A new alternative: SME liquidity in India

India produced the second-largest number of start-ups globally last year, after the US, according to Gust, a global platform for early-stage investing. Early-stage transactions accounted for 44% of total deal volume, up from 24% in 2011 and 16% in 2010.

The role played by angels in this movement received official recognition earlier this year, when Finance Minister Palaniappan Chidambaram announced that angel investor pools would become a subset of the venture capital category of Alternative Investment Funds (AIF), which means they can qualify for tax breaks. He also proposed that an exchange be set up to allow small- and medium-sized enterprises (SMEs) and start-ups to list.

The Securities and Exchange Board of India (SEBI) subsequently announced that these companies would be able to sell shares on an Institutional Trading platform (ITP) without having to do an IPO.

"The intent was two-fold: to help SMEs raise money through private placements, and also to offer exits to early stage VCs and angels," says Mahendra Swarup, managing director at Avigo Capital and president of the Indian Venture Capital and Private Equity Association (IVCA). He is on the panel SEBI tasked with suggesting guidelines for firms trading on the SME platform.

The ITP will exist in parallel to SME platforms launched last year by India's two main stock markets because the companies listed will only be accessible to informed investors such as angels, venture capital funds and PE. The minimum amount for trading or investment will be INR1 million ($16,787).

Flexibility in favor

Another move, to exempt companies from having to sell 25% equity in order to list on the ITP, has been welcomed by entrepreneurs.

"The hitch with the existing SME platforms is that you have to dilute 25% equity in the first go. Early stage companies usually don't know how much money they need," says Sanjay Vijayakumar, CEO of MobME Wireless Solutions. "For example, if I don't need $5 million, I can raise $1 million by diluting a small amount of equity unlike the 25% required now. Then at a later stage I might sell a larger stake at a much higher valuation as my model has been proved with the $1 million."

MobME is a mobile, media and entertainment company that provides value-added services for mobile phone users and network operators. It launched in 2006 and received equity investment of INR30.3 million between 2008 and 2012 from angel investors in the Middle East and Silicon Valley. The company generated a net profit of INR51.3 million for the 2012 fiscal year.

When it came to raising further capital, VC investment was not available and neither were bank loans because MobME was unable to offer collateral - a common problem for start-ups in India. In such cases, an SME listing could allow entrepreneurs to unlock value from their equity.

"I can take the equity to a bank and pledge it because there is a market value to it," Vijayakumar adds. "So I can raise debt with this equity as collateral."

Swarup endorses this use of the ITP but warns that the government must clarify that equity could be valid collateral.

On the exits side, the ITP is expected to offer existing investors a better chance to find alternate buyers, as both IPOs and corporate M&A of new companies are lacking in India. These exits might also be tax efficient as a sale over a listed platform attracts less capital gains tax - there's a 10% levy if the investment is less than a year old, and no tax if it is longer.

By bringing angel funds under the AIF umbrella, SEBI is trying to formalize the segment and encourage investment. Funds must have corpus of at least INR100 million, and minimum investment per investor of INR2.5 million - lower than the requirements for other AIFs.

"That's been one of the long-standing demands from angel investors. There were a lot of informal angel clubs which were investing individually and they could not do a pooling because the AIF regulations would have then meant that they would have to put in a minimum of INR10 million per person," says Siddharth Shah, a partner at law firm Khaitan& Co.

As a result, angel funds might be able to tap high net worth individuals (HNWIs) for capital. According to Gopal Srinivasan, chairman and managing director of TVS Capital Funds, there is roughly $2 trillion in rupee-denominated capital in India, the bulk of it with HNWIs. Take 10% of that - the typical alternate assets allocation by a global pension fund - and you have $200 billion.

Investment limitations

Angel funds are limited to investing in unlisted companies less than three years of age and with an annual turnover below INR250 million. Commitments must be INR5-50 million, with a minimum holding period of three years.

This stipulation has been criticized because funds often invest less than INR5 million to test the business viability of a venture. Also, incubators and accelerators put in as little as INR500,000 at the seed stage and exit within three years through the Series A or B rounds.

SEBI has created three categories of angel investor - funds, individuals and corporates - and each must have a certain net worth and experience with the asset class in order to participate. While angel fund investments are restricted to a certain size, individuals could step in to provide funding at the very early stages.

However, another problem is the "angel tax" introduced this year. If an unlisted company receives funds against the issue of shares in excess of the fair market value (FMV), the investee company can be taxed on the excess amount as "income from other sources."

This will not apply to investments from angel funds, but individual investors still face the issue.

"This results in 30% [above FMV arrived by the regulator] of an investor's money being indirectly subject to income tax, plus the cash flow of the company is impacted and growth impeded. It discourages investment in start-up companies," says Padmaja Ruparel, president of Indian Angel Network.

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• Topics
• South Asia
• Exits
• Investments
• Early-stage
• Venture
• India
• SEBI
• Venture
• Exit
• SME