to Trump’s victoryto India’s demonetization. Theseevents have contributed to marketvolatility and its impact has beenseen across all the asset classes,making the investing environmentmore challenging.


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India was ranked 130 amongst 189 countries, on the World Bank’s DoingBusiness index for 2017, as against 134 in 2015. India does not have the luxuryto grow at this pace as this would certainly take a century for India to be at parwith developed nations. To foster a vibrant investment environment, both thecentral, state and local authorities will have to implement big bang reforms forfacilitating ease of doing business in India.

To attract more FDI in PE & VC space and otherwise, policymakers have over ayear made several attempts to address the concerns of startups and PE/VCinvestors, including relaxing conditions for foreign investments in trading infood products, investment in financial sector, defence sector and alternativeinvestment funds. Additionally, despite a number of positive steps undertakenby the government such as ‘Make in India’, ‘Digital India’, ‘Start up India’, ‘SkillIndia’ and so on, it has not been successful in increasing investor confidence.We have attempted to list out some of the ‘Significant Legal Developments inthe PE & VC sector’.

It is imperative that the Government bring about path breaking big bangreforms. The forthcoming budget could be a precursor to achieving theobjective including the implementation of the most awaited goods and servicestax (GST), the land acquisition bill, the tax regime rationalization and labourreforms. A select list of “Policy & Regulatory Wish-list for 2017” has beenhighlighted that requires immediate attention to ignite the investment cycle.

Renegotiated tax treaties by India with Countries like Mauritius, Singapore andCyprus, where the Capital Gains for investments after March 31, 2017 wouldbe taxed in India, would have far reaching effects on fund structuring fromthese jurisdictions. Further, other changes in domestic tax laws with theintroduction of Indirect transfer taxation, GAAR and Place of EffectiveManagement would create uncertainty on the taxation front for offshore fundsinvesting in India.

Other changes in domestic tax laws with introduction of Indirect transfertaxation, GAAR and Place of Effective Management would create uncertaintyon the taxation front for offshore funds investing in India.

Given the above challenges and risks there can be no better time to capitalizeon the value based investment which is what PE/VC is all about! Some of theinteresting sectors to look out for in 2017 include consumer and technology,fintech, health care, IT & ITES.

It is with great pleasure that we, along with our partners, present this PE & VCHandbook titled ‘INDIA PRIVATE EQUITY LANDSCAPE 2016-17’. I would like tothank our clients for their active and candid participation in sharing their insightsfor this book.

PE & VC 2016: THE YEAR IN FOCUSINVESTMENT TRENDS: SECTORAL AND QUANTITATIVE ANALYSIS


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Private Equity and Venture Capital investments into India have declined by almost 50% in2016 to US$10.34bn (based on data till mid-December 2016) after showing an all-timehigh of US$21.93bn in 2015. The decline was not only visible in the deal value, but alsoin the total volume of deals both in the PE and VC space. The e-commerce sector,specifically, witnessed a sharp fall in investments mainly due to a decrease in the valuationof companies.

PE & VC INVESTMENTS IN INDIA - 2016

Source: VCCEdge


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In terms of deal volume based on type of deal, 2016 witnessed a smaller number of dealshappening in both the PE and VC space. However, angel and early stage investments wereaffected much less than other types of investments. These trends clearly suggest thatinvestors wrote smaller cheques this year.


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Similarly, PE and VC investments in 2016 totalled US$4991mn and US$2567mn,respectively: a drop of more than 50% in total deal value compared to 2015.


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On a quarterly basis, there was a trend of falling PE investment activity. While Q1 2016 sawa total of US$4.1bn in investments (143 deals), the total investment activity decreased toUS$3.0bn in Q3 2016. A similar trend was also seen in big deals (US$100mn and above)during the course of the year. In fact, October and November 2016 witnessed investmentsof US$1.19bn (decline of 27% over the previous year) and US$0.9bn (decline of 50% overthe previous year). At the current pace, the 4th quarter is expected to close with US$3bn(143 deals).

Source: VCCEdge; Volume of deals extrapolated for Nov-Dec 2016 period, Value of deals extrapolated for Dec 2016


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IT & ITES, consumer discretionary, industrials and financials attracted the highest amountof investment throughout the year. On the other hand, sectors like real estate andinfrastructure showed encouraging signs of deal activity in the year 2016. The real estatesector, in the first nine months of 2016, saw commitments of $4.2bn, an increase of20% from the same period last year, according to a report by Cushman & Wakefield andthe Global Real Estate Institute.1 The potential to list under real estate investment trusts(REITs) led to a growing interest in leased office assets in an otherwise residential sectordominated asset class.

1 http://www.livemint.com/Companies/cXQlCRxeyGse1nVSiEcQpI/PE-investments-in-real-estate-set-to-touch-72-billion-in-2.html

The value ofinvestment in IT & ITES wasUS$3.2bn across 715 deals.

Share of the sector intotal PE investment inthe year has beenmaintained ataround 30%

Source: VCCEdge

The value ofinvestment inconsumerdiscretionary wasUS$1.5bn across 210 deals.

Share of the sector intotal PE investment inthe year was around15%.

Source: VCCEdge

The total value of PEinvestment in BFSIsector in the 2016was US$2.6bn, agrowth of around40%

The sector is expectedto continue to attractinvestment in thenext year.

Source: VCCEdge

Private equity (PE)investment in realestate is estimated totouch $7.2bn in2016, up 53% from2015.

Status as onSeptember 2016:• Total investment: $4.2bn• Domestic Funds: $2.9bn; Foreign Investors: $1.15bnResidential to Commercial Ratio = 54% to 46%

Source: Cushman & Wakefield and the Global Real EstateInstitute

TRENDS IN PE INVESTMENTS BY SECTOR


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The private equity exits began on a slow note in 2016. The first quarter of the year sawa total deal value of US$265mn (59 deals). Though the total deal value picked up pacein the second quarter (US$1.3bn), the total number of deals (58 deals) remainedsubdued. The same trend was visible in the July-September period when number ofprivate equity exits hit the lowest in the past 17 quarters but a few big-ticket deals donethrough the strategic route inflated the quantum of the transactions which hit a highof US$2.08bn.

Though the year started with M&A being the preferred route for exit, the July-Septemberquarter witnessed higher exits through the IPO route. The private equity backed IPO tallytouched 12 till September 2016, which is the highest in the past five years. Some of thePE players who diluted their holdings through IPOs include marquee names like SequoiaCapital, Helion Venture Partners and Sarva Capital (Earlier known as Lok Capital II LLC).

Source: VCCEdge

PE EXITS IN INDIA - 2016


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START-UP FUNDING

Investment in start-ups also saw a significant change in the current year as compared tothe previous year. In terms of statistics, the number of deals fell by (28%) and value ofdeals fell by (44%).

Though, the first quarter saw investors backing startups (number. of deals were morethan that in Q1 2015), both deal value and volume dropped significantly across all theremaining three quarters of the current year. The size of deals also got significantlysmaller as angel and early stage funding were much higher than late stage funding.

Source: VCCEdge


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Source: VCCEdge

In terms of segment funding, fintech lead in terms of number of deals, followed byhealthtech. Overall, the highest amount of funding continues to be attracted byconsumer technology start-ups, though the investors have become more selective intheir investment decisions.


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The year 2016 saw some very interesting deals taking place in the PE & VC sector. However, investorsremained cautious of the valuations at which the deals were being closed. ARA LAW, an expert in thesector, managed to close a series of deals in an otherwise dull environment. Some of the publishabledeals that ARA LAW has represented include:

REPRESENTATIVE DEALS OF 2016

Investor(s)� Kalaari Capital Partners III, LLC;� GVK Davix Technologies Private Limited

Target CompanyRKSV Securities India Private Limited

DescriptionThe deal involved investment by KalaariCapital Partners III, LLC and GVK DavixTechnologies Private Limited in RKSVSecurities India Private Limited wherein theproprietary and commodity tradingbusinesses of the Company were hived offfrom the Target Company, as a part of therestructuring of the Target Company so as toremain in compliance with FDI norms.

Round of InvestmentSeries A

Investor(s)� Kalaari Capital Partners III, LLC;� SIDBI Venture Capital LimitedTarget Company� Holachef Hospitality Private Limited

DescriptionThe deal involved investments by SIDBIVenture Capital Limited and furtherinvestment by Kalaari Capital Partners III, LLCin Holachef Hospitality Private Limited.Round of InvestmentSeries B1

Investor(s)� Malabar India Fund Limited and � Malabar Value FundTarget CompanyNeuland Health Science Private Limited

DescriptionThe deal involved investment by Malabar IndiaFund Limited and Malabar Value Fund inNeuland Health Science Private Limited by wayof share purchase, which contained structuringchallenges and finalization of definitivedocuments within exacting timelines.Round of InvestmentSecondary sale of shares

Investor(s)� JungleVentures

Target CompanyPaysense Pte Limited and its Indian Subsidiary

DescriptionThis deal involved investment by Jungle Ventures IIInvestment Holding Pte. Ltd along with otherinvestors in Paysense Pte. Ltd., a private limitedcompany incorporated in Singapore with a subsidiaryin India engaged in the business of developingsoftware and activities for payment, lending andcredit solutions to customers through anonline/android based platform wherein FDIallowance as well as local regulatory aspects of theIndian subsidiary were deeply analyzed.

Round of InvestmentSeries A

� Represented by ARA LAW


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Investor(s)� Kalaari Capital Partners III, LLC;� India Quotient 2Target CompanyHolachef Hospitality Private Limited

DescriptionThe deal involved investment by KalaariCapital Partners III, LLC and India Quotient 2in Holachef Hospitality Private Limited, apopular online restaurant engaged inpreparation of meals and delivery of thesame through its mobile application andwebsite wherein regulatory concerns wereanalyzed in relation to the e-tail storetrading third party food products throughan inventory.Round of InvestmentSeries B

Investor(s)� Greenvisor CapitalTarget CompanyGet Simpl Technologies Private Limited

DescriptionInvestment by Greenvisor Capital in relationto its pre-series A round of investment inthe Target Company. This transactioninvolved prolonged negotiations andfinalization of definitive documents andclosing within exacting timelines.Round of InvestmentPre-series A round

Investor(s)� Ventureast Life Fund III & � Ventureast Trustee Company Pvt. Ltd.Target CompanyEMBL Retail, Inc. (a US company) and itsIndian Subsidiary.

DescriptionThe deal involved investment by Ventureastin the US Holding Company and in theIndian Subsidiary through a domesticinvestment vehicle wherein a treasury poolwas created by the Holding Company so asto accommodate the exit by Ventureastfrom the Indian Subsidiary at the same exitprice as that of the exit from the USHolding Company.Round of InvestmentSeries seed


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The year 2016 saw may legal developments brought about by SEBI, RBI and DIPP with respect to the PE& VC sector. Below are the month-wise relevant updates starting January 2016 till November 2016.

JANUARY

2016Increase in Liberalised Remittance Scheme (LRS) Limits

FEBRUARY

2016E- Reporting under FDI Scheme

The LRS limit has been revised up to USD2,50,000/- per Financial Year (April-March) for anypermitted current or capital account transaction ora combination of both. The LRS allows residents toacquire and hold shares, debt instruments or other

assets outside India without prior approval of theRBI. With the improvement of the forex situationin India such an increase will open gateways formore investments outside India.Source: RBI - FED Master Direction No.7/2015-16

W.E.F February 8, 2016 the physical filing of formsARF, FC-GPR and FC-TRS will be discontinued andforms submitted in online mode only through e-Biz portal will be accepted.This will make the reporting of transactions under

the FDI faster, convenient and more efficient for theinvestors. Also going forward in the long run, it willbe a more efficient mode of preserving all recordsand filings by the authorities.Source: RBI- A.P. (DIR Series) Circular No.40

• A Start-up in India with an overseas subsidiary ispermitted to open a foreign currency accountabroad to pool the foreign exchange earningsout of the exports/sales made by the concernedstart-up.

• The overseas subsidiary of the start-up is alsopermitted to pool its receivables arising from thetransactions with the residents in India as well asthe transactions with the non-residents abroad

into the said foreign currency account openedabroad in the name of the start-up.

• A start-up is also permitted to avail of the facilityfor realising the receivables of its overseassubsidiary or making the above repatriationthrough Online Payment Gateway ServiceProviders for value not exceeding USD 10,000.

Source: RBI- A.P. (DIR Series) Circular No. 51

Regulatory relaxations for start-ups [relating to acceptance of payments]

DEVELOPMENTS IN THEREGULATORY LANDSCAPE


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Following issues related to issue of shares withoutcash payment by the investor were clarified:• Issue of shares without cash payment through

sweat equity: Indian companies may issue sweatequity, subject to conditions of the schemedrawn in terms of applicable laws mentioned.

• Issue of shares against legitimate payment owed:Indian companies may issue equity shares against

any other funds payable by the investee company(e.g. payments for use or acquisition ofintellectual property rights, for import of goods,payment of dividends, interest payments,consultancy fees, etc.), remittance of which doesnot require prior permission of the Governmentof India or RBI.


Regulatory relaxations for start-ups [relating to issue of shares]

SEBI ICDR Regulations have been amended toprovide for exit offers by promoters to shareholderswho have voted against the resolution for change inobjects or variation in terms of a contract, referredto in the prospectus of the issuer. Eligibilityrequirement, exit price, manner of exit, etc. havebeen provided for. This amendment takes care of the interests of the

investors and makes sure they have a way out if theresolution voted for is against their best interests. Inthis way, the investors are not stuck in the Companywhich is managed against their wishes. Consideringthat easy exit options have always been one of themajor requirements for the investors, thisamendment will give a boost to the investors’ rights.Source: RBI- A.P. (DIR Series) Circular No. 52

Exit option to Dissenting Shareholders

FDI up to 49% under automatic route has beenpermitted. Please note that additionally suchinvestment in Pension Sector is regulated by PFRDAAct, 2013 and therefore the FDI in this sector is

subject to fulfilment of the conditions laid downby the same.

Source: DIPP Press Note 2

E- Reporting under FDI Scheme

The limits for investment by FPIs in CentralGovernment Securities and state developmentloans have been increased from an aggregate ofINR 1865 Billion to INR 2005 Billion from April 04,2016 and INR 2140 Billion from July 05, 2016.The limits for the long term investors remaining

unutilized at the end of half year ending Sept 30,2016 will be released for investment under theopen category in October, 2016.

Source: RBI- A.P. (DIR Series) Circular No. 55; SEBIIMD/FPIC/CIR/P/2016/45

As per the current guidelines, 100% FDI ispermitted under automatic route for market placemodel. However, it has been clarified that no FDIis permitted in inventory based model. The

guidelines have also, in a consolidated manner,reiterated the recent amendments made in the E-Commerce sector last year including (i) FDI up to100% under automatic route is permitted in B2B

Investment by Foreign Portfolio Investors (FPI) in Government Securities

FDI in E-Commerce (Guidelines)

MARCH

2016


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model; (ii) No FDI permitted under B2C modelexcept as provided.DIPP further clarified that the e-commercemarketplace may provide support services to sellersin warehousing and logistics. This move has alsobrought a long overdue clarity on the definition ofthe term ‘marketplace format’. Such a move by theFDI is sure to lure in foreign investors.The significance of these guidelines lies in theimpact of the restriction of not effecting more than25% of the sales from any single vendor and its

group companies and the obligation to maintain alevel playing field with regard to pricing ofgoods/services, on the current business modeladopted by the e-commerce companies. Anothercritical condition introduced seems to be regardingmarket competition, where the Guidelines simplystate that "E-Commerce entities providingmarketplace will not directly or indirectly influencethe sale price of goods and services and shallmaintain level playing field."Source: DIPP Press No. 3

• Companies in infrastructure sector, Non-BankingFinancial Companies - Infrastructure FinanceCompanies (NBFC-IFCs), NBFCs-Asset FinanceCompanies (NBFC-AFCs), Holding Companiesand Core Investment Companies (CICs) will alsobe eligible to raise ECB under Track I withminimum average maturity period of 5 years,subject to 100 per cent hedging.

• NBFCs-IFCs and NBFCs-AFCs will be allowed toraise ECB only for financing infrastructure.

Holding Companies and CICs shall use ECBproceeds only for on-lending to infrastructureSpecial Purpose Vehicles.

• Companies in infrastructure sector, HoldingCompanies and CICs will continue to have thefacility of raising ECB under Track II of the ECBframework.

• The individual limit of borrowing of USD 750 Mshall be applicable.


Relaxation of ECB norms for Infrastructure Sector

Limit on foreign investment in insurance sectorincreased from 26 to 49 percent under theautomatic route. It will help this sector in beingable to raise more capital from overseas. As the

sector expands, it will also lead to an increase inthe number of jobs in the sector.


Increase in FDI limits in Insurance Sector

Clarified that keeping deposits with an Indiancompany by persons’ resident outside India, inaccordance with section 160 of the Companies Act,2013, is a current account (payment) transaction

and, as such, does not require any approval fromRBI.

Source: A.P. (DIR Series) Circular No.59

• Self-certification of APRs is sufficient in case ofresident individuals;

• In case multiple resident parties have invested inthe same overseas JV / WOS, the obligation to

Acceptance of deposits by Indian companies from a person residentoutside India for nomination as Director

Overseas Direct Investment – Clarification and relaxations on submission of Annual Performance Report (APR)

APRIL

2016


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submit APR shall lie with the investor havingmaximum stake in the JV / WOS, unless mutuallyagreed.

• An APR in Form ODI Part II in respect of each JV

/ WOS outside India and other reports ordocuments to be submitted to AD by 31st ofDecember each year.


• A new reporting format has also beenintroduced for Venture Capital Fund (VCF) /Alternate Investment Fund (AIF), PortfolioInvestment and overseas investment by MutualFunds.

• Any post investment changes subsequent to theallotment of the UIN are required to be reportedas indicated in the operational instructions onsubmission of Form ODI Part I

• Self-certification by the resident individualconcerned may be accepted.

• Online OID application has been revamped tofurther reduce the traditional paper based filingsystem.

• The rationalised and revised Form ODI will beapplicable now.


Overseas Direct Investment – Rationalization of reporting obligations

In order to streamline procedures for issuance ofdebt securities on private placement basis andenhance transparency to discover prices, aframework for issuance of debt securities on

private placement basis through an electronic bookmechanism has been laid down.

Source: SEBI CIR/IMD/DF1/48/2016

Electronic book mechanism for issuance of debt securities on privateplacement basis

IDF-NBFCs were allowed to raise resources throughissue of bonds of a minimum of five-year maturity.Now IDF-NBFCs are allowed to raise funds throughshorter tenor bonds and commercial papers (CPs)

from the domestic market to the extent of 10% oftheir total outstanding borrowings.

Source: DNBR(PD).CC. No.079/03.10.001/2015-16

Relaxation for investment norms for Infrastructure Debt Fund-Non-Banking Financial Companies (IDF-NBFCs)

Amongst other amendments,• An amendment by way of insertion of a new

revised Schedule 6 dealing with the manner ofinvestment by FVCIs has been introduced.

• “Start-Ups” have been included as a separate

category. ‘Startup’ has been defined to mean anentity, incorporated or registered in India not priorto five years, with an annual turnover notexceeding INR 25 Crores in any preceding financialyear, working towards innovation, development,

Foreign Exchange Management (Transfer or Issue of Security by a PersonResident outside India) (Third Amendment) Regulations, 2016

Foreign investment in the units of InvestmentVehicles registered and regulated by SEBI or anyother competent authority (REITs, InvITs, AIFs) has

been allowed subject to conditions provided in thecircular.Source: A.P. (DIR Series) Circular No.63

Foreign Investment in units issued by Real Estate Investment Trusts,Infrastructure Investment Trusts and Alternative Investment Funds

governed by SEBI regulations


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deployment or commercialization of newproducts, processes or services driven bytechnology or intellectual property, provided that

such entity is not formed by splitting up, orreconstruction of a business already in existence.

Source:Notification No. FEMA.363/ 2016-RB

Amongst other amendments,• No tax on income from start-ups: a 100%

deduction of profits for 3 out of 5 years for start-ups, during April, 2016 to March 2019, withcertain riders will be available. To promoteinnovation, a special patent regime with a 10%rate of tax on income from worldwide, toprevent the exploitation of patents developedand registered in India was proposed.

• While listed companies do not attract LTCGbeyond a holding period of 12 months, unlistedcompanies (read start-ups and privately held)companies attract 20% till a holding period of 3years. The Finance Minister has now reduced theholding period from three to two years to getbenefits of long term Capital Gain regime in caseof unlisted companies.

• NBFCs- deduction to the extent of 5% of itsincome in respect of provision for bad and

doubtful debts.• To get more investment in Asset Reconstruction

Companies (ARCs), which play a very importantrole in resolution of bad debts, a complete passthrough income-tax to securitization trustsincluding trusts of ARCs has been proposed. Theincome will be taxed in the hands of the investorsinstead of the trust.

• The Prime Minister had in his Start-up India planmentioned that 1-day incorporation via a mobileapp would be possible. This is an importantproposal and would be a big boost for aspiringentrepreneurs, if it can be pulled off. As of now,it takes anywhere between 15 and 30 days for acompany to get incorporated.

• “Make in India” initiatives: measures aimed atincreasing ease of doing business andencouraging manufacturing in India.

Start Up India Plan

Earlier Limit: FDI limit increased to 100% of paidup capital of ARC (FDI +FII/FPI) –automatic up to49%.

Revised Limit: FDI limit increased to 100% underautomatic route.Source: DIPP Press Note 4

FDI in Asset Reconstruction Companies (ARCs)

Higher FDI limits as under, to entities which havean established track record of running a Credit

Information Bureau in a well regulatedenvironment:

Investment in Credit Information Companies (CICs)

The revised DTAA provides for changes in the taxregime including, inter alia, change of basis to“source” instead of “residence” and hence thisamendment effectively takes away the capital gainsexemptions that were available by investing

through the Mauritius route.The Protocol will be effective for investments madeon or after April 01. 2017. Similar amendments inIndo-Singapore DTAA are also expected soon.Source: Press Release dated May 10, 2016 by CBDT

Amendment to Indo-Mauritius DTAA

MAY

2016


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• up to 49% if their ownership is not welldiversified (i.e., one or more shareholders eachhold more than 10% of voting rights in thecompany)

• up to 100% if their ownership is well diversifiedor if their ownership is not well diversified, atleast 50% of the directors of the investee CIC inIndia are Indian nationals/ Non-Resident Indians/Persons of Indian Origin subject to the conditionthat one third of the directors are Indiannationals resident in India.

• The investor company should preferably be alisted company on a recognized stock exchange.

FII/FPI investment would be permitted subject tothe conditions (i) a single entity should directly orindirectly hold below 10% equity; (b) anyacquisition in excess of 1% will have to be reportedto RBI as a mandatory requirement; (c) FIIs/FPIsinvesting in CICs shall not seek a representation on

the Board of Directors based upon theirshareholding.In case the investor in a Credit InformationCompany in India is a wholly owned subsidiary(directly or indirectly) of an investment holdingcompany, the above conditions will be applied tothe operating group company that is engaged incredit information business and has undertaken toprovide technical know-how to the CreditInformation Company in India.Please Note: As per Consolidated FDI Policy of June2016, FDI up to 100% under automatic route isapplicable to CICs. This is subject to otherconditions including (i) regulatory clearance fromRBI, (ii) conditions on FII/FPI investment asmentioned above and (iii) compliance with CreditInformation Companies (Regulation) Act, 2005

Source: DBR.CID.BC. No.98/20.16.042/2015-16

The Insolvency and Bankruptcy Code 2016, animportant reform to make it easier to do businessin India, was passed this year. With this, investors

will find it simpler to wind up non-performingbusinesses quickly and easily.

Insolvency and Bankruptcy Code 2016

The amendment provides that in a transactioninvolving purchase of shares of an Indian companyby a non-resident buyer from a resident seller, orvice versa, the consideration may be paid on adeferred basis subject to the following conditions:• The deferred component of consideration must

not exceed 25% of the total consideration• Such deferred payment must be made within a

maximum period of 18 months from the date ofthe share transfer agreement

Such deferred consideration may be structuredeither through an escrow arrangement or througha seller indemnity (in a case where the entirepurchase consideration has been paid up-front).Any deferred consideration mechanism which doesnot meet the restrictions as to the amount (i.e. upto 25% of the total consideration) or duration (i.e.no longer than 18 months) would continue torequire the approval of the RBI.Source: Notification No.FEMA.368/2016-RBI

Deferred Consideration in Cross-Border Share Purchase Transactions Allowed

Restriction may be imposed when there arecircumstances leading to a systemic crisis or eventthat severely constricts market liquidity or theefficient functioning of markets such as liquidityissues, operational issues, market failures andexchange closures. Mutual funds can currentlyimpose restrictions on redemption after approval

from the board of the AMC and trustees.This neworder of the SEBI will prevent AMCs from freelyimposing limits on redemptions in any of theirschemes at any time, merely with a board ortrustee approval which is a very investor friendlymove as their redemption rights will be protected.Source: SEBI/HO/IMD/DF2/CIR/P/2016/57

Restrictions on Redemption of Mutual Funds


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Regulations in relation to constitution/management of IPF, utilization of IPF, andcontribution of IPF have been prescribed.

Source: SEBI/HO/MRD/DP/CIR/P/2016/58 dated June 07,2016&SEBI/HO/CDMRD/DEICE/CIR/ P/2016/94 datedSeptember 26, 2016

Regulation of Investor Protection Fund (IPF) of depositories

With a view to rationalizing and expediting theprocess of giving approval, it has been decided thatECB proposals received in the RBI above a certainthreshold limit (re-fixed from time to time) beplaced before the Empowered Committee. The RBI

will take a final decision in the cases taking intoaccount the recommendation of the EmpoweredCommittee.

Source: A.P. (DIR Series) Circular No. 80

ECB- Faster approval process

• RBI had earlier permitted Indian corporates toissue Rupee denominated bonds overseas withinthe ceiling of FPI investments in corporate debt.

• Foreign investments in Overseas Rupeedenominated bonds shall now be reckonedagainst the Combined Corporate debt limit ofINR 244,323 Cr. However, these investments shall

not be treated as FPI investments and hence shallnot be under the purview of the SEBI (ForeignPortfolio Investor), Regulations, 2014

• The entire Combined Corporate debt limit of INR244,323 Cr shall be available on tap forinvestment by foreign investors.

Source: SEBI/HO/IMD/FPIC/CIR/P/2016/67

Foreign Investment in Rupee denominated bonds issued overseas byIndian Corporates

Under Regulation 24 of the Delisting regulationsthe whole time directors, promoters andcompanies promoted by such individuals shall notaccess the securities market for a period of 10 yearsfrom the date of such delisting.

Regulation 23(3) requires promoters to acquiredelisted equity shares from public shareholdersprovided that such shareholders have the optionof retaining their shares. The value of these sharesis to be determined by an independent evaluator

Restrictions on Promoters and Whole Time Directors of CompulsorilyDelisted Companies Pending Fulfilment of Exit Offers to the Shareholders

JUNE

2016

AUGUST

2016

SEPTEMBER

2016


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that is appointed by the Stock Exchange fromwhich the company has been delisted.In addition to the existing restriction imposedunder Regulation 24 of the Delisting Regulations,in order to ensure effective enforcement of exitoptions to the public shareholders in case ofcompulsory delisting and taking into account theinterests of investors it was found necessary by SEBIto strengthen the relevant regulatory mechanisms.To this end the following regulations now apply tocompanies whose fair value is positive:• The equity shares held by the promoters /

promoting group shall not be transferred and allcorporate benefits accruing to these shares suchas dividend shall be frozen, till an exit option incompliance with Regulation 23(3) of thedelisting regulation is not provided to publicshareholders

• The promoters and whole time directors of sucha delisted company shall not be eligible tobecome directors until the exit option specifiedabove is provided.

Source: SEBI/HO/CFD/DCR/CIR/P/2016/81

With a view to make the process of transmissionof Securities more efficient and investor-friendly,SEBI had issued a circular dated October, 2013.After receiving comments by the investors however,the SEBI through this latest circular tried to removethe discrepancies in its earlier circular by modifyingclause 2 of Annexure-A.

It has been now clarified that the affidavit isrequired for the identification and claim of legalownership to the securities. Clarity has also beenbrought with regards to the required successioncertificate/ probate of Will, henceforth removingthe difficulty in interpreting those terminologies.Source: SEBI/HO/MIRSD3/CIR/P/2016/0000000085

Standardization and simplification of process of share transmission

• SEBI tightened corporate governance norms oncompensation agreements between promotersand private equity (PE) funds so that theywouldn't cut other shareholders out of the loopand allowed foreign portfolio investors to invest

directly in corporate bonds without a broker. • The markets regulator also approved raising the

ceiling on shares reserved for employees in publicissues to `5 lakhs from `2 lakhs.

Corporate governance norms on compensation agreements betweenPromoters and private equity (PE) funds

• No RBI approval required by a SEBI registeredFVCI.

• Investment permitted in equity or equity linkedinstrument or debt instrument issued by anIndian company whose shares are not listed ona recognised stock exchange at the time of issueof the said securities/instruments and engagedin any of the prescribed sectors.

• FVCI can invest in equity or equity linked

instrument or debt instrument issued by anIndian 'startup' irrespective of the sector in whichthe startup is engaged.

• FVCI can also invest in units of a Venture CapitalFund (VCF) or of a Category I AIF (Cat-I AIF) orunits of a Scheme or of a fund set up by a VCFor by a Cat-I AIF.


Liberalization of norms of investment by a Foreign Venture Capital Investor(FVCI) registered under SEBI (FVCI) Regulations, 2000

OCTOBER

2016


30

NOVEMBER

2016


31

Foreign investment up to 100% under theautomatic route in ‘Other Financial Services’ ispermitted.Other Financial Services will include activities whichare regulated by any financial sector regulator viz.RBI, SEBI, IRDA, PHRHDA, NHB or any otherfinancial sector regulator as may be notified by the

Government of India in this regard. Such foreign investment shall be subject toconditions, including minimum capitalisationnorms, as specified by the concerned Regulator/Government Agency


Foreign investment in Other Financial Services

To simplify the procedure relating to ECB, it hasbeen decided to delegate the powers to designatedAD Category-I banks to approve requests fromborrowers for extension of matured but unpaidECB, subject to the prescribed conditions.

Powers are also delegated to designated ADCategory – I banks to approve cases of conversionof matured but unpaid ECB into equity subject tosame prescribed conditions.Source: A.P. (DIR Series) Circular No.10

Further simplification of ECB approval process

• The fourth Bi-monthly Monetary Policy Statementfor the year 2016-17 released on October 04,2016 has permitted Startup enterprises to accessloans under ECB framework.

• The borrowing per Startup will be limited to USD3 million or equivalent per financial year either in

INR or any convertible foreign currency or acombination of both.

• Regulations on eligibility, maturity, recognizedlenders end uses, conversion to equity andguarantee obligations have been prescribed by RBI.


ECB by Start Ups

The revised DTAA provides for changes in the taxregime including, inter alia, source based taxationof capital gains arising from alienation of sharescomprising more than 5% of share capital.

The Protocol will be effective for investments madeon or after April 01. 2017.

Source: Press Release dated October 26, 2016 by CBDT

Amendment to Indo-Korea DTAA

• As announced in the Union Budget 2016-17, ithas been decided to expand the investmentbasket of eligible instruments for investment byFPIs under the corporate bond route to includeunlisted corporate debt securities in the form ofnon-convertible debentures/bonds issued bypublic or private companies subject to prescribedconditions.

• Investment by FPIs in unlisted corporate debt

securities and securitised debt instruments shallnot exceed INR 35,000 Cr within the extantinvestment limits prescribed for corporate bondsfrom time to time, which currently is INR2,44,323 Cr.

• Further, investment by FPIs in securitised debtinstruments shall not be subject to the minimum3-year residual maturity requirement.


Investment by FPI in corporate debt securities


32

General Health insurers have been given thefreedom to invest out of their funds abroad,without prior approval of the RBI subject to twoconditions (i) Statutory requirements of the hostcountry; and (ii) IRDAI regulations, if any and in

accordance with applicable FEMA regulationsrelating to investments abroad.

Source: RBI/2016-17/137 A.P. (DIR New Series) CircularNo.18 [(1)/12 (R)]

Investments by General Health Insurers

SEBI Board has approved the followingamendments related to Angel Investors:• The upper limit for number of angel investors in

a scheme is increased from forty-nine to twohundred.

• The definition of startup for Angel Funds’investments will be similar to definition of DIPPas given in their startup policy. Accordingly,Angel Funds will be allowed to invest in startupsincorporated within five years, which was earlierthree years.

• The requirement of minimum investmentamount by an Angel Fund in any venture capitalundertaking is reduced from �`50 lakhs to �`25lakhs.

• The lock-in requirements of investment made byAngel Funds in the venture capital undertakingis reduced from three years to one year.

• Angel Funds are allowed to invest in overseasventure capital undertakings upto 25% of theirinvestible corpus in line with other AIFs.

Source: PR No. 161/2016, SEBI Board Meeting

Amendments relating to Angel Investors

• With the GST, there will just be one registration,a common tax rate. Complete uniformity. Foraccounts departments, tax payment will be muchsimpler, as will return filing.

• Lower Taxes on Small Businesses: With the GST,however, tax burdens will be heavily reduced forbusinesses with a turnover of `10 lakhs to `50lakhs, and those with revenue of `10 lakhs neednot apply for GST at all.

• Easier Business Expansion: A VAT registration isrequired in every state one wants to operatefrom and this creates a hurdle in terms ofbusiness expansion. With a central law, havingthe same rate of tax everywhere, this hurdle getsremoved quite a lot. GST requires theentrepreneurs to get only one license for theircompany and with only one license you can dobusiness in any number of states. Businessexpansion will now become seamless.

Goods and Service Tax (GST) (To be implemented from April 01, 2017)

The Union Cabinet on August 31, 2016 hadapproved the scheme for grant of PermanentResidency Status (PRS) to foreign investors subjectto the relevant conditions as specified in the FDIPolicy and other rules notified by the Governmentfrom time to time. The Union Cabinet has nowreaffirmed the same vide a press release datedNovember 29, 2016. The detailed rules are yet to

be notified.In order to get the permanent residential status, aforeign investor must fulfil the following additionalcriteria (i) bring a minimum of �10 crores within18months or �25 crores within 36 months (ii) foreigninvestment should result in generatingemployment for 20 residents in a financial year.Source: Press Release dated November 29, 2016

Permanent residency status to foreign investors

Like the revised Indo-Mauritius DTAA, the revisedIndo-Cyprus DTAA, inter alia, provides for thesource-based taxation of capital gains arising on

alienation of shares.

Source: Press Release dated November 18, 2016 by CBDT

Amendment to Indo-Cyprus DTAA

PE & VC SECTOR: KEY ISSUES, IN PERSPECTIVE


34

As per a 2015 survey by Nasscom (the National Association of Softwareand Service Companies) India has paved the way to secure the thirdposition in the world with three to four startups emerging every day,primarily in the areas of e-commerce, consumer services andaggregators. The report also states that total funding in 2015 hadgrown by about 125% from a year earlier. Various campaigns launchedby the government – Start Up India, Make In India, Digital India,National Policy for Skill and Entrepreneurship – and various other policymeasures in the form of tax rebates have contributed to a favourablestartup ecosystem.

A startup may seek funding for varied reasons. Funding can providecapital required to back its business plan or the pace at which it aimsto grow, visibility and reputational benefits, a mentor that willconstantly guide it in making critical business decisions, risk allocationand other benefits.

Legal due diligenceA startup may go through various stages of fundraising, includingangel funding, seed round funding and growth/early stage funding.After the angel funding stage, an important exercise that a startup willhave to go through during a fundraising process, after having executeda term sheet, is a legal due diligence.

A legal diligence exercise is typically conducted at the seed and thegrowth/early stage rounds of funding and identifies: (a) risks associatedwith the investment; (b) a risk mitigation plan; and (c) a list of itemsthat would need to be inserted in the definitive documents in thenature of conditions precedent to funding, conditions subsequent,representations and warranties to be obtained from the founders, andindemnities.

Most startups spend a lot of time developing their business and tendto neglect various legal and regulatory compliances. The importanceof a legal diligence cannot be underestimated given that the investorwill not write the cheque until they are satisfied with the outcome ofa legal diligence. Given the above it is important for startups to puttheir house in order before commencing fundraising initiatives.

Key aspectsA legal due diligence on a startup will cover five main areas: (a) captable; (b) regulatory; (c) intellectual property; (d) agreements; and (e)employment.

Cap table: This includes a thorough check on the issued and paid-upshare capital of the startup. Startups often fail to make importantfilings with the Registrar of Companies or other regulatory bodies andhave many small shareholders. It is important for a startup to have aclean and a short list of shareholders on its cap table as the lack ofsuch a list could be a nuisance during subsequent rounds of funding.

I.FUNDRAISING

FOR STARTUPS: ISYOUR HOUSE IN

ORDER?


35

Regulatory: Obtaining appropriate registrations and approvals for thenature of the business is also very important. Startups often tend totake risks at the early stages, which come to haunt them when theygrow. It is imperative for startups to seek appropriate legal advice atthe inception stage. Another regulatory aspect to be considered incases of foreign investment is the foreign direct investment norms.Since most startups operate in the area of business-to-consumer e-commerce, some structuring could be needed to facilitate theinvestment.

Intellectual property: It is important for startups to ensure that theintellectual property which is a valuable asset of the company isprotected adequately. This may include registering the intellectualproperty and entering into detailed employment agreements,containing comprehensive intellectual property assignment clauses,with members of the research and engineering team. Founders shouldalso ensure that they are not violating any employment terms of anyprevious employers. Startups often fail to take adequate steps toprotect their intellectual property.

Agreements: It is important for startups to document theirarrangements with suppliers, vendors, consultants, etc. Startupsgenerally are lax and fail to put in place formal arrangements with thirdparties, which could help resolve a dispute.

Employment: Various labour laws impose penalties for non-compliance,in view of which it is important for startups to understand theapplicability and compliance requirements of the relevant labourstatutes.

ConclusionThe key to successful fundraising is recognizing and accordinglypreparing for diligence exercises and investor scrutiny from theinception stage. Being prepared prior to even thinking of fundraisingwill go a long way in ensuring a satisfactory outcome when afundraising opportunity arises.

It is also important to look at due diligence as a housekeeping exerciseand be open with potential investors about non-compliance. This willhelp build a positive, trusting, working relationship and establish thegroundwork for an ongoing partnership.


36

India is seeing a boom in private investments in e-commerce andtechnology startups and a large number of funds have invested billionsof US dollars in such online companies. Most of these private equityinvestors are expected to exit their portfolio companies through sharelistings, putting a spotlight on the sector and the potential candidatesfor an initial public offering (IPO).

Bankers expect them to explore overseas markets, mainly the Nasdaqexchange in the US, due to various regulatory requirements in India aswell as the difficulty in finding valuation benchmarks on exchanges onwhich no comparable rivals trade. This has also motivated startups toexternalize their business models to offshore jurisdictions, particularlySingapore.

Taking the above into consideration the Securities and Exchange Boardof India (SEBI) floated a discussion paper on an “alternate capitalraising platform“ as a next step to address the lacunae. Some of theimplications that would be required to be considered in this regard arediscussed below.

Key considerationsPre-tax operating profit: Regulation 26(1)(b) of the SEBI Issue of Capitaland Disclosure Requirements) Regulations, 2009 (ICDR Regulations),prescribes that a company may float an IPO if it has a minimumaverage pre-tax operating profit of �150 million (US$2.3 million),calculated on a restated and consolidated basis, during the three mostprofitable years out of the immediately preceding five years. SEBI’stight grip on profitability adds to the startup’s woes before getting anod for its IPO.

Lock-in restrictions: Under regulation 36(a) of the ICDR Regulations,the promoters are required to offer a minimum 20% of post-issuecapital as lock-in for a period of three years. The lock-in provisionensures promoters’ skin in the game for at least three years. However,many start-up companies that have flourished in recent times, andseveral which have also achieved scale, have a lower foundingmembers’ holding (often less than 20%) and a large institutionalinvestors’ holding.

Objects of the issue and basis of issue price: The ICDR Regulations requiredisclosure of the objects of the issue and the basis of the issue price,including the purpose of the issue, means of financing the project forwhich monies are proposed to be raised, proposed deployment status ofthe proceeds at each stage of the project, interest of promoters anddirectors, earnings per share, diluted earnings per share, price-earningsratio, pre-issue average return on net worth, etc. Start-up companies areoften loss-making and belong to sectors for which there are nocomparable financial ratios available, which acts as a process limitation.

End-use restrictions: SEBI has prescribed restrictions on the wayscompanies can use their IPO proceeds and retains discretion to rejectoffer documents if a big chunk of the issuance is not allotted to

II.LISTING VENUEFOR STARTUPS:

ISSUES AND WAY FORWARD


37

creating tangible assets. Startups require funds for brand building (anintangible asset) and any regulatory restriction on this would defeatthe purpose of their capital raising exercise.

Minimum post-issue paid-up capital requirement: The BSE (BombayStock Exchange) prescribes a minimum post-issue paid-up capital ofthe startup of �100 million for an IPO on the exchange. This may restrictthe access of some startups to the BSE as a listing platform to raisecapital.

The best alternativeOne of the primary questions with regards to listing of startupsconcerns their ability to attract institutional investors and valuationissues. Given that technology companies have soaring valuations withdeeper liquidity requirements, the debate revolves around whether aseparate exchange for such start-up companies is needed or whetherthey should be allowed to list on the main board of the stockexchanges with easier norms. The issue is critical to address in view ofthe negligible activity in other specific platforms such as SMEexchanges (for small and medium-sized enterprises) and institutionaltrading platforms, which have been unable to attract significantinterest from the investor community.

The better approach would be to allow listing on the main board ofthese “alternative“ companies with certain regulatory relaxations asagainst proposing an alternative platform.

A constructive move on this front in the nature of the proposed StartupAct, which would address issues on delayed incorporation, cumbersomedocumentation and single window clearance, would hopefully arrestexternalization plans of the startups and take the government’s ease ofdoing business initiative notches higher. The framework should ideallyprovide for adequate analyst coverage for the startups to target suitableinvestors for their stock.

In the US, the average tech company has around 20 analysts coveringits stock. The aim should be surpassing that number and providing aneven better capital raising platform to Indian startups than Nasdaq. Theproposed startup listing platform should ideally take this opportunityto address the entire gamut of issues from incorporation to exit listing.


38

The period between 2006 and 2008 saw a large number of venturecapital and private equity (PE & VC) deals in the Indian market. Theexit rights negotiated by PE & VC investors during the heydey of India’sgrowth story gain importance in today’s context, as most of the fundshave now reached the end of their fund lifecycle. In view ofdecelerating capital markets, exits remain a key challenge for PE & VCinvestors, and this has hampered fresh fundraising prospects from theirlimited partners (LPs) in the absence of a track record.

Key factors in an exit include: 1) the promoters managing and negotiating rights and expectations of

the new investor with those of the exiting investor or any othercontinuing investors;

2) the exiting PE & VC preference for a complete release and waiver fromthe investee company, its promoters and the new investor from all pastand future liabilities, and negotiating representations, warranties andconsequent indemnities; and

3) the new investor conducting thorough due diligence.

VC/PE investors should negotiate the following five exit challenges asearly as the term sheet stage:

Due diligence: A common challenge PE & VC investors face includesnegotiating and agreeing on the scope of the diligence exercise. Anexisting investor should always try to limit the scope of diligence to thebare minimum and ensure it is conducted in a timely manner. Some otherchallenges include: 1) procuring the active cooperation of the promoters; 2) absence of enough secondary data; and 3) reluctance among promoters of a family-run businesses to shareinformation with investors conducting diligence. From the purchasers’perspective, it is imperative to gather as much market intelligence on thecredentials and background of the promoters, in particular the reasonfor the PE & VC exit.

Warranties and indemnities: The extent and nature of warranties to besought from an existing PE & VC investor will entirely depend on thestatus of that investor (i.e. financial investor or a strategic investor). Anincoming investor would want a full set of representations andwarranties, but to what extent the exiting investor can provide suchindemnities is a moot question. The exiting investor should limit itsrepresentations and warranties to title, author and performance.

Tax indemnities: Post the Vodafone judgment, seeking a withholdingtax indemnity on capital gains from the seller has become a keychallenge. Some safeguards that purchasers have considered includecash holdback for an agreed percentage of purchase consideration,tax insurance, and backstop indemnities from LPs. These mitigators,however, need to be evaluated keeping in mind the lifecycle of thefund and provisions relating to clawback contained in the funddocumentation. The recent protocol of 10 May which amended theIndia-Mauritius double taxation avoidance agreement has cleared the

III.FIVE EXIT

CHALLENGES FOR VC AND PE

INVESTORS


39

air of uncertainty by exempting transactions undertaken prior to 1 April2017 from the purview of capital gains tax (CGT), after which the taxon capital gains will be charged at 50% of the domestic CGT from 1April 2017 until 31 March 2019, and at the full rate after 1 April 2019.The above issues continue to be relevant until the India-Singaporetreaty is formally modified.

Buyback: This route is predicated upon the target company havingenough resources to honour its buy-back commitments. There is a viewthat buyback of compulsorily convertible preference shares (CCPS) issuedto a foreign investor is not permissible under India’s foreign directinvestment (FDI) policy as such buyback would be akin to the redemptionof preference shares, which would indirectly run afoul of the FDI policy,which states that preference shares should be compulsorily convertible.In view of this, CCPS would have to be converted to equity mandatorily,and after conversion the company would have to meet with theconditions specified in the Companies Act, 2013.

Put/call options: Enforceability of put and call options has always been atopic of debate with conflicting regulatory and judicial views.Clarifications by the Securities and Exchange Board of India on 3 October2013, and the Reserve Bank of India on 9 January 2014, specificallyrecognizing put and call options as valid contracts have helped easeinvestor concerns. But their implementation still requires promotercooperation and has resulted in such disputes being referred toarbitration.

There are enough issues in terms of economic progress, sector-specificlegal and regulatory compliance, and risks associated withimplementing an exit strategy that could jeopardize the returns ofexiting PE & VC investors. Active promoter cooperation is vital for anysuccessful exit. A systematic approach by PE & VC investors towardstheir investments and returns, and managing their relationship withthe promoters is key to a successful exit.


40

Branding, customer data, technology such as software, mobileapplications, etc., form an integral part of the intellectual property (IP)portfolio of any start-up company. Protection of IP is crucial for startupsin view of the value it brings to the business, right from attractinginvestors and making financing easier to leveraging againstcompetition, generating revenue from licensing, assignment or transferarrangements, and contributing to the company's branding andmarketing strategy. Given the above, startups need to invest and takeas many measures as they can to protect their IP.

Perils of infringementIn addition to protecting their IP from third party infringement, startupsshould be aware of others' IP rights to ensure that someone else's rightswill not limit them or prevent them from operating their business. Therehave been various cases where prominent brand names or logos havebeen infringed and the courts have passed restraining orders orinjunctions in relation to the infringements.

In December 2014, Delhi High Court in Make My Trip (India) Pvt. Ltd VsMake My Tours Pvt. Ltd held that the defendant (Make My Tours) hadinfringed the mark and logo of the plaintiff (Make My Trip) on thegrounds that use of the mark and logo by the defendant was likely tocause confusion and deception and was bound to mislead the public tobelieve that the plaintiff was the source of the defendant's services.Hence the court ordered an injunction to prevent the defendant fromusing the same mark and logo.

In another case, Tata Sons moved the World Intellectual PropertyOrganization's WIPO Arbitration and Mediation Center demanding thetransfer of the domain name “oktatabyebye.com“ from the owners ofthe name on the grounds that “tata“ in oktatabyebye was similar toTata. The court held in favour of Tata Sons and the domain nameoktatabyebye.com was transferred in favour of Tata Sons.

Thus, IP infringement not only affects brand value but may result incompanies closing shop or having to rebrand themselves. Therefore,depending on the nature of service/product, it is extremely important toseek IP protection.

Danger of theftMany startups have an in-house research and development team ofemployees who create works that carry IP rights. Early stage startupsoutsource branding and marketing work to third party consultants.Thus a lot of sensitive, proprietary, confidential client data, dealer data,etc., are handled by employees and consultants and may be stolen bythem.

Another aspect that founders of startups tend to overlook is that whenthey start their own business, they may unintentionally use the tradesecrets of their previous employer and this may invite action from theemployer on grounds of violation of confidentiality obligations

IV.KEY ASPECTS OFINTELLECTUAL

PROPERTY RIGHTS FORSTARTUP’S


41

imposed under their contract with their previous employer. It istherefore important that founders make sure that using anyinformation from prior employers does not amount to illegal use ofthe prior employer's IP.

Safeguarding one’s rightsIn light of the above, the first step to secure IP is through registration.Depending on the nature of service/product, startups can register theirservices and products as: (a) trademarks, to protect word signature,name, device, label, or combination of colors; (b) copyrights, to protectoriginal literary, musical and artistic works and cinematographic filmsand sound recordings (e.g. website design, graphics); (c) patents, toprotect any invention which is novel, non-obvious and has utility (e.g.software development); and (d) designs, to protect original designscreated for particular articles to be manufactured by industrialprocesses or means.

Another step in seeking IP protection against theft is executingcomprehensive employment agreements and non-disclosure and IPassignment agreements with clauses on non-compete, confidentiality,non-solicitation, IP protection, assignment of inventions/IP, work forhire, etc. Also, when licensing any IP to a third party, a detailedlicensing/sub-licensing agreement must be executed.

Issues pertaining to IP protection may sometimes get brushed asideduring the early stages of a business as it seems an expensiveproposition for a startup to act on. However, it is important to do acost/benefit analysis to determine which IP protection is best suited forthe business and put in place an IP strategy to obtain and sustainbenefits for the business in the long run as for most startups IP is theonly business asset.

Also, a lot of startups prefer to vest and register their IP rights in theiroffshore company incorporated in a developed country and license therights to its wholly owned Indian subsidiary as the IP laws in developedcountries are more robust and stringent. Slightly older companies mayalso consider conducting an IP audit for a systematic review of the IPrights owned or acquired by the company to accurately gauge andassess its IP portfolio.


42

Employee stock option plans (ESOPs) are being widely used by bothpublic companies and startups as a means of monetary compensationand to provide incentives for employees. While startups use employeestock options in order to attract talent on account of not being ableto afford high salaries and to manage direct cost, publicly tradedcompanies use such plans as a retention tool. The wealth creatingpotential of ESOPs has been highlighted by reports about how theyhave created millionaires of employees at Infosys and the likes ofFlipkart.

Globally, companies adopt one or more of the following types of plans,depending on their business requirements and objectives: (a) employeestock option scheme (ESOS); (b) employee stock purchase plan; (c)restricted stock units; (d) stock appreciation rights; and (e) phantomstocks. In India, the most commonly used ESOP vehicle by privatecompanies is the ESOS. Also, ESOP structuring can be done by settingup a trust based on commercial and tax considerations.

Statutory compliance: It is mandatory for every private company andpublic unlisted company that proposes to issue employee stock optionsto employees to have in place an ESOP scheme that is in consonancewith section 62(b) of the Companies Act, 2013, read with rule 12 of theCompanies (Share Capital and Debentures) Regulations, 2014 (ESOPRegulations). Prior to the ESOP Regulations, there was no legislationregulating issuance of ESOPs by private companies. Public listedcompanies, however, have been governed by the Securities andExchange Board of India (Share Based Employee Benefits) Regulations,2014.

Who is an eligible employee: The ESOP Regulations permit issuance ofESOPs to: (i) permanent employees who have been working in Indiaor outside India; (ii) directors; and (iii) employees of subsidiaries,associate companies and holding companies. However, a director(directly or indirectly holding more than 10% of equity shares), anemployee who is a “promoter“ and consultants are excluded fromdefinition of an employee to whom employee stock options can issued.There has been a major concern around exclusion of promoters fromthe definition of employees under the ESOP Regulations, which hasled to structuring promoter compensation by way of issuance of sweatequity, convertible preference shares, equity shares with lock-inprovisions, etc. The startup community and the report of CompaniesLaw Committee led by Tapan Ray have raised this issue, which isexpected to be addressed in this budget session.

The Foreign Exchange Management (Transfer or Issue of any ForeignSecurity) Regulations, 2004, permit resident employees of foreignsubsidiaries in India or Indian companies (in which a foreigncorporation directly or indirectly holds equity) to acquire options fromits foreign holding company, provided the options are issued under acashless ESOS (without any remittance from India) and that the sharesunder the scheme are offered globally on a uniform basis.

V.EMPLOYEE STOCK

OPTIONS INSTARTUPS: ALLYOU NEED TO

KNOW


43

Vesting schedule: The ESOP Regulations stipulate a minimum lock-inperiod of one year between grant of options and vesting. However, asa general practice most companies adopt a vesting period over fouryears, where options vest proportionately or otherwise over each year.Typically, vested options become exercisable on the occurrence of aliquidity event.

Exercise price: Vested options can be exercised at an exercise pricewhich is usually at par for startup companies and at a discount to fairmarket value for slightly more mature companies. ESOP vehicles usuallyalso stipulate the exercise period, i.e. the period during which thevested options can be exercised.

Transfer restriction: ESOPs usually impose transfer restrictions in linewith the charter documents of companies on the shares that are issuedupon the exercise of options. In certain cases, companies prefer to keepcontrol over the vested shares. In such situations various mechanismsor structures can be devised to address this concern.

ConclusionStartups and public listed companies consider ESOPs as a majorincentive to motivate key employees, retain intellectual capital, attractnew talent and create wealth for employees. Accordingly, it isimportant to structure an ESOP vehicle taking into account thecommercial and tax implications on the company.

The startup community as well the Companies Law Committee led byTapan Ray in its report pressed for relaxations of the ESOP Regulationsand ESOP taxation so as to allow flexibility in structuring of ESOPs andsimplify the ESOP issuance process. It is hoped that the budget sessionwill be productive in addressing these concerns.


44

The last few years have witnessed a sluggish primary market activityand very few startups and mid-size companies have taken effectivesteps towards going public. In this background, one of the typical exitstrategies that assumes importance as a feasible exit option remainsthe put/call option.

SEBI has historically objected to options as being in contravention toSecurities Contracts (Regulation) Act, 1956 (“SCRA“) which permittedonly spot delivery contracts. Initially, the Government vide itsnotification dated June 27, 1961 exempted specified contracts for pre-emption or similar rights contained in the promotion or collaborationagreements or in the articles of association of limited companies.Although there was no specific mention of “options“, however thesame could be implied to be similar to ‘pre-emption’. However, vide anotification dated June 27, 1969, the Government under Section 16of the SCRA prohibited all kinds of contracts except spot deliverycontract or contract for cash or hand delivery or special delivery in anysecurity under SCRA. The SCRA was amended in the year 2000providing that a derivative contract would be invalid if they weresettled outside the stock exchange.

In the case of Cairn and Vedanta merger and in Diageo and UnitedSpirits merger, SEBI prohibited the use of call/put options in theagreements. Further, in the informal guidance dated May 23, 2011issued to Vulcan Engineers Limited, SEBI specified that an optioncontract would not meet the criteria of a spot delivery contract underSection 2 of the SCRA and would also not be considered as a validderivative contract under Section 18A of SCRA.

However, SEBI relaxed its position through a notification dated October3, 2013 granting validity to contracts providing for preemptive rights,right of first offer, tag-along right, drag-along right, and call and putoptions.

The Department of Industrial Policy and Promotion (“DIPP“) vide theFDI Policy (Circular 2 of 2011) dated September 30, 2011 providedthat equity instruments issued/transferred to non-residents having in-built options or supported by options sold by third parties would losetheir equity character and such instruments would have to comply withthe extant External Commercial Borrowings (ECB) guidelines whichraised concerns for the regulators as the foreign investors were nottaking genuine equity risks in Indian companies and instead seekingan exit at guaranteed prices (which classifies such investment as debt).This attracted a lot of criticism by the investors as such a provisionaffected genuine commercial transactions, where the foreign investoris provided an exit at the then prevailing fair market value. Accordingly,this provision was deleted vide Press Release on FDI Policy (Circular 2of 2011) dated October 31, 2011. Later, the RBI vide its circular datedJanuary 09, 2014, permitted issuance of equity shares, fully andmandatorily convertible preference shares and debentures containingan optionality clause. However, the circular specified that such anoption / right should not provide a guaranteed return to such investor

VI.OPTION

CONTRACTS: ENFORCEABILITY

ISSUES


45

at the time of exit and subjected the same to conditions such as (i) minimum lock-in period of 1 year from the date of the agreement,(ii) buy-back of securities to be at a prevailing price or at a valuedetermined at the time of exercise of such an option etc.

The Supreme Court in Vodafone International Holdings vs. Union OfIndia & Anr, observed that the provisions for pre-emption rights, call/putoptions etc., incorporated in investment agreements, may regulate therights between the parties which are purely contractual and such rightsshall have efficacy only if such shares are owned by the parties. It wasalso held that the shares in a company are freely transferable in anymanner subject to the articles of association of such company.

In the case of Nishkalp Investments and Trading Co. Ltd. v. HindujaTMT Ltd the Bombay High Court took a view that a contingent contractis within the scope and applicability of the SCRA. The question whicharose in this case was with respect to a buyback agreement torepurchase certain specified shares where the shares were not listedon the stock exchange by a certain agreed date. In this case, theBombay High Court held that a contingent contract for anarrangement of buyback of shares is hit by the provisions of the SCRAand is invalid in law.

The issue on enforceability of option contracts was further dealt within MCX Stock Exchange Limited vs. SEBI, wherein the Bombay HighCourt cleared the air by holding that option contracts are differentfrom forward contracts, which are prohibited under SCRA.

For a long period, companies and investors have been concernedregarding the enforceability of option contracts. The aforesaid positiontaken by the Indian regulatory authorities is an investor friendly stepand in the right direction that should surely boost investor appetite forIndian portfolio companies.


46

Banks, non-banking financial companies, debt funds and companies areincreasingly using the route of private placement of listed and unlistednon-convertible debentures (NCDs) to raise funds from players such aspension funds, insurance companies, foreign portfolio investors andmutual funds to retire debt and for on-lending. However, this route isbeset with legal and regulatory challenges, some of which are outlinedbelow.

RBI approval: Creation of security over immovable property in favour of aforeign lender requires prior approval of the Reserve Bank of India (RBI)under the Foreign Exchange Management (Acquisition and transfer ofimmovable property in India) Regulations, 2000. This poses a challengein structuring the security package.

Classification as “deposits“: Under the Companies Act, 2013, bonds ordebentures issued by a company must be secured by a first charge or acharge ranking pari passu with the first charge on the tangible assets ofthe company. Any subsequent charge is considered as a deposit, andoptionally convertible debentures are also now considered as deposits.However, compulsorily convertible bonds or debentures convertiblewithin five years are exempted from the definition of deposits.

Contractual restrictions: Step-in rights of the existing lenders of theborrower company may require the security package to be structuredeither by way of substitution of rights in favour of the NCD holders or byway of a charge over the immovable property.

Industrial zoning restrictions: India’s urban development authorities leaseparcels of land to industrial enterprises restricting their right to create anysecurity interest on the leased land without the authority’s prior approval.Such approvals are usually discretionary and pose both structuring andtimeline challenges.

Stamp duty issues: High rates and lack of uniformity in the levy of stampduty poses a challenge for security creation.

Enforcement timelines: The remedies under the Securitisation andReconstruction of Financial Assets and Enforcement of Security InterestAct, 2002, and the Recovery of Debts Due to Banks and FinancialInstitutions Act, 1993, for fast-track disposal of enforcement proceedingsare not available to other NCD investors. They would need to resort totime-consuming civil law remedies. Post-decree execution proceedings inIndia are a nightmare creating further challenges to the enforcement ofsecurity interest.

Insolvency proceedings: Section 14(1)(c) of the Insolvency and BankruptcyCode, 2016, provides for placing a moratorium on the debtor’soperations during the insolvency resolution process. During this “calmperiod“, no judicial proceedings for recovery, enforcement of securityinterest, sale or transfer of assets, or termination of essential contractscan take place against the debtor. This restricts the right of the NCDholders to enforce their security.

VII.NON-

CONVERTIBLE DEBENTURES:

ISSUES IN PRIVATE

PLACEMENT


47

Inadequate penal provisions: Section 138 of the Negotiable InstrumentsAct, 1881, does not prescribe a strong deterrent for dishonour of acheque.

Security cover: Under the Companies Act, a company can issue secureddebentures only upon creation of a charge on its assets or immovableproperties having sufficient value for redemption of such debentures. Thisrequirement with respect to adequacy of security poses a challenge forcompanies with an asset light model. Further, debentures secured by wayof share pledges are not recognized as “secured debentures“ in terms ofrule 18(1)(d)(i) of the Companies (Share Capital and Debentures) Rules,2014, which further weakens the security package.

Asset quality and valuation: The Indian real estate market is a volatilespace in which the valuation of assets is not range bound. Being anunregulated market, the degree of credit risk is higher for real estateassets than other asset classes. Although the transactiondocumentation typically provides for maintaining adequate securityfrom the borrower, there is no assurance that the value of the securitywill remain adequate to secure the redemption of the NCDs.

Public offer norms: The issuer company is required to strictly complywith the private placement guidelines provided under the CompaniesAct for private placement of NCDs, which can be issued to a maximumof 200 people per financial year. In case of breach such placementwould be construed as a “public offer“ under the act, leading toonerous compliances. However, many issuers of NCDs take a differentposition on what constitutes “public“, thereby leaving scope for debateon whether an issue is valid.

It is time for the regulators and the government to focus on makingthe legal framework for debt instruments simpler and enforceable forensuring a challenge-free debt market.


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A Real Estate Investment Trust (“REIT“) is a trust that uses pooledcapital of investors to purchase and manage income property (“EquityREIT“) and/or mortgage loans (“Mortgage REIT“). REITs offer severaladvantages to people who do not have sufficient money to invest inreal estate but desire to own property. Other than UnitHolders/Investors, the other primary players in REITs constitute theTrustee, Sponsors, Managers and Principal Valuer.

The Securities and Exchange Board of India (“SEBI“) has vide anotification dated September 26, 2014 notified the SEBI (Real EstateInvestment Trusts) Regulations, 2014 (“SEBI REITs Regulations“)towards regulating investments in REITS. The SEBI REITs Regulations,inter alia, set out the registration requirements and procedure ofregistration, and eligibility requirements of REITs as well as that of theprimary players. The key highlights of the SEBI REITs Regulations areset out below:

Eligibility Requirement for REIT: A REIT must be a trust set up under theIndian Trust Act, 1882 and registered under the SEBI REITs Regulations.The trust deed of a REIT has to be duly registered, is required to setout that its main objective is to undertake the activity of REITs andshould also include the responsibilities of the Trustee. There should notbe any disciplinary action taken by the SEBI or any other regulatoryauthority against the REIT or any related party. The parties to the REITshould be fit and proper persons as per in Schedule II of the SEBI(Intermediaries) Regulations, 2008. Further, multiple classes of units ofREIT are not allowed.

Investments through a SPV: REITS may invest either directly or througha SPV. Where the investment is through a SPV, it is required to holdcontrolling interest and not less than 50% equity in such SPV. Also, theSPV is required to hold 80% equity in the REIT assets. Multilayer SPVstructure may not be permitted and multiple schemes under REIT arenot permitted.

Dividend Distribution: SEBI REITs Regulations prescribe mandatorydistribution of at least 90% of the net distributable cash flows toinvestors on a half yearly basis and at least 90% of the sale proceedsfrom sale of assets to unit holders, unless reinvested in anotherproperty.

Foreign Investments in REITs: The RBI has vide a circular dated April 21,2016 permitted foreign investments in REITs without any approvalrequirements. NRIs and FPIs have also been allowed to invest in REITsunits.

The said circular also provides that downstream investment by REITswill be regarded as foreign investment if either the Sponsor or theManager is not Indian 'owned and controlled' as defined in Regulation14 of the Foreign Exchange Management (Transfer or Issue of Securityby a Person Resident Outside India) Regulations, 2000. In case thesponsors or managers are organized in a form other than companies

VIII.REAL ESTATEINVESTMENT

TRUSTS (REITS)REGULATORY & TAXATION

ASPECTS


49

or LLPs, SEBI would have the power to determine whether the sponsoror manager or investment manager is foreign owned and controlled.Also, SEBI in its Board Meeting held on September 23, 2016 haspermitted REIT to invest in two level SPV structures through a holdingcompany, subject to sufficient holding in the holding company andthe underlying SPV and other safeguards including (i) the right toappoint majority Directors in the SPV; and (ii) the requirement by theholding company to distribute 100% cash flows realized fromunderlying SPVs and at least 90% of the remaining cash flows. Further,REITs have been allowed to invest up to 20% in under constructionassets.

Open for high net worth entities: Till the market develops, REIT unitscan be offered only to high net worth individuals/institutions with aproposed minimum subscription size of INR 2 Lakhs and unit size ofINR 1 Lakh each. All unit holders are given equal voting rights. Also,voting by related parties for any unit holder's approval is not taken intoconsideration.

Valuation Requirements: SEBI REITs Regulations prescribe a mandatoryrequirement for full-fledged valuation of all REIT assets on a yearly basisthrough a registered valuer. Semi-annual updation is also mandatory.Net Asset Value is required to be declared within 15 days from thedate of valuation/ updation of valuation of assets. Any acquisition/transfer of REIT Assets is required to meet the prescribed valuationguidelines.Listing Requirements: After registration, REITs are required to raisefunds through an initial public offer and subsequently through followon offers, rights issues and qualified institutional placements. In thisregard, SEBI Regulations prescribe the following:

i. Detailed disclosures are required in case of a follow on offer, rightsissue, qualified institutional placement, etc.

ii. REITs units have to be in dematerialized form and are mandatorilyrequired to be listed on recognized stock exchanges in India andcontinue to be listed unless delisted as per the SEBI Regulations.

iii. The minimum IPO asset size of REITs is prescribed as being INR500 Crore and the minimum offer size is prescribed as INR 250Crore.

iv. A minimum of 200 subscribers are required to form a REIT(excluding related parties) and the minimum public share in aninitial offer should not be less than 25% of the number of unitsof the REIT on post issue basis.

v. The procedure for delisting of REITs has also been provided underthe SEBI Regulations.

REIT Investments: At least 80% of the value of REITs Assets is requiredto be invested in completed and rent generating properties. Specificconditions are prescribed for investing the balance funds in otherassets. Further, REITs are required to invest in at least two projects andinvestment in any one project should not exceed 60% of the value ofassets owned by the REIT. REITs are permitted to invest only in the


50

assets situated in India. Lastly, a specific list of inclusions (like TDRs,land and any permanently attached improvements to it (whetherleasehold or freehold, etc.) and exclusions (like Hospitals, Hotels andconvention centers with specified conditions, agricultural land,mortgages, other REITs units, etc.) have been provided under the SEBIREITs Regulations.

Taxation Perspective

i. Dividend Distribution Tax (DDT): The Finance Budget of 2016proposes that any distribution made out of income of SPV to REITsand infrastructure investment trusts having specified shareholdingwill not be subjected to any DDT. It is exempted for unit holdersand REIT.

ii. Capital Gains Tax: (a) Capital Gains earned by REITs on the sale ofshares of SPV are taxable for REITs as per the applicable capitalgains tax rates; (b) Long Term Capital Gains earned by unit holderson the sale of units of REITs is exempt for the unit holders. ShortTerm Capital Gains is taxable at the rate of 15%; (c) Capital Gainsearned by sponsors on the sale of units of REITs/ swap of SPVshares with REIT units is exempted.

iii. Interest from SPV: The Interest amount is exempt from tax forREITs and is taxable as income for unit holders.

iv. Other income: Any other income is taxed at maximum marginalrate for REITs and is exempt for the unit holders.

Way ahead and RecommendationsAlthough a lot has been done to liberalize investments in REITs, furthertaxation and regulatory incentives are required to make REITs a realsuccess in India and attract the desired investors. Tax measuresgoverning REITs do not offer much by way of encouragement, neitherto the sponsor nor the unit holders. Towards addressing the above,the recent Union Budget proposes relief in the form of exemption fromDDT. However, it is critical that the government considers furtheramendments to the Income Tax Act to provide a tax efficient and stableregime for REITs in India. Exemption is available only in case of thetransfer of shares of the SPV by the sponsor in exchange of REIT unitsand not direct transfer of the property to the REIT. The lack ofexemption to sponsors is likely to deter direct holding of properties byREITs.

Capital gains tax is the second biggest hurdle after DDT. When a REITsells shares of a SPV or assets, the capital gain is taxable at the handsof the REIT. A complete pass-through is what is desired by investors.In the previous Budget of 2015, the government announced capitalgains tax exemption at the hands of the sponsor but it remains an issueat the REIT level where it is still applicable. Suitable exemptions fromcapital gains incidence (long term as well as short term) should beprovided. Also, Minimum Alternate Tax (MAT) applicable on thetransfer of shares to REITS should ideally also be exempted.Apart from the tax challenges set out above, there are several non-tax


51

issues which may hinder the success of REITs in the Indian market,which include the following:

• The transfer of assets at the initial stage of setting-up a REIT couldbe regarded as a transfer, which may attract stamp duty thereon,which ranges from approximately 5% to 10% depending upon thestate in which the property is located. In this regard, the governmentought to consider waiving or reducing the applicable stamp duty onREITs specifically in relation to specified period of years for whichREIT holds the property or alternatively, state governments couldconsider a one-time waiver of stamp duty on transfer of assets toREITs or SPVs owned by REITs to encourage the creation of REITS inthis nascent stage.

• Norms of investment by foreign portfolio investors and non-residentIndians should further liberalised. Towards this, there should be nocap or restriction on the units of REITs that can be acquired by theseentities.

• The Insurance Regulatory and Development Authority's (IRDA)investment regulations should also be amended to allow insurancecompanies to invest in REITs. Similarly, changes should be broughtabout in the provident fund regime, and REITs should be made aseligible investment in the prescribed pattern of investment.

• Units of REITs set-up as a trust should be included in the definitionof 'security' as per the Securities Contract (Regulation) Act, 1956.

• The eligibility requirement of a sponsor having a real estate trackrecord would restrict a lot of non-real estate entities like banks andfinancial institutions from becoming sponsors in the REITS. Ideally,the track record requirement should only be for the key employee(s)or partners of the sponsor entity and not on the sponsoring entityitself. Further, foreign sponsors should be allowed to acquire unitsof REITs under the automatic route. In such a case, swap of existingshares of a SPV held by a non-resident sponsor with the units of aREIT should be permitted under automatic route.

In light of the above, it is imperative for the Government to fast tracktaxation and other regulatory amendments and reforms to promoteREITS in India in order for it to have the desired effect on the economy.

Footnote1 RBI/2015-16/377, A.P. (DIR Series) Circular No. 63


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Venture capital (VC) fundraising and deals have a promising outlookparticularly with the government’s desire to create an ecosystem inwhich entrepreneurs can mushroom. For this to happen, one cannotrely solely on funds from offshore jurisdictions. It is important to havea strong domestic fundraising environment so as to facilitate multipleinvestments.

In view of the above India’s capital market regulator – the Securitiesand Exchange Board of India (SEBI) – issued the SEBI (AlternativeInvestment Funds) Regulations, 2012 (AIF Regulations), to regulatedomestic investment vehicles.

Under the AIF Regulations, VC funds, angel funds, infrastructurefunds, and small and medium-sized enterprise funds are classified ascategory I AIFs. Private equity (PE) funds and real estate funds areclassified as category II AIFs and hedge funds are classified as categoryIII AIFs. Further, the AIF Regulations require all pooling vehicles to beregistered with SEBI and stipulate various investment conditions andrestrictions, including on offshore investments, for each of the AIFcategories.

As per the AIF Regulations, the entities involved in setting up atypical AIF are: (a) investment vehicle – a privately pooled investmentvehicle in the form of a trust or a limited liability partnership; (b)sponsor – the entity or person that sets up the investment vehicle; (c)investment manager – an entity that is appointed by the investmentvehicle to manage investments and which employs investmentprofessionals, evaluates potential investment opportunities and incursthe expenses associated with day-to-day operations and administrationof the fund; and (d) trustee – an entity appointed to manage theinvestment vehicle trust in accordance with the trust deed.

As per the AIF Regulations, both category I and category II AIFs areclosed-end investment vehicles having a minimum tenure of threeyears which can be extended with prior investor consent. Currently,the fundraising period for PE-VC funds is typically 12 to 18 months.

The initial closing of the fund depends on various market factorsand the track record of the manager. Often initial closing occurs aftera minimum amount of capital has been raised by the fund. After initialclosing subsequent closings occur throughout the life cycle offundraising. It is recommended that managers consult with localcounsel while raising capital outside of India, so as to ensurecompliance with applicable local securities laws.

As per the AIF Regulations, the following documents must besubmitted to SEBI at the time of registration:

1. Private placement memorandum (PPM): This is the primary marketingdocument through which the fund markets its interests to prospectiveinvestors. As per the AIF Regulations, the PPM must contain a businesssection, which consists of investment objective, strategy, track recordof investment manager and team; a summary of principal terms; riskconsiderations; and legal and tax considerations.

The summary of principal terms relates to the key economic termsof the fund, which include tenure, investor capital commitment,investment period, subsequent investments, fees and expenses,winding up, key service providers, distribution waterfall, key man event

IX.BRIEF OVERVIEW

OF AIFREGULATIONS


53

and removal of manager with or without cause, conflict of interest andany such information necessary for an investor to take an informeddecision.

2. Contribution agreement: An investor subscribes to a fund byexecuting a contribution agreement, which sets out the investor’scapital commitment, rights and obligations, including representationsand warranties confirming that they are qualified to invest.

3. Investment management agreement: This contains general termsunder which the investment manager is authorized to act as the fund’smanager in exchange for the management fee.

Often funds enter into side letters with certain investors thatdemand additional or special economic, informational or otherbenefits as a condition of their investment. Side letters are not requiredto be submitted to SEBI and the validity and enforceability of sidearrangements have to be tested in a court.

Thus, prior to setting up a fund, one must analyse the structuredepending on the fund objective and sector focus so as to ensure thatit is compliant and optimal from a legal, regulatory and tax standpoint.With the government now allowing up to 100% foreign investmentunder the automatic route in AIFs, AIFs can be structured to allowresidents as well as non-residents, foreign portfolio investors and non-resident Indians to invest directly in the fund without floating multiplestructures in different jurisdictions.

Recommendations made by the SEBI-constituted, Narayan Murthy-led Alternative Investment Policy Advisory Committee on creating afavourable AIF tax regime, unlocking diverse domestic capital poolsfrom pension funds, insurance companies, banks, charitableendowments. etc., are a positive move for the AIF industry, whichcould help create a steady and progressive regime for pooledinvestment structures in India.


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E-commerce marketplaces have been a game changer when it comesto online retail trading in India. The e-commerce market players havebeen resorting to any means possible to acquire a customer base forthe purpose of enhancing their gross merchandise value. For some yearsthese online players have been able to lure customers by providing deepdiscounts to them which has, as a result, increased the tendency of thecustomers to rely more on such e-commerce offers and sales.

Offers and discounts provided by e-commerce players and predatorypricing have for long now been entangled with each other. Physicalretailers or brick and mortar stores have been pressing the issue ofunfair practices by online players, who have the intention of adverselyaffecting competition in India, for a long time.

The physical retailers’ community has always been concerned aboutthe infusion of foreign capital in e-commerce marketplaces in Indiaand has continuously been accusing such e-commerce players ofdumping foreign capital to offer disruptive prices with an intention todiminish healthy competition in the market. However, now even thedomestic e-commerce players have started raising some eyebrows overthe easy accessibility of foreign capital to the foreign e-commercemarketplaces operating in India and the hefty discounts and offersprovided by such marketplaces to the customers.

The Department of Industrial Policy and Promotion (“DIPP“) vide itsPress Note 3 of 2016 (“Press Note“) dated March 29, 2016, whileallowing 100% FDI under the automatic route in marketplaces, alsoimposed certain conditions upon them including the restriction ondirectly or indirectly influencing the sale price of goods or services. Thismove taken by the DIPP to curb any form of influence that e-commercegiants might have over the sale price of goods or services was toprovide a level playing ground and equal opportunities to the brickand mortar stores.

However, the Competition Commission of India (“CCI“) has as yetremained silent on the issue despite the fact that the issue of predatorypricing falls within the ambit of CCI.

Do discounts amount to Predatory Pricing?Under Section 4(b) of the Competition Act, 2002 (“Act“), predatorypricing is defined to mean “the sale of goods or provision of services,at a price which is below the cost, as may be determined byregulations, of production of the goods or provision of services, witha view to reduce competition or eliminate the competitors.“ However,in order to establish predatory pricing, it is essential to determinewhether an entity is enjoying a dominant position in the market andwhether at the same time such entity is abusing the same.

There has always been a substantial difference between the sale pricesof goods offered by the offline retailers and e-commerce players. Goingby the assertions put forth by the brick and mortar stores, such markeddifference in prices is because the online marketplaces which are

X.IS DUMPING OF FOREIGN

CAPITAL TO OFFERDISCOUNTS

“ANTICOMPETITIVE“?


55

flooded with foreign capital, fund the discounts with an intention toeliminate competition from the market.

In the case of the All Delhi Computer Trader Association, severalcomplaints were filed against various online retail platforms for sellingproducts at extremely low prices that the brick and mortar retail outletscould not compete with. However, the Competition Commission ofIndia (“CCI“) held that the e-commerce players had no dominance inthe market as the entire e-commerce industry forms only a minisculepart of the entire retail market in India. Thus, it was prima facie heldthat the conduct of such online retail platforms was not anti-competitive as per Section 4 of the Competition Act.

Position under US Anti-trust lawIn 2009, Apple Inc. announced the release of ‘iBookstore’ which solde-copies of books that were priced accordingly by the respectivepublishers. Amazon on the other hand, priced these copies at acomparatively lower cost, according to the customer base. Pursuantto the same, Apple executed agreements with major publishingcompanies to ensure that their prices are further lowered to competewith those of other resellers in order to maintain dominance. However,the US Supreme Court found Apple to be in violation of the US Anti-trust law and levied a penalty of $450 taking into consideration thedominant position enjoyed by Apple in the US and the intention ofcreating a monopoly.

The officials of DIPP have also vide certain press statements maintainedthat the Press Note does not restrict e-commerce vendors from offeringdiscounts and no action can be taken against them unless it isestablished that such e-commerce players have resorted to predatorypricing.

Limitation of CCI’s jurisdictionCCI’s jurisdiction is limited by the criteria for determination of theexistence of predatory pricing stipulated under the Competition Act, asper which predatory pricing can only be established if an entity enjoys adominant position in the relevant market. Thus, if an e-commerce entitywith a minimum market share in the relevant market is providingproducts or services at a price lower than the cost price of such productsor services, such an entity cannot be held guilty of predatory pricingsince it does not hold a dominant position in the relevant market. In acomplaint filed by Meru Travel Solutions Pvt. Ltd. against Uber groupwith the CCI in relation to reduction of the fares and discounts providedby Uber, CCI held that e-commerce players such as Uber cannot beabstained from providing discounts to their consumers since they arenot dominant players in their relevant market.

However, DIPP has vide the Press Note imposed a blanket condition onthe e-commerce marketplaces without setting out any criteria fordetermination of predatory pricing such as market shares, dominantposition and the intent.


56

Thus, on one hand, any e-commerce marketplace flouting thecondition prescribed by the DIPP by directly or indirectly influencingthe sale price of the goods or services shall be liable to be probed bythe DIPP, however, on the other hand under Section 4 of theCompetition Act, none of the e-commerce players can be held liablefor exercising predatory pricing since they hold a miniscule marketpresence in the relevant market, which also includes brick and mortarstores.

ConclusionAn extreme argument on the condition under the Press Note can be thatany activity done by the online marketplace to match up with thecompetition can fall under the purview of ‘indirectly or directlyinfluencing prices’, violating their fundamental right to freedom of trade.

Under the Competition Act, an e-commerce entity cannot be heldliable for adversely impacting competition in the market until itbecomes a dominant player in such relevant market, does that give aright to such e-commerce entities to continue resorting to anti-competitive measures to maintain sustainability in the market?

The DIPP has placed general restrictions on marketplace entitieswithout taking into consideration the objective criterion provided bythe Competition Act to prevent predatory pricing. Pursuant to thesame, the Press Note has created a dilemma as to whether theprovisions of the Competition Act would prevail over the condition setout under the Press Note considering the fact that CCI enjoys solejurisdiction over antitrust issues. It would be quite interesting to see ifCCI rises to this occasion to clear the dilemma.

Further, taking into account the present scenario, a question arises asto whether there is a requirement for an anti-dumping law orregulation to provide checks and balances in relation to dumping orutilization of foreign capital by e-commerce players? India is stillprogressing towards opening up the market for overseas investors. Willa step towards setting up of a regime to check or impose conditionson utilization of overseas capital be progressive or digressive?


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While the economy is witnessing a fast transition from “offline“ to“online“ markets and there is a steady buzz of “demonetization“ and“one click“ access to everything, yet laws relating to regulation of mostof these e-commerce businesses are in a very nascent stage. Thegrowth in usage of new technology and digitalization to disrupt themarketplace of traditional institutions and intermediaries in the deliveryof services have significantly touched upon all industries includingpharmaceutical sector wherein the fintech has given rise to a lot ofbudding e-pharmacy businesses. There are various business models one-pharmacies which are being adopted by start-ups as well asestablished players in the market, however the absence of definitelegislations regulating these business models has started raising seriousconcerns over the black hole in our regulatory framework and theGovernment departments certainly need to gear up and come out witha definite regulatory framework for these business models without anyfurther delay. This update is an attempt to analyze the legal sanctity ofsuch existing business models of e-pharmacies in India.

Indian pharmaceutical laws have not kept pace with the developing e-commerce market and the Government has not framed any specificlegislation to regulate online distribution/ sale of drugs yet. In fact, wehave no laws that can effectively deal with legal issues like sanctity ofonline pharmacies, distribution of drugs without proper prescriptions,whole sale or retail e-trading of drugs, to name a few. The issue gainsprominence when we talk about “Schedule X“ Drugs i.e. the drugswhich cannot be sold without the authorized prescription frommedical practitioners and are specifically named under Schedule X ofthe Drugs and Cosmetics Act of 1940 (“D&C Act“). With the recentcontroversies involving renowned market players, for instance theSnapdeal controversy, wherein it came to the notice of state FDA thatrestricted drugs were being sold freely online without any requirementof prescription, and the on-going public interest suit in Bombay HighCourt, the issue has gained a lot of public visibility.

Existing Legal Framework on E-Distributionof Drugs in IndiaIndian Laws relating to pharmacies were written prior to the arrivalcomputers, let alone internet. There are no dedicated e-health andtelemedicine laws in India. Even essential attributes of these laws likeregulatory requirements, cyber security data security, etc. are notgoverned by much needed dedicated laws. Whereas physical meansof conducting such businesses are very well regulated under thevarious pharmaceutical laws and legislations in India, the online modeis still largely unregulated. Other than a circular issued by the DrugsController General of India on December 30, 2015 (“DCGI Circular“),wherein it has been referred that the online pharmacists should complywith the D&C Act requirements and has directed the state FDAs to takestrict action against any unauthorized online sale of drugs, the lawhowever is silent on the permissibility of e-distribution aspects of thesame and requirement of specific compliances and restrictions.

XI.PHARMACY -LEGAL SANCTITY?


58

Numerous statues carry individual provisions that may be (or at leastmay be interpreted to be) applicable to e-health and telemedicineactivities in India. For instance, there are many techno legalrequirements pertaining to privacy, data protection, encryption, cyberlaw due diligence, internet intermediary obligations, cloud computing,etc. that are required to be complied with by online pharmacy storesoperating in India.

The “Gray“ Area:One direct consequence (if not be termed as an “advantage“ or“disadvantage“) of the absence of an explicit regulatory framework isthat there is no express permission or prohibition to carry out suchbusiness models. Hence the legality of online sale of drugs remainsunclear and there exists a “gray“ zone. Moreover, other than the recentactions taken by respective state FDAs on several such e-commercebusinesses, there is no judicial pronouncement on the subject till date.

Critical ConcernsIn addition to the issue of ambiguity and applicability of laws, thereare several other concerns relating to legal and business viability of e-distribution model for drugs in India. For example, unlike othere-commerce products/services, “pharmaceutical industry“ iscategorized as “high risk“ sector by the Reserve Bank of India andpayment gateways generally don't accept online payments formedicines, however the same depends upon case to case basis andquantum of security. Further, the issue of authenticating or checkingthe validity of scanned copies of prescriptions is not foolproof and thepossibility of usage of fake or amended copies of prescriptions cannotbe overruled. Moving towards the penal consequences,pharmaceutical laws are known for the strictest penalties whether interms of monetary penalties or imprisonment for non-compliances.Also, FDAs are witnessed to have been very strict in terms of any non-compliance or complaints against such business activities. States FDAslike Karnataka FDA and Maharashtra FDA have set examples of strictactions like complete shutting down of business activities for any non-compliance. Lastly, drugs and medicines, being essential and criticalproducts, it will require quite some time for Indian consumers torepose their faith and confidence on online models for purchase anddelivery of such products. Equally challenging would be to live uptothat faith and confidence!

Precautionary Measures to be followedwhile carrying out such Business withoutEncroaching upon Illegal Territory:As said previously, the business model of e-distribution of drugs is notillegal in India. Individuals and companies may explore the e-distribution of drugs, provided that they don't fall foul of the existingpharmaceutical and IT legislations. Hence, set out below are some ofthe precautionary measures which the businesses should consider andfollow to remain within the ambit of the law while carrying out such


59

activities:

• Strict compliance/ conservative view would be to hold a “retaillicense“ even for e-distribution of drugs. Note that a retail druglicense is only issued to persons who possess a degree or diploma inpharmacy from a recognized institute or university. Medibizcontroversy in Karnataka also supports the above view.

• Online pharmacies/drugs distribution websites can be categorizedas “internet intermediaries“ within the meaning of InformationTechnology Act, 2000 (“IT Act“) and are therefore required to complywith cyber law due diligence requirements in India.

• As per D&C Act, there is no concept of “digital prescriptions“. Whileas per the IT Act, digital documents have full legal sanctity and thisIT Act takes precedence over all other acts where digital documentsare in question. Therefore, it is better to obtain a copy of digitalprescription as a condition precedent to accepting any order for e-sale/distribution of Schedule X drugs. Further, it is advisable to verifythe physical copy of the prescription during the time of delivery.

• Arrangements and tie ups should be done only with licensedpharmacies. Further, orders should be taken and accepted from thecustomer(s) either over the phone or internet only from the areaswhere the pharmacy retail license is applicable.

• Ideally, the medicines/drugs need to be delivered to the customersby a registered pharmacist, not the courier person. However, a morefeasible option for distribution is to tie up with a firm whichpossesses a distribution license. Alternatively, distribution can becarried out by licensed pharmacies directly.

• As far as payment option is concerned, it is recommended tonegotiate for prepayment mechanisms with banks and/or otherpayment gateways. If not allowed, then Cash on Delivery is still anavailable and legally valid option.

INVESTOR SPEAK


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VC and PE investments in India declined significantly in 2016both in terms of number of deals as well as by amount. Trendsin mean and median deal value suggest that investors havestarted writing smaller cheques. Hence, not only was raisingcapital difficult in the year gone by, the amount raised was alsosmall. The decline characterized by low fund raising, tepid exitsand a moribund/declining deal market has been across allinvestor types though Angel/Seed funds (who placed smallerand numerous bets) were a beacon of hope for the industry.

The discernible trend though was that the quality ofinvestments has increased dramatically as investors havefocused on companies with clear business models and greaterprofitability potential. In 2016 Information Technologycontinued to rule for VC and PE investments and sectors likeConsumer Discretionary, Healthcare, and Financials weresignificant contributors. However, the decline across all sectorsremains secular.

The other significant point of note has been the markdown invaluations especially for some of India’s unicorns. This hasmade it challenging for Indian firms to raise funds in anextremely competitive global environment.

PE exits saw a marginal decline in 2016 and being acquired bya larger company seems to be the preferred exit route asevidenced by the rise in M&A exits. Domestic M&A was strongin 2016, dominated by a few large ticket deals. The EquityCapital Market saw IPOs make a stellar comeback, replacingQIPs and Rights Issues as the preferred means to raise capital.

Looking into the future, though demonetization in India hascreated ruffles which will possibly be transitory in nature, ourmacro story remains intact and India is bound to be abeneficiary of global liquidity in the listed and unlisted space.The investment environment in India is becoming stable andclearer business models are emerging in the startup ecosystem.Though the speed of investments has not increased, we see anincreased interest by investors in FinTech start-ups with O to Omodels which have better control in the ecosystem, as well asinterest in the payments space. Interest in health-tech isgrowing too, particularly in technologies that are enablinghigher quality primary care or more convenient healthcaredelivery, such as new models of care, digital health screening,scheduling, and digital referral services.

MR. KARAN BHAGAT

FOUNDER, MANAGING DIRECTOR AND CEO

IIFL WEALTH MANAGEMENT LTD.


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The PE investment on an overall basis was reasonable, barringtechnology. There were several large deals that gotconsummated in consumer, financial services and healthcareservices sectors. In Tech, the VC market was very slow althoughinvestments happened at Series A (although very selective)levels but in subsequent rounds the investors are being veryselective. On late stage side also, B2B deals still happened whileB2C has suffered after the exuberance in 2015.

We continue to be bullish on tech as we believe the time is ripefor new companies in enterprise software side as well as techenabled B2C business models to emerge. We believe fin tech,enterprise tech and health tech would be interesting sectors towatch for in 2017. Fin tech especially would be an interestingarea as the government is focused on improving the circulationof money. Outside tech, we expect consumer and logisticssectors will continue to see lot of interest and some techenabled models may also play a big role in B2B logistics as well.

Indian LP ecosystem is still not very active and I believe for trulyIndian models to succeed Indian LP ecosystem has to growfaster. Also on regulatory front things have improved but thereis still lot of confusion for e-commerce businesses includingFDI, GST, etc.

2016 has been a very good year for exits in Indian markets forPE investors although on VC side 2015 looked better. Webelieve entrepreneurs have to be more focused on the businessmodels and the unit economics of their businesses as theymove forward because the markets will value businesses thatcan create value.

I believe we will see more Chinese investors in India in 2017.Domestic is still probably couple of years away. US funds thatare already active in India will continue but I don’t think anynew funds will come to India as US is looking good forinvestments currently.

MR. ATUL GUPTA

PRINCIPALPREMJI INVEST


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Venture Capital has played an increasing central role in fundingthe startup eco system in India over the past decade. Over$100bn of VC/PE capital has been invested in India since 2006.The Venture eco-system runs on four dominant engines. Theseare the Exit Engine, Fund Raising Engine, RecapitalizationEngine as well as the New Deal Flow generation engine. Allfour engines performed well in 2016 for the venture Industry.

EXITSExits witnessed increased secondaries, M&A as well as IPOtransactions. More Indian buyers emerged in the technologyspace. At IDG we saw Momoe being bought by Shopclues andHiree being bought by Quickr. Yatra listed on Nasdaq andPremji Invest bought IDG as a secondary at Lenskart. On theM&A front IDG Portfolio “Firstcry” bought Babyoye fromMahindras to strengthen its leadership position in the babycare market in India.

I do see the pace of exits increasing over 2017.

FUND RAISINGMost funds have capital available for investment. There is noconstraint on availability of seed or Series A capital. In fact,RupeeCapital availability increased.

Increasingly Rupee Capital will shape the VC Industry over thenext 10 years. I see this trend becoming stronger every yearwith Indian family offices and institutions committing to Indiafocused VC funds. At IDG we have raised over $100mninvestments for India.

RECAPITALIZATIONOn the Recapitalization front, VC Investors became veryselective. The number of Series A’s funded reduced and SeriesB’s became harder to come by from traditional investors.However, we saw the entry of a number of new investors,especially Rupee funds.

For IDG, 2016 was very good for Portfolio follow on rounds/recapitalization. Sixteen of the IDG Portfolio received follow-ons including Playsimple, Cloudcherry, Tripoto, eShakti, Unbxd,Zimmber, Firstcry, Lenskart and Yatra amongst others.

DEAL FLOWExciting, Innovating, Disruptive and a never ending flow is howone would describe the high quality deal flow in India.At IDG we saw approx. 2800 new deals in 2016 and expect

MR. SUDHIR SETHI

FOUNDER, CHAIRMANIDG VENTURES INDIA ADVISORS

this to grow at 30% to 40% per year.

VIEW ON 2017I do expect the VC industry to grow from strength to strengthin 2017. More exits, additional capital availability and strongdeal flow are expected to continue.

I also expect the separation of the wheat from the chaff in asignificantly pronounced manner. Only excellent performers, bethey VC funds or startups will get funded. The bar has goneup. Mortality is likely to increase. However ample capital isavailable for good deals to be funded.


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�

In 2016, the VC/PE industry saw some sharply contrastingtrends, very interesting and intriguing. For instance, thenumber of Angel investors and investments were at an all-timehigh but series B and C investments were hard to come by formany young companies. So, in 2017 I believe the start-up rushis likely to abate and also funding will smoothen out thevarious stages of the companies.

Another unexpected trend was that of the reversal ofvaluations in the hot e-commerce sector signalling the returnto value based investing and business model fundamentals. Awelcome change!

One other noteworthy event of 2016 was that of theGovernment strongly indicating its support to entrepreneurshipthrough its Start-up India initiative. Though the details willneed to change, get refined and honed, the fact thatGovernment is acknowledging the import of entrepreneurshipis a great step.

I believe that the VC industry is coming of age and will matureand stabilize in 2017.

MS. BALA DESHPANDE

SENIOR MANAGING DIRECTORNEA INDIA


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The PE & VC investment activity in 2016 can be described assubdued. The year 2017 will be a year of consolidation for theindustry.

There has been a general lack of clarity in various areas (for e.g.GST) which is likely to persist in 2017. The industry will alsoneed to ride out the impact of demonetization in the first threemonths of the next year.

The way exits have been handled in the current year has beenvery slow and complex. Any ease by regulators will definitelyhelp exits in the next year.

The PE & VC interest in India in 2017 is expected to bedominated by the same players who have been active this year.

MR. SANDEEP TANDON

CO-FOUNDERFREECHARGE

�

�

SECTOR VIEWS & WISH-LIST FOR 2017


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The year 2016 had been one where investment sentiments have been down and it hasbeen a particularly difficult year for the PE & VC sector, both for the investors and investeecompanies.The year has seen valuations give way to value creation. While, companies foundit difficult to raise capital, specially second and third stage investments, investors saw asubstantial decrease in the value of their current investments, which have made many ofthem re-strategize their investment approach next year. We expect that the likely investmenttide that ebbed in 2016 will turn in 2017.

PE & VC SECTOR VIEW - 2017

• As many as 36 new investment funds have been launched till October2016 by existing as well as new investors. A total amount of US$3.6bnis expected to be raised by these funds. For example, the largest fundlaunched till now this year was the Reliance Jio Digital India Startup Fundwhich raised a corpus of US$745mn.2

• Funds which have been able to make successful exits will continue toattract more funds compared to funds launched by new teams.

• The lower tax rates applicable from 2017-18 would make Mauritius amore attractive route of investment than Cyprus for PE firms. Many big,India-focussed PE firms3 are on the road to raise sector agnostic funds.This would provide them flexibility to chase deals in various sectors.4

• Alternative Investments Funds (AIF), an investment vehicle establishedto pool in funds for investing in real estate, private equity and hedgefunds, have become popular since foreign investments have beenallowed in AIFs in the Union Budget 2016. Close to 80 new AIF launchesthis year alone taking the number of AIFs in India to 268 in 2016. Manyinstitutional investors have expressed interest in the alternatives space inIndia and this is expected to go up by leaps and bounds in the comingyears.5

• A lot of interest is expected to be garnered by sectors such as technology,healthcare and financial services. Within the financial services space,insurance companies are likely to attract big investments before they gopublic (for example, ICICI Prudential IPO). Asian Sovereign funds havealso shown their interest in the Indian Financial Industry, for example,Singapore’s Temasek Holdings and PE giant KKR have together acquired3.9% ownership interest in SBI Life Insurance.6

• Two sectors – consumer products and enterprise technology - whichhave been the sector of choice for private equity and venture capital mayactually continue to attract money as they are still seem to be perceivedas safe sectors with assured returns.7 Investors believe that the consumer

2 http://techcircle.vccircle.com/2016/11/03/good-news-for-startups-36-new-funds-with-1-65-bn-in-pocket-to-begin-shopping-soon/3 http://www.business-standard.com/article/economy-policy/mauritius-gets-debt-advantage-over-cyprus-116121600033_1.html4 http://www.vccircle.com/news/alternative-investment/2016/11/14/ilfs-pe-raises-new-sector-agnostic-growth-fund5 http://www.business-standard.com/article/pti-stories/sebi-registered-aif-count-touches-268-in-four-years-116112900730_1.html6 http://www.swfinstitute.org/swf-article/5-signs-showing-sovereign-funds-gearing-for-spending-in-2017/7 http://tech.economictimes.indiatimes.com/news/startups/vcs-2017-sectors-of-choice-are-enterprise-tech-consumer/55846302

I.FUNDS

II.SECTOR-SPECIFIC

INTEREST


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sector is very big in India and many aspects of the same still remain tobe uncovered. Specifically, the consumer internet space should witnessan increase in investment interest as internet penetration and purchasingpower continue to increase in tier-II and tier-III cities. The enterprisetechnology sector also remains under-penetrated, due to a lack of solidrevenue models and access to global markets.

• Another area which has started eliciting interest of startups is theenabling technology area such as, Internet of things (IoT), deep learning,analytics, cloud, virtual reality and block chain. Internet of things (IoT)has the ability to revolutionize sectors like healthcare, fintech, housing,safety and security, transport and automobiles, energy conservation andagriculture, etc.8 Many companies like Bosch India9 and Mahindra havealready taken up these technologies seriously. Event financial companiesin India have shown interest in bitcoins as they see this as a goodalternative given India's underdeveloped banking system and theunstable monetary policies.

• Real Estate: Record investments are expected in the office sector in 2017by Private Equity companies as there is growing interest in leased officeassets due to the potential to list under real estate investment trusts(REITs). Companies are also increasingly exploring opportunities to investin India's shopping malls as such retail assets can also be listed underREIT portfolios.10 According to real estate consultant Cushman &Wakefield, the first half of 2016 witnessed the highest annual PEinvestments in retail. Some firms also intend to make investments instart-ups that are developing disruptive technology solutions for thesector.11

• Another area where Private Equity companies will continue to operateaggressively is in the stressed assets investment segment.12

• Global venture capital funds are expected to primarily make early age, seedand series A investments in the coming year.

• Chinese investors’ interest in the Indian market has also grown over thepast years and is expected to grow further in the next year, especially in thereal estate sector.13

• One of the major reasons which slowed investments this year was acautious approach by the investors because of sky-rocketing valuations andhay-wire unit economics of most enterprises.14 We expect that the currentand new businesses will keep their valuations at more realistic levels in thecoming year and will give more emphasis to profitability than to marketshare.

8 http://economictimes.indiatimes.com/small-biz/startups/how-these-startups-are-hoping-to-cash-in-on-massive-opportunity-in-internet-of-things-market/articleshow/53467777.cms

9 http://www.bgr.in/news/heres-how-bosch-india-plans-to-contribute-to-the-indian-startup-ecosystem/10 http://economictimes.indiatimes.com/industry/banking/finance/reit-listing-on-mind-private-equity-firms-look-to-invest-in-malls/articleshow/54845767.cms11 http://www.livemint.com/Companies/cXQlCRxeyGse1nVSiEcQpI/PE-investments-in-real-estate-set-to-touch-72-billion-in-2.html12 http://www.vccircle.com/news/alternative-investment/2016/09/21/multiples-pe-plans-enter-stressed-assets-biz13 http://www.vccircle.com/news/real-estate/2016/09/15/chinese-conglomerate-fosun-invest-1b-indian-realty-market14 http://www.livemint.com/Industry/X2GtZLcOYj3Z57Ynn3AyRP/ecommerce-Life-after-the-boom.html

III.DEALS


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15 http://www.globalcapital.com/article/b10vb7rbdn068h/equity-markets-enjoy-an-indian-summer16 http://economictimes.indiatimes.com/small-biz/money/startups-with-global-operations-attract-funds-from-indian-venture-capital-

firms/articleshow/55776259.cms17 http://www.vccircle.com/news/finance/2016/10/21/rbi-eases-norms-PE & VC-investments-infrastructure-biotech-it-other-sectors

• The year 2016 has seen many Start-ups with global operations attractfunds from Indian venture capital firms. There are three big reasons whythis trend is here to stay in 2017. First, it makes a lot of sense for thosecompanies that see a larger than expected user base coming from India.Second, several overseas start-ups may be planning to venture or mayalready have back-end operations in India. Third, when founders have abetter network in India than in other parts of the world; it gives themquick access to decision makers in the institutional investment and angelcommunity.16

• Due to relaxation of norms by RBI allowing SEBI registered ForeignVenture Capital Investors (FVCIs) to invest in start-ups without priorpermission, a new source of investment has emerged for this category.In fact, FVCIs can also invest in unlisted firms belonging to various sectorsincluding biotechnology, nanotechnology, and dairy, without RBI’spermission.17

• Private Equity firms will continue to use Offer-for-sales (OFS) route to cashout from investments made by them since a lot of investments were madein 2011 (the investment cycle of private equity companies is around fiveyears). 2017 should see pricing of issuances becoming more affordable.This will be pushed by increased competition from government divestmentofferings, and this competing supply of paper will make companies offerbetter pricing. However, some companies have already started looking atalternative routes to raise funds and provide exits to their investors.15

• The equity market in India is expected to get a boost with the introductionof investment trusts, first by Infrastructure investment trusts (InvITs) andthen by real estate investment trusts (REITS).

IV.EXITS

V.STARTUPS


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18 http://economictimes.indiatimes.com/small-biz/legal/startup-india-action-plan-tax-incentives-and-bottlenecks/articleshow/54749711.cms

POLICY & REGULATORYWISHLIST FOR 2017

RELAX LONG TERM CAPITAL GAINS TAX NORMS ON SALE OF UNLISTED EQUITIES BY INVESTORS

As per the current Indian tax regime, there is nolong term capital gains tax on sale of listedequities, however, the PE & VC investors have to

factor an additional expense of 10% (overseasinvestor) and 20% (domestic investor) as long termcapital gains tax on the sale of unlisted securities.

LIBERALIZE THE TAX HOLIDAY NORMS FOR STARTUPSCorporate tax exemption for 3 years during first 5years of a start-up seems to be contrary to the

general expectations as the start-ups usually takemore than 5 years to break even.

SELF-CERTIFICATION UNDER STATE SHOPS AND COMMERCIAL ESTABLISHMENTS ACTS

Background: Under the Start-Up India Plan, Start-Ups are allowed to self-certify compliances for thefollowing labour laws:• The Building and Other Constructions Workers’

(Regulation of Employment & Conditions ofService) Act, 1996;

• The Inter-State Migrant Workmen (Regulation ofEmployment and Conditions of Service) Act,1979;

• The Payment of Gratuity Act, 1972;

• The Contract Labour (Regulations and Abolition)Act, 1970;

• The Employees Provident Fund andMiscellaneous Provisions Act, 1952;

• The Employees’ State Insurance Act, 1948;Additionally, no inspection will be conducted withrespect to the abovementioned labour laws for aperiod of 3 years except on receipt of credible andverifiable complaint of violation filed in writing andapproved by an officer atleast one level senior to

Recommendation: The reduction in the taxation norms in relation to sale of unlisted securities wouldhelp in attracting more investment as it would reduce the transaction cost to a large extent.In jurisdictions such as Singapore, no capital gains tax is levied on transfer of securities. The recentamendment to the India – Mauritius DTAA has given India an opportunity to build up a favourableplatform for the businesses, especially the start-ups, by eliminating the long term capital gains tax orby reducing the same to a bare minimum of 5%.

Recommendation: The cap of 5 years should be extended to 10 years to provide sufficient time tothe start-ups to get established in the market.18


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the inspecting officer.• The Water (Prevention & Control of Pollution)

Act, 1974;• The Water (Prevention & Control of Pollution)

Cess (Amendment) Act, 2003; and • The Air (Prevention & Control of Pollution) Act,

1981.In this regard, most of the abovementionedlegislations pertaining to environmental laws,migrant and construction workers will not berelevant/pertinent for Start-Ups.

Recommendation: It would be helpful for start-ups if the Shops and Commercial Establishments Act isalso made a part of the labour laws wherein self-certification and exemption from inspection is permitted.

FDI IN MARKETPLACE MODEL OF E-COMMERCEThe latest ‘Guidelines for Foreign Direct Investment(FDI) on E-commerce’ issued by the Ministry ofCommerce & Industry, Department of IndustrialPolicy & Promotion (“Guidelines”) permits 100%FDI under automatic route in marketplace modelof e-commerce, subject to certain conditions.However, there is lack of clarity on the conditionsto be fulfilled for the marketplace model of e-commerce, such that the meaning of the termdirectly or indirectly in the condition “entities

operating marketplace model of e-commerce willnot directly or indirectly influence the sale price ofgoods or services and shall maintain level playingfield”. Also the conditions state that entitiesoperating in the marketplace model of e-commerce will not exercise ownership over theinventory, i.e., goods or services sold. Inventory isgenerally in relation to goods and not services.Therefore, require clarity on the inclusion ofinventory for services.

Recommendation: (i) Clarity on the term e-commerce entities will not directly or indirectly influencethe sale price of goods or services. It should be clarified whether the discounts and offers which arecommonly provided by online players are valid and also, whether any scheme/offer other thanmonetary discounts would also come under the purview of this restriction? and; (ii) clarity on therestriction on ownership over the inventory of services.

100% FDI UNDER THE GOVERNMENT APPROVAL ROUTE IS ALLOWED IN TRADING, INCLUDING THROUGH E-COMMERCE, OF FOOD PRODUCTS MANUFACTURED

AND/OR PRODUCED IN INDIA

Under the current FDI Policy, upto 100% FDI underthe Government approval route is allowed in

trading, including through e-commerce, of foodproducts manufactured and/or produced in India.

Recommendation: To provide a boost to the food manufacturing market and trading of food productsmanufactured / produced in India, it is essential that the Government eliminates the requirement ofprocuring Government approval for FDI in trading of food products manufactured/ produced in India.


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In furtherance of its objective of tackling risingnon-performing assets of banks, and in line withthe Central Government's announcements in theUnion Budget of 2016, the Department ofIndustrial Policy and Promotion ("DIPP") has, videPress Note No. 4 issued on May 6, 2016 ("PN2016") brought about significant changes to theForeign Direct Investments ("FDI") policy relating toAsset Reconstruction Companies ("ARCs") allowing

100% FDI under the automatic route in ARCs,which would help in bringing in much neededforeign capital to deal with stressed and non-performing assets in the banking sector. This wouldenable ARCs struggling for funds, especially due tothe requirement under current RBI guidelines, ofupfront payment of 15% of the new value of assetsto banks for the purchase of bad loans.

EASE OF RESTRICTIONS IN SINGLE BRAND TRADINGUnder the extant FDI regulations, FDI cap for singlebrand product retail trading is 49% under theautomatic route and 51% under the Governmentroute. Additionally, FDI in single brand productretail trading would be subject to variousconditions such as:a) Products should be sold under a ‘Single Brand’

only;b) Products should be sold under the same brand

internationally i.e. in one or more countries;c) ‘Single Brand’ product-retail trading would cover

only products which are branded duringmanufacturing;

d) Only a single brand product retail trading entityoperating through brick and mortar stores, is

permitted to undertake retail trading through e-commerce;

e) In respect of proposals involving foreigninvestment beyond 51%, sourcing of 30% of thevalue of goods purchased, will be done fromIndia, preferably from MSMEs, village andcottage industries, artisans and craftsmen, in allsectors. This procurement requirement wouldhave to be met, in the first instance, as anaverage of five years’ total value of the goodspurchased, beginning 1st April of the year of thecommencement of the business i.e. opening ofthe first store. Thereafter, it would have to bemet on an annual basis.

NECESSARY AMENDMENTS IN SARFAESI ACT AND INCOME TAXACT TO FACILITATE THE ALLOWANCE OF 100% FDI UNDER THEAUTOMATIC ROUTE IN ASSET RECONSTRUCTION COMPANIES

Recommendation: FDI in Single Brand Product Retail Trading should be increased to 100% underthe automatic route, subject to specific conditions; or keeping the FDI cap restrictions on single brandproduct retail trading, it should be ensured that certain conditions such as 30% local sourcing shouldbe diluted such that for the initial five years the local sourcing requirement should be capped to 10%and after the expiry of 10 (ten) years it can be changed to 30%.

Recommendation: The changes under PN 2016 are expected to further open up the ARC sector,boost foreign investment in and provide relief to ARCs struggling for capital. However, concurrentamendments in the SARFAESI Act will have to be made to reflect the changes pertaining to permissibleshareholding of sponsors in ARCs. Also, related changes pertaining to taxation of ARC trusts issuingsecurity receipts will also have to be brought about in the Income Tax Act, 1961.


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REMOVAL OF ONEROUS FDI COMPLIANCEUnder the extant FDI regulations, receipt of foreigninvestment by a company requires adherence toelaborate filing and reporting requirements such asfiling the advance reporting form with the RBI

through the AD category bank, filing of the Form FC-GPR. Also, any transfer of shares to a foreigninvestment requires the filing of Form FC-TRS.

Indian regulators have eased certain norms for IPOin India especially for start-ups. Start-ups are now

allowed to go for public listing without going for anIPO.

NEED FOR A BETTER FRAMEWORK TO PROVIDE SMOOTH EXITS TO THE INVESTORS

RIGHT TO DATA PRIVACY LAWS NECESSITY WITH THEDIGITALISATION OF THE BANKING SECTOR

Recommendation: Some of the onerous compliance requirements relating to reporting of FDI shouldbe done away with. Since the Company anyway files Form FC-GPR and Form FC-TRS, additionalrequirement of filing the annual return on Foreign Liabilities and Assets (FLA Return) by all the IndianCompanies which have received FDI and/or made FDI abroad should be done away with.

Recommendation: There is a need for liberalization of the fund-raising norms for corporates other thanstart-ups as well. The conditions such as (a) minimum contribution of 20% of the post issue capital bypromoter; (b) lock-in of the minimum contribution of the promoters for a period of 3 years; (c) numberof mandatory disclosures, should be streamlined.

In 2011, the Information Technology (ReasonableSecurity Practices and Procedures and SensitivePersonal Data or Information) Rules were notifiedunder the Information Technology Act, 2000 toprovide protection to sensitive personal informationor data and any transfer or sharing of the same.Further, the Privacy (Protection) Bill, 2013 is due tobe passed by the Parliament. The above said laws arenot as developed as that of the West and thepressure to provide stronger legislative protection hasincreased as India is becoming a favourable nationfor foreign investment. Lack of adequate dataprotection and privacy laws in India are often citedas reasons for companies to avoid outsourcing

business to India.Further, the Government has released the NationalData Encryption Policy (data encryption meansconversion of data into form). Banks and e-commerce sites use encryption to protect yourfinancial and private data, online government sitesand several other messaging platforms useencryption to protect your personal data and so on.However, the draft fails to protect data as it indicatesthat a company will have to keep passwords in plaintext, which means your data will remain unencryptedand hence vulnerable, for 90 days. It gives attackers/hackers good 90 days to get to the plain text or yourvulnerable data.

Recommendation: Enactment of the Privacy (Protection) Bill, 2013 which is in cognizance with theprivacy laws in USA and UK. We require a comprehensive Act and the provisions of IT Act deal basicallywith extraction of data, destruction of data, etc. Companies cannot get full protection of data throughthat which ultimately forced them to enter into separate private contracts to keep their data secured.Further, it is necessary to update and plug the loopholes in the National Data Encryption Policy.


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CLARITY ON DETERMINATION OF OWNERSHIP AND CONTROL IN AIFS MAKING DOWNSTREAM INVESTMENTS

BITCOIN: AND BEYONDA block chain is an anonymous online ledger thatuses data structure to simplify the way we transact.Blockchain allows users to manipulate the ledgerin a secure way without the help of a third party. Abank's ledger is connected to a centralisednetwork. However, a blockchain is anonymous,protecting the identities of the users. This makesblockchain a more secure way to carry outtransactions. Several financial institutions,investment funds, and financial infrastructure

bodies have taken notice of the potential impactof blockchain technology on clearing andsettlement. As mentioned earlier, R3 leads aconsortium of over 50 large financial institutionsexploring the use of blockchain technology.Investors in blockchain startups in the clearing andsettlement space include Khosla Ventures, SVAngel, Citigroup, JP Morgan, and Santander. Thepractical challenges are (i) cyber security (ii) privacyand (iii) uncertain regulatory status.

The notification provides that if either the ‘Sponsor’or the ‘Manager’ is not Indian ‘owned andcontrolled’, the entire downstream investment bythe AIF will qualify as foreign investment and besubject to the restrictions on foreign investments.The above rule creates significant challenges formany AIFs which are sponsored and managed byforeign companies, Indian banks, NBFCs, orholding companies of such financial institutions. Inmany such cases, given the significant level ofForeign Portfolio Investors’ (FPIs) ownership, the

institutions fail to meet the criteria of being Indianowned and controlled. However, there could be instances where themanager or sponsor is Indian “owned andcontrolled” but the majority of the investors in AIFsare foreign investors. In such a situation, theconditions of downstream investment would notget triggered and foreign investors could ultimatelyinvest in sectors that are directly or indirectlyprohibited under the FDI Policy.

Recommendation: The test to determine whether the condition for downstream investment isapplicable to an AIF should be based on the percentage of foreign and Indian investment in the AIFand not the ownership of ‘sponsor’ or ‘manager’. Accordingly, sub clause 4, 5 and 6 of Schedule 11of the Foreign Exchange Management (Transfer or issue of security by a person resident outside India),Regulations 2000 should be modified to reflect the aforesaid.

Recommendation: To provide a regulatory framework for block chain transactions.


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BRING DEFINITION OF SOPHISTICATED INVESTORS IN LINE WITH THE GLOBAL PRACTICES

Investment products like AIFs require theparticipation of sophisticated investors. SEBI’s AIFregulations require the use of the ‘ticket size’ of aninvestment as a criterion to identify sophisticated

investors. Besides the ticket size criteria, there is aneed for a mechanism to identify investors towhom complex investment products can be madeavailable.

MAKING THE FUND MANAGEMENT SAFE HARBOUR PROVISIONSEFFECTIVE AND ALIGNING IT WITH PREVAILING PRACTICES AND

CHARACTERISTICS OF THE GLOBAL PRIVATE EQUITY ANDVENTURE CAPITAL INDUSTRY

Most Indian focused funds are managed outside ofIndia, in order to avoid the risk of beingcharacterized as a permanent establishment. Whilethe investment is being made in India, the fees formanaging such investments would be paid toinvestment management entities outside India.Section 9A of the Act was introduced into the Actwith an objective to encourage onshore

management of offshore funds leading to increasedemployment, retention of talent, and increasedincome being generated in India. While the benefitsthat can be reaped by enabling a liberal tax regimeare huge, the strict investor concentration and safeharbour conditions have so far not lead to anyinterest from offshore funds in setting up onshorefund management activities in India.

Recommendation: Recommendations made by Alternative Investment Policy Advisory Committee(AIPAC) under the chairmanship of Shri. N. R. Narayana Murthy to define the concept of ‘sophisticatedinvestor’ must be implemented. In various countries, the concept of “Accredited Investors” is usedwhere an investor who has a certain minimum income, or asset, or net worth, is considered to be anAccredited Investor who can make investments in vehicles such as AIFs. Such investors are usuallyself-certified. In USA, ‘a natural person with income exceeding US$200,000 in each of the two mostrecent years’ is said to fit the definition of the term “Accredited Investor”. In Singapore, definition ofterm ‘Accredited Investors’ is based on net asset of the individual or corporation, entity, partnershipor trust.

Recommendation: It is therefore imperative to assess whether practically these conditions can bemet by offshore funds especially the ones relating to eligibility of offshore investment funds,investment criteria, functioning of CBDT’s pre-approval mechanism wherein a fund can seek approvalat its option from the CBDT regarding its eligibility for the safe harbour. Further, to ensure that thereis consistency between the safe harbour conditions and provisions of GAAR (whenever implemented)so as to avoid any ambiguity in the future on the same.


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NOTES

DisclaimerThis document captures the facts based on information available in the public domain and based on publicannouncements. Further, our analysis of the deal values is based on publicly available information andbased on appropriate assumptions (wherever necessary). Hence, if different assumptions were to beapplied, the outcomes and results would be different. ARA Law does not take any responsibility for theinformation, any errors or any decision by the reader based on this information.

This document should not be relied upon as a substitute for detailed advice and hence, we do not acceptresponsibility for any loss as a result of relying on the material contained herein.

Whilst due care has been taken in the preparation of this document and information contained herein,ARA Law in India does not accept any liability whatsoever, for any direct or consequential loss arising fromany use of this document or its contents or otherwise arising in connection herewith.

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