SEBI’s Oversight on Angel Investments to Foster Start-Up Growth in India

Parvathy Roy, is a third year law student at Gujarat National Law University, Gandhinagar.

Unveiling the Evolution of India’s Start-up Landscape

In the past two decades, India has witnessed a profound transformation in its investment culture, catalysing a robust expansion of its economy. Start-ups have emerged as proactive agents, leveraging technology and innovation to address societal challenges and create substantial employment opportunities, particularly for the youth. Recent statistics reveal a remarkable surge in the number of registered start-ups, indicating a two-fold increase since 2015.[1] This surge has been accompanied by a noticeable uptick in investor interest and capital influx, with Angel Investors, Venture Capitalists, and Private Equity Firms playing pivotal roles.[2]

Angel investment, a form of equity financing, has become indispensable, especially in funding early-stage start-ups. Angel Investors, including Lone Wolf Investors and participants in Angel Networks like the Indian Angel Network (IAN), provide crucial seed funding and mentorship, propelling the growth of emerging ventures. Lone Wolf Investors, typically affluent individuals, operate independently, while Angel Networks adopt a collective investment approach, serving as vital conduits for capital and mentorship, particularly in tier 1 cities.[3]

The emergence of new investor archetypes—Pure Angels and Super Angels—underscores the dynamic nature of India’s start-up ecosystem. Pure Angels, whether acting individually or within networks, actively contribute to funding and mentoring start-ups, while Super Angels, successful entrepreneurs with a track record of exits, reinvest in start-ups, fostering innovation and community-building.

India’s status as an emerging economy has further fuelled the growth of its start-up ecosystem, resilient even in the face of global challenges like the COVID-19 pandemic. Buoyed by substantial funding and the success of recent unicorns, India now boasts the second-largest start-up ecosystem globally, highlighting the importance of robust investor support and domestic market potential.

Deciphering the Dynamics of Angel Investing

In 2002, Freear highlighted a persistent challenge in understanding the temporal dynamics and universality of angel investing processes across diverse industries, regions, and nations.[4] Angels display diversity in financial expertise, entrepreneurial experience, wealth origins, and investment motivations, resulting in significant variance in governance mechanisms. Research suggests that angels often adopt a non-predictive control-oriented approach to investing, prioritizing “affordable loss” over “expected value” logic.[5] This approach, coupled with relatively weaker due diligence capabilities compared to venture capitalists (VCs), leads to the use of incomplete contracts to address agency issues post-investment. Despite mixed findings on post-investment engagement, angels tend to strategically emphasize business acumen over industry-specific experience. A study of nine angel-funded companies revealed positive impacts on balance sheets and credibility, facilitating access to debt funds. However, entrepreneurs noted a lack of industry-specific experience among many angels.[6]

The SEBI Venture Capital Fund (VCF) Regulations, 1996 laid the foundation for regulating venture capital activities in India, aiming to facilitate investment in innovative and high-growth potential sectors.[7] These regulations provided a framework for registration, operation, and exit mechanisms for venture capital funds, promoting the flow of capital into promising start-ups and small businesses. In 2012, SEBI introduced the Alternate Investment Fund (AIF) Regulations, encompassing a broader spectrum of alternative investment funds beyond traditional venture capital funds.[8] This transition marked a significant evolution, offering a more comprehensive regulatory framework to regulate various categories of alternative investment funds, including angel funds, hedge funds, and private equity funds, thereby adapting to the changing dynamics of the investment landscape.

Current Institutional Framework regarding Angel Investments in India

Presently, angel investments in India operate through private transactions without regulatory oversight. However, leveraging the Accredited Investor framework could transition these transactions into a regulated exchange framework.[9]

Historically, angel networks provided funding to start-ups privately on a one-to-one basis. To stimulate the growth of Indian start-ups, SEBI introduced angel fund regulations in 2013 through an amendment to the AIF Regulations. Under this framework, SEBI extended the mainstream AIF platform to the Indian angel network, facilitating the establishment of funds focused on start-up investments. Angel funds were integrated as a sub-category of venture capital funds, falling under Category I AIFs.

To qualify as an angel investor, individuals must meet specific criteria, including possessing early-stage investment experience, serial entrepreneurship experience, or a minimum of ten years in senior management. Corporate entities must have a net worth of at least ten crore rupees. Alternatively, Alternative Investment Funds or Venture Capital Funds registered under SEBI regulations are eligible.[10]

The angel investment agreement, with its diverse clauses, establishes a comprehensive framework governing the intricate relationship between a start-up and its angel investor. It covers essential elements from initial investment terms to eventual exit strategies.

SEBI has provided angel funds with more favorable terms under the AIF Regulations compared to other AIF categories. Angel funds must have a minimum corpus of INR 5 crores, with a minimum commitment of INR 25 lakhs from angel investors. SEBI has imposed specific prerequisites under the angel fund regulations to ensure that these funds are exclusively pooled from angel investors and directed towards the growth of start-up companies.

These prerequisites include defining eligibility criteria for angel investors, specifying portfolio companies that an angel fund scheme can invest in, and stipulating a lock-in period for each investment. These measures aim to streamline the angel investment process, fostering a conducive environment for start-up growth while maintaining regulatory standards.[11]

Reasoning behind SEBI’s extended powers over Angel Investments

Start-ups commonly function as privately held unlisted entities, as delineated in Section 2(40) of the Companies Act.[12] A clarification has been appended to Clause (40) of Section 2 of the Companies Act, 2013, specifying the definition of a Startup. It elucidates that a ‘Startup Company’ denotes a privately incorporated company under the purview of the Companies Act, 2013, duly acknowledged as a startup pursuant to the notification issued by the Department of Industrial Policy & Promotion, Ministry of Commerce & Industry.

Additionally, the SEBI (AIF) Regulations, 2012 explicitly govern the investment landscape for angel investments. Despite the general exemption of private unlisted companies from SEBI Regulations, it is crucial to interpret that angel investments which are mostly done in start-ups[13] fall under the purview of these regulations.[14] This implies that angel funds associated with such investments are subject to the aforementioned regulatory framework.

Moreover, in the case of SEBI v. Subrata Roy Sahara,[15] the Supreme Court affirmed SEBI’s authority to investigate and resolve investor-related issues. It emphasized that the SEBI Act confers special jurisdiction upon SEBI to safeguard investors’ interests. These powers are not in conflict with any other legal provisions and should be interpreted in harmony with them. The Court clarified that SEBI’s powers are supplementary and compatible with existing laws, particularly concerning the Ministry of Corporate Affairs (MCA). This ruling ensures coherence and collaboration between regulatory bodies, avoiding jurisdictional conflicts while prioritizing investor protection.

Conclusion

In conclusion, the regulation of angel investments in India is integral to nurturing and sustaining the dynamic start-up ecosystem. Over the past two decades, the evolution of angel investing culture has significantly contributed to India’s economic growth by fostering innovation and creating employment opportunities. Angel investors, whether operating individually or through networks, provide crucial early-stage funding and mentorship to emerging ventures.

SEBI’s extended powers over angel investments, demonstrated through the AIF Regulations and landmark judicial rulings, highlight the importance of regulatory oversight in safeguarding investor interests. By establishing specific preconditions for angel funds and ensuring alignment with existing legal frameworks, SEBI aims to balance investor protection with the promotion of entrepreneurial ventures.

Moreover, the Accredited Investor framework holds promise for transitioning angel investments to a regulated exchange framework, enhancing transparency and accountability. Collaboration between regulatory bodies like SEBI and the MCA is essential for ensuring coherence and addressing jurisdictional conflicts, thereby bolstering investor confidence and fostering sustainable growth in India’s start-up ecosystem.

[1] https://www.isec.ac.in/wp-content/uploads/2023/07/WP-514-Fakih-Amrin-Kamaluddin-Final.pdf

[2] https://www.ijmh.org/wp-content/uploads/papers/v9i8/H1592049823.pdf

[3] https://www.ijmh.org/wp-content/uploads/papers/v9i8/H1592049823.pdf

[4] https://www.tandfonline.com/doi/abs/10.1080/1369106022000024923

[5] https://www.iimb.ac.in/sites/default/files/2018-07/WP_No._448.pdf

[6] https://hbswk.hbs.edu/archive/angel-investing-matching-start-up-funds-with-start-up-companies-the-guide-for-entrepreneurs-individual-investors-and-venture-capitalists

[7] https://www.sebi.gov.in/legal/regulations/dec-1996/sebi-venture-capital-funds-regulations-1996_19387.html

[8] https://www.sebi.gov.in/sebi_data/docfiles/23767_t.html

[9] https://www.sebi.gov.in/sebi_data/attachdocs/1480591844782.pdf

[10]https://www.sebi.gov.in/legal/regulations/apr-2017/sebi-alternative-investment-funds-regulations-2012-last-amended-on-march-6-2017-_34694.html

[11] https://nishithdesai.com/SectionCategory/33/Funds-Hotline/12/40/FundsHotline/4435/1.html

[12] https://www.mca.gov.in/Ministry/pdf/CompaniesAct2013.pdf