No Hallelujahs From Angels But Full Marks To SEBI

Ajeet Khurana

A few days ago, I wrote about the potential impact of SEBI’s regulations on angel investors. I think the move is a positive development for the ecosystem but pain is bound to accompany any significant change. In this article, I will examine SEBI’s proposals for angel investment and evaluate their repercussions.

Proposal 1: Angel Funds Will Be Seen As Venture Capital Funds

Angel funds will now enjoy pass-through status. Thus, profits from investments will not be taxed at the hands of the angel fund. This will solve problems such as double taxation, deemed dividends and dividend distribution tax.

Proposal 2: Not Everyone Can Make Angel Investments

This proposal seems counter-intuitive. After all, if someone is willing to invest, why should SEBI stop them? For instance, SEBI does not recommend qualifications for mutual fund investors. But the mutual fund beast is very different from an angel investment opportunity.

In the past, we have seen how financial instruments and investment opportunities can be gravely misused. A case in point was the way ULIPs were sold. Justifiably, SEBI wants to ensure that the investor knows what she or he is getting into. This objective could have been met in different ways:

The investor should pass a test that makes them eligible for angel investing

(i)     The investor must have a background in the start-up space

(ii)    The investor must have a certain minimum net worth

(iii)   The investor should be informed about all aspects of angel investment – its risks, strategy, realistic expectations, etc, before making the investment

Each one of these criteria is fraught with risk. For instance, when you open a trading account with a brokerage firm, you have to sign a 30-50 page booklet that explains the nature of the engagement. I am still to meet anyone who has actually read the booklet. So, ‘informing’ the investor does not cut any ice. On the other hand, asking the investor to take a test would kill the industry. So what SEBI stipulates is that the angel investor should have both of the following:

(i)    Experience as an early-stage investor, or as a serial entrepreneur, or as a senior management professional with at least 10 years’ experience

(ii)    Net tangible assets of at least Rs 2 crore. (Note this Rs 2-crore floor is for individual angels. For corporate angels, it is Rs 10 crore).

During 15 years of angel investing, I have not come across one angel investor who does not meet the Rs 2-crore net tangible asset requirement. But I have come across several 20-somethings who are angel-investing family money. When they start out, they would not have met SEBI's guidelines for experience. If this proposal is implemented stringently, it could spell trouble for such angels. But then, these investors could come in through the corporate route, if they meet the Rs 10-crore net tangible asset requirement.

Proposal 3: Angel Funds Should Have A Corpus Of At Least 10 Cr

The corresponding number for Venture Capital funds is Rs 20 crore. I would have expected a lower number – probably Rs 5 crore. This is because a Venture Capital fund plays a substantially later-stage game than an angel fund. However, angel fund managers draw most of their reward from ‘carry’, ie a share of the profits earned for investors. Given that the life cycle of such funds is expected to be 5-7 years, even a Rs 10-crore corpus is too small to make an acceptable return for the fund manager. I don’t think this proposal will meet with any real resistance.

Proposal 4: The Minimum Investment By An Individual Investor In An Angel Fund Must Be at Least Rs 25 Lakh

The corresponding number for Venture Capital funds is Rs 1 crore. Till SEBI's AIF (Alternative Investment Funds) guidelines took effect in 2012, many Venture Capital funds were accepting investors with ticket sizes of Rs 25 lakh. SEBI's Rs 25-lakh floor for individual angel investors does not make sense for the following reasons:

(i)     According to SEBI's own thinking, an individual with net tangible assets of Rs 2 crore is eligible to make angel investments. How likely is it that an investor would allocate one-eighth (Rs 25 lakh of Rs 2 crore) of their net tangible assets to one investment? This number should be more like one-twentieth. A number such as Rs 10 lakh would make far more sense. To allow angel investors to diversify their risk by investing in multiple angel funds, this number should be lowered even further – perhaps even Rs 5 lakh.

(ii)     SEBI's guidelines are not meant to regulate only existing angel investors. They should also be oriented towards incubating a healthy angel ecosystem that invites new angels. If a first-time angel needs to invest Rs 25 lakh in one particular investment opportunity, this would keep away a large number of perfectly suitable angel candidates.

SEBI further stipulates that the Rs 25 lakh can be accepted over a maximum 3 years. This is in keeping with the way alternative funds such as Venture Capital funds, Private Equity funds, REITs and the like accept investments. So far, so good. But what if an investor commits to pay Rs 25 lakh over 3 years and makes an initial payment of Rs 5 lakh but does not pay the future money when it is called for, then who is at fault?

It would be unfair for SEBI to penalise the fund, as the fund may have a built-in adequate disincentive for investors to not renege on future payments. But if SEBI forgives the fund, then rogue funds could use this loophole to accept lower ticket sizes from some investors.

Proposal 5: The Sponsor / Manager Of An Angel Fund Should Have Some of Their Own Money In The Fund

The minimum amount proposed by SEBI is 2.5 per cent of the corpus or Rs 50 lakh, whichever is lower. One could argue that this is something that market forces should dictate, ie, SEBI should not care if investors themselves do not insist on it. Despite that, I get the sense that market participants are not really affected by this regulation. If the total corpus of the angel fund is at the minimum prescribed Rs 10 crore, then the sponsor's contribution can be as low as Rs 25 lakh (ie, 2.5 per cent of Rs 10 crore).

Proposal 6: The Investee Company Should Meet A Set Of Criteria

One could argue that the investor should decide where they want to invest. However, SEBI's biggest motivator in regulating angel investors seems to stem from its fear that in the name of angel investment, one might allow money-laundering scams, or present vehicles for bribery and corruption.

Despite this valid concern, some of the proposed criteria are highly restricting. It is important to note that the present SEBI regulations prescribe these criteria only for angel funds. So, these should not be applicable to individual investors. Let us examine the criteria that investee companies need to meet:

(i)      The company should be incorporated in India. It should not be more than 3 years old. I do not anticipate too much resistance to these criteria. I have seen a couple of transactions in companies older than 3 years or in companies incorporated abroad but those are exceptions.

(ii)     It should not have a turnover greater than Rs 25 crore. It should be unlisted. It should not be related to an industrial group with a turnover of more than Rs 300 crore. These 3 criteria do not seem like too much of a problem, as genuine angel investment tends to be restricted to unlisted companies with a small turnover.

(iii)     It has no family connection with the investors. Individual angel investment often comes in from relatives. But since this regulation deals with angel funds, we should be happy that this restriction is in place.

(iv)     It will raise angel investment of a minimum Rs 50 lakh and a maximum Rs 5 crore from an angel fund. This proposal will be a problem since I have often seen investments on both sides of these boundaries. The biggest irrationality comes into play when you consider subsequent rounds that a company raises from the same angel fund. Does the total sum raised in all the rounds have to satisfy this criterion or is it applicable to each individual round? What if the later round is from a different angel fund? This proposal needs to be reworked.

(v)     Angel funds must stay invested in a company for a minimum 3 years. This is another problem area. What if there is an attractive exit opportunity for a fund in 15 months?

Despite what Doomsayers predict, I do not think the current set of SEBI proposals will sound the death knell for angel investment in India. However, there are some pain points that need to be addressed. In addition, there is a need for clarity on some of the proposals. I suspect we haven't heard the last of this, and some updates will be forthcoming from SEBI soon.

The author of this article, Ajeet Khurana, mentors start-ups. An angel investor, trainer, author, entrepreneur and digital marketer, he is a member of the screening committee of Mumbai Angels, one of India's oldest angel networks. He is on the boards of Carve Niche Technologies and Rolocule Games. You can reach him on LinkedIn and Twitter

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