Get All Access for $5/mo

How FDI Regulation will Change the Game for Indian Startups An Ernst & Young's technology report this year ranks India as the third most preferred investment place for technology investments globally

By Sandeep Soni

Opinions expressed by Entrepreneur contributors are their own.

You're reading Entrepreneur India, an international franchise of Entrepreneur Media.

Entrepreneur India

Capital flow is much like a pyramid. The higher you go the lesser is the capital available per start-up. Even as 36 new funds were launched last year (as per data tracker VCCEdge), late-stage dilemma continues with multiple private equity (PE) and hedge funds "revisiting' their investment strategy. As the market correction continues, recently released new consolidated foreign direct investment (FDI) policy will strengthen much needed foreign investment in startups in India. But will it be a game changer or just a step forward?

The answer to that question would be easy if we look at some facts to understand where India stands right now when it comes to foreign institutional investment (FII). An Ernst & Young's technology report this year ranks India as the third most preferred investment place for technology investments globally. Meanwhile, FII - equity and debt funding peaked to $7.46 billion in 2016-17 due to expected higher economic growth rate, lowered interest rates and better earnings outlook. That means we aren't doing bad in contrast to what many start-up pundits say. The biggest believers in Indian start-up story, in terms of the maximum foreign investments since 2012 till August this year, are the US-based investors followed by Singapore, Hong Kong, Japan and the UK.

Valuation Friendly

With that as the basis, we look at the developments that consolidated policy talks about – first, allowing startups to raise up to 100 per cent of the capital from a foreign fund, registered with Securities and Exchange Board of India (SEBI) as a foreign venture capital investor (FVCI - incorporated and established in a foreign country), through issuance of equities like common or preferred stocks, equity linked instruments or debt instruments like bonds, debentures etc.

Second, offering convertibles notes to a foreign person for raising minimum INR 25 lakh in a single tranche. So it seems just another window opened up for investors to invest here. Now let's measure their impact – good or average – from the perspective of stages at which the investment is raised – early, mid and growth. Particularly at early stage, when valuations are little haywire due to lack of growth history, issuing convertible notes help avoid valuation matrix which is never absolute.

"It makes life simpler for individual investors at seed or series A stage with the valuation arrived at instead of putting an artificial valuation at the seed level and facing down rounds later. This is more beneficial as it encourages more people to invest in start-ups. The disparity between overseas investor and domestic investor is being rationalized now," says Sarath Naru, Managing Partner, Ventureast – among the earliest early stage venture funds based in Bengaluru.

Convertible notes let issuers link the valuation to the company's next round of fundraising as it gets time to develop some track record to help arrive at a fair valuation for the next round. The level of impact though, won't be high.

"The investors are going to be friends and family kind only. It would not lead to a flood of investments. It makes things simple for existing friends and family who are likely to invest," he maintains. Several funds were registered under Ventureast as FVCI such as Ventureast Biotech fund, healthcare fund Ventureast Life Fund III, Ventureast Proactive FVCI Company and Ventureast Sedco Proactive FVCI Company.

All of them are deployed. Moreover, convertibles notes are much less of a hassle compared to raising an equity round. "Convertibles are a very established instrument in the Silicon Valley ecosystem. There are many times where instead of going through a lot of complex agreements and processes, using convertibles notes are more convenient," says T C Meenakshisundaram, Managing Director, IDG Ventures India.

Word of Caution

While the regulation allows to raise up to 100 per cent funds from an FVCI, it would make little sense for beyond Series A or mid stage deals. Meenakshisundaram echoes the same concern, "The impact would not be in a big way because VC institutional investors would generally price their transaction." IDG has two of its funds – IDG Ventures India I and IDG Ventures India Fund II registered as FVCI.

The new regulation would also push those investors who were earlier reluctant to invest in Indian start-ups and sought downside protection. This means that investors would look at lowering the risk of the decrease in value of their investments by hedging them.

"Many equity investors unlike in convertibles prefer downside protection since they may want seniority in capital structures so that when company doesn't do well they may have a chance to get their money back. It becomes a debt like structure in a downside scenario," says Mukul Gulati, Co-founder and Managing Partner, Zephyr Peacock – the PE fund that has its two funds under FVCI category – Zephyr Peacock Investment Holding II and Zephyr Peacock India Fund III.

Registering as an FVCI has its own advantages - as an investor you are not subject to Reserve Bank of India's pricing norms which can be negotiated directly with entrepreneur. For Gulati, however, it is not a game changer but a step forward.

"It gives us the confidence of doing different kind of deal structures. In future, it might encourage our limited partners to give us more money. So it is unambiguously a positive move," concludes Gulati.

(This article was first published in the November, 2017 issue of Entrepreneur Magazine. To subscribe, click here)

Sandeep Soni

Former Features Editor

News and Trends

"45% of All Ongoing Hydropower Projects in India are Ours": Patel Engineering

Patel Engineering reported a turnover of INR 4,400 crore in the last fiscal year, with a projected 10 per cent growth for the current year.

Business Solutions

Still Paying for Adobe Acrobat? Try This Instead.

Everything you need in a PDF editor—minus the subscription.

Business Ideas

63 Small Business Ideas to Start in 2024

We put together a list of the best, most profitable small business ideas for entrepreneurs to pursue in 2024.

Side Hustle

'Hustling Every Day': These Friends Started a Side Hustle With $2,500 Each — It 'Snowballed' to Over $500,000 and Became a Multimillion-Dollar Brand

Paris Emily Nicholson and Saskia Teje Jenkins had a 2020 brainstorm session that led to a lucrative business.

Data & Recovery

Say Hello to the Secure Cloud Storage Alternative Entrepreneurs Need

Secure, scalable, and cost-effective: Internxt is the smarter choice for cloud storage.