Despite the global decline in VC investments, the Indian investment ecosystem, in 2023, witnessed significant developments in the flow of capital, via investments, exits and secondary sale transactions.

Investments

Notable VC-backed deals included the following investments:

• USD850 million by TVS Capital, General Atlantic and Walmart in PhonePe;
• USD340 million by M&G Prudential, Lightspeed India Partners and DST Global in Uddan;
• USD231 million by StepStone Group, Goodwater Capital and Nexus Ventures in Zepto; and
• USD201 million by Goldman Asset Management and TVS Capital Funds in Insurance Dekho.

Exits

Per Bain & Company’s India Venture Capital Report (2024) (B&C Report), VC exits in 2023 totalled USD6.6 billion, with exits through public trade (including IPO) at USD3.6 billion, followed by exit by way of secondary sale and strategic sale at USD1 billion and USD2 billion, respectively.

IPO

Noteworthy exits through IPO included the exit of VC investors: (i) Stellaris, Fireside Ventures from Mamaearth for USD110 million; and (ii) Qualcomm Ventures and IndusAge Partners from Ideaforge for USD34 million.

Secondary sale

Big ticket exits included the sale of stakes by: (i) Chiratae Ventures, Softbank, etc, in Lenskart for USD480 million to ADIA; and (ii) Softbank in FirstCry USD75 million to, inter alia, Sachin Tendulkar and Ravi Modi.

Strategic sale

The largest exit by strategic sale in India was the exit of Tiger Global and Accel India from Flipkart by sale to Walmart for USD1.8 billion.

Decrease in VC Fundings

Per the B&C Report, the volume of VC fundings in India decreased by 45% in 2023 in comparison to 2022.

Shift in Strategy of Investors and Start-ups

In 2023, a notable shift occurred in the strategy of investors and start-ups, marking a transition towards a more value-driven and sustainable approach. VC investors seemed keen on investing in impact-driven ventures. Consequently, ESG compliance became a decisive factor in fundings.

The spotlight on governance lapses at start-ups like BYJU’s, BharatPe, GoMechanic and Mojocare, prompted VC investors to exercise greater caution while making investments.

In terms of securing investments, start-ups also shifted their focus to maintaining profitability and extending their runway, as opposed to growth and expansion. As a result, many start-ups deferred funding rounds and IPOs.

Valuation Markdowns

News reports indicate that several late-stage start-ups such as BYJU’s (valuation slashed by over 95%) and OYO (valuation slashed by over 70%), Swiggy (valuation slashed by over 39.25%), and Ola Cabs (valuation slashed by over 51%) faced valuation markdowns by their investors.

Emerging Start-up Ecosystem in Tier 2 and 3 Cities

Industry reports indicated that entrepreneurship was flourishing deeper into India, with start-ups operating out of tier 2 and tier 3 cities like Pune and Jaipur attracting seed funding from venture capitalists at levels comparable to those based out of tier 1 cities.

Reverse Flip to India

Start-ups like PhonePe and Pepperfry redomiciled to India, with industry reports suggesting that several others like Groww, Zepto and Razorpay are actively considering similar moves.

Investments

The information technology and SaaS sectors (consumer and financial technology ventures) attracted the maximum number of VC investments in 2023. Per the B&C Report, 2023 also recorded an increase in investments in the electric vehicles and AI sectors.

Exits

Per IVCA Private Equity – Venture Capital Report (2023), India witnessed 82 VC exits in 2023, with close to double the value of exits compared to 2022. The maximum number of high-value exits were from the consumer tech sector, followed by the fintech sector.

Industry reports indicate that interestingly, the sectors that witnessed the highest number of investments also witnessed the most number of exits in 2023

Legal Form

Venture capital funds (VCFs) are typically structured in the form of a trust, company, limited liability partnership (LLP) or body corporate. Foreign VCFs can invest in India under the following modes: (i) foreign direct investment (FDI); (ii) foreign portfolio investment, as foreign portfolio investors (FPIs); and (iii) Foreign Venture Capital Investors (FVCI).

FDI

For an investment to qualify as an FDI, such investments must either be made in: (i) unlisted Indian companies; or (ii) at least 10% of the equity share capital of a listed Indian company. While no registration is required for making an FDI, such investments must comply with the conditionalities, sectoral caps and pricing guidelines prescribed in the Foreign Direct Policy of India (“FDI Policy”). Further, to make investments in restricted sectors, approval would be required from the government of India.

FPI

Investments by foreign investors in equity securities of listed Indian companies for a stake below 10% qualify as a foreign portfolio investment. To undertake such an investment, FPIs are required to obtain a certification from a designated depository participant in accordance with the SEBI (FPI) Regulations, 2019 (“FPI Regulations”) and meet the prescribed eligibility criteria set out therein.

FVCI

Eligible foreign funds may obtain a certification from SEBI to operate as an FVCI under the SEBI (FVCI) Regulations, 2000 (“FVCI Regulations”). An FVCI may invest up to 66.67% of its investible funds into equity securities of unlisted Indian companies. Further, FVCIs are permitted to invest in certain specific sectors, such as infrastructure and biotechnology, etc.

Domestic funds

Domestic venture capital funds are typically structured as alternative investment funds (AIFs) in accordance with the SEBI (AIF) Regulations, 2012 (“AIF Regulations”). AIF is a privately pooled investment vehicle that collects funds from Indian as well as foreign investors for investments in accordance with its investment portfolio and strategy.

AIF Regulations stipulate three categories of AIFs:

• Category I AIF (invests in start-ups or early-stage ventures);
• Category II AIF (typically invests in unlisted securities of mid-stage or late-stage companies, either through debt or equity); and
• Category III AIF (employs complex trading strategies and leverage to make short term returns, such as a hedge fund).

Decision-making Process

• Managers: Typically, funds are managed by their Managers, who are tasked with managing the funds’ investment portfolio, implementing the funds’ strategy, protecting the interests of investors and operating the funds in accordance with the applicable laws.
• Investment committee (IC): Funds set up an IC to scrutinise the potential avenues of acquisitions and exits, in line with the funds’ portfolio. On the basis of such assessment, the IC provides recommendations to the Manager.

Standard Documentation

Set out below are some of the standard documents typically executed by funds:

• Incorporation document: Based on the form of incorporation, funds are required to execute a trust deed, partnership agreement, or articles and memorandum of association, as applicable, for its overall management and incorporation.
• Private placement memorandum: Funds raise investments through an information/placement memorandum, which contains material information about the fund, its Manager, targeted investors, tenure, schemes, investment strategy, etc.
• Investment agreement: This is an agreement executed between the fund and its Manager, setting out the terms of delegation for management and administration of the fund.
• Contribution agreement: This is an agreement recording the terms of contribution/subscription by the investor to the units of the fund (ie, a contribution agreement for trusts and a shareholders’ agreement and share subscription agreement for a company).
• Side letters: These are letter agreements executed between the Manager and investors to record commercial terms of transfer, co-investment, confidentiality, inspection rights, etc.

Participation in Fund Economics

Managers and initiators of the funds (“Sponsors”) are entitled to participate in the fund economics. In this regard, in addition to the management fees, Managers are paid a carried interest in lieu of their role in funds/performance of the funds. “Carried interest” is a Manager’s entitlement to a percentage of the profits made by the fund. Managers are issued a special class of units against which such carried interest is payable, per the distribution waterfall – ie, after the return of capital to investors.

Further, under the AIF Regulations, a Manager/Sponsor is mandatorily required to maintain a continuing interest in the AIF, by investing at least INR50 million or 2.5% of the corpus of the fund, whichever is less. 

Investor Protection and Governance

The investor protection, governance and decision-making framework of VC funds typically involves, inter alia:

• the appointment of the Manager for the overall supervision and management of the fund;
• the institution of an IC to scrutinise potential avenues of acquisitions and exits and provide recommendations to the Manager;
• Managers and IC abiding by the “code of conduct”, which stipulates, inter alia, confidentiality obligations, professional standards, and disclosure requirements.
• Managers and Sponsors disclosing all critical information pertaining to the funds, including their investments in the funds and their conflicts of interest, to investors;
• investors being informed about the investments made by the funds; under the AIF Regulations, approval from at least 75% of investors is required prior to making investments in associates and units of other AIF managed by its Managers/Sponsors; and
• provision of a robust grievance redressal mechanism; recently, SEBI introduced an online dispute resolution mechanism to streamline the dispute resolution process for arbitration and conciliation proceedings.

In India, VCFs are regulated by the Indian Trusts Act, 1882, Companies Act, 2013 (Companies Act), the Partnership Act, 1932, the Limited Liability Partnership Act, 2008, the FDI regulations, FPI Regulations, FVCI Regulations and AIF Regulations, depending on their structure of incorporation.

FDI Regulations

Foreign investments in India, including investments made by VCFs are regulated per the provisions of the FDI Policy read with the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (the “NDI Rules”). These FDI regulations prescribe the conditionalities, sectoral caps and pricing guidelines that are required to be complied with for undertaking foreign investments in India.

Fund-Specific Legislation

FPIs

FPIs are required to carry out their operation in accordance with the FPI Regulations, which, inter alia, stipulates that:

• FPIs may invest in shares, debentures and warrants issued by a body corporate that is either listed or to be listed, on the Indian stock exchanges.
• FPIs are not permitted to invest in more than 10% of the equity capital of an investee venture.

FVCIs

The FVCI Regulations primarily regulate the amount and nature of investments permitted in FVCIs in India. Under the said regulations, investments made by a FVCI, through preferential allotment, in equity shares of a listed company, is subject to a lock in period of one year.

AIFs

AIFs are mandated to conduct their affairs in conformity with the stipulations under the AIF Regulations, such as:

• While Category III AIFs are not subject to any tenure, Category I and Category II AIFs are required to have a minimum tenure of three years.
• Any alteration to the fund strategy is subject to the consent of at least two-thirds of the unit holders of the AIF.
• Units of close ended AIFs can be listed on the stock exchanges subject to a minimum tradeable lot of INR10 million. 

VC investments in India have, over the years, compounded exponentially, leading to a thriving VC fund environment. Set out below are the distinct categories of VCFs operating in India with brief details of the traction witnessed by each category of VCF during 2023.

Sovereign Funds

Investments by sovereign funds are on the rise. Notable deals for sovereign funds/government-backed funds in India included the investment of:

• USD1 billion by the Qatar Investment Authority in Reliance Retail Ventures;
• USD841 million by the Government Pension Fund Global (Norway) in several Indian stocks (including Reliance industries and HDFC Bank);
• USD480 million by the ADIA in Lenskart; and
• USD140 million by Temasek in Ola Electric.

Impact Funds

Given the maturing start-up ecosystem in India and the rise of impact-driven innovations, the volume of impact financing in India has significantly increased. For example: Omnivore, a thematic fund, has been set up for making investments in agriculture technology and climate sustainability ventures.

Fund of Funds

To bolster fund of funds activities in VCFs, the India government introduced the Fund of Funds for Start-ups Scheme (FFS) with corpus of INR100 billion. In this regard, Small Industries Development Bank of India has been appointed as the operating agency.

Family Office

Despite the plunge in the deal volume for family offices, funds from family offices were critical in aiding early-stage start-ups in 2023. In this regard, some notable investments by family offices included the investments by MEMG Family Office in Bluestone and FirstCry.

Corporate Venture Capital

Per the B&C Report, Corporate Venture Capital while remaining salient, exercised caution in investing, resulting in a significantly reduced number of deals for 2023.

Thematic Funds

Per news reports, for the year 2023, investments by thematic funds (eg, Lumikai, a thematic fund set up for the gaming and media sector) contributed to 19% of the total equity investments made by funds in India.

Typically, VC investors focus on conducting due diligence into the business, financial, taxation and legal aspects of the investee venture. Lately, we have seen that investors prefer a red flags issues report highlighting critical non-compliances as opposed to long-form due diligence reports.

Key focus areas of each type of due diligence are set out below:

Financial Due Diligence

The financial reports, books and accounts of the investee venture are reviewed by financial advisers to verify its financial performance, which include a scrutiny of its adherence to accounting standards, quality of earnings, debt, synergies, liabilities and forecasts.

Business Due Diligence

Investors evaluate the veracity of the founders/management credentials and competencies of their teams in terms of operating the business.

Tax Due Diligence

The potential and outstanding tax liabilities, proceedings and investigations against the venture are identified.

Legal Due Diligence

This involves a review of the share capital information; material contracts; employment benefits; title on assets; regulatory compliances; intellectual property; and litigations. Secondary transactions may also include a title diligence on the particulars of the shareholding of the selling shareholders.

Timeline of a Financing Round

Generally, the timeline of a new financing round in a growth company ranges between two to four months depending on the: (i) structure of the transaction; (ii) need for any regulatory approval; (iii) level of diligence and negotiations; and (iv) the time taken for the completion of due diligence-based conditions precedent.

Relationship Between Investors

The relationship, rights and obligations between incoming and existing investors in any fundraise are contractually agreed upon in the transaction documents.

Typically, where there are multiple investors, the rights of the investors in terms of board nomination, information and inspection are pegged to a shareholding threshold. Additionally, instead of giving veto rights to any single investor, an affirmative voting right is exercised by the major investors (ie, investors meeting a prescribed shareholding threshold) on the basis of a democratic governance construct, linked to either a specified number of major investors or a percentage of the major investors’ shareholding, such that no single investor has the ability to independently veto any decision.

In relation to the rights attached to the securities of investors (for, eg, liquidation preference, anti-dilution, dividend distribution, etc), the rights of institutional investors generally rank pari passu with each other, in priority to angel investors, founders and other common stockholders. Inter-se rights between the investors (ie, transfer restrictions, exit, etc) are subject to extensive negotiations.

In terms of seeking legal representation, to avoid any conflict of interest, investors/shareholders tend to engage separate counsels to represent their interests.

Other than “common stock” – ie, equity shares, the most common type of security opted for by investors in India are compulsorily convertible preference shares (CCPS). Statutorily, preference shares take precedence over equity shares in terms of dividend payouts and return of capital on winding-up.

The market standard rights attached to CCPS are set out below:

• Liquidation preference: Typically upon the occurrence of any liquidity event (IPO, strategic sale, insolvency, etc). the return of capital for CCPS holders takes precedence over the equity shareholders and is pari passu to other CCPS holders.
• Conversion ratio: The conversion ratio changes depending on the corporate reorganisation or anti-dilution event. 
• Anti-dilution protection: This protects investors’ interest from dilution in the event of a down round. To give effect to the anti-dilution right, the investee venture may choose to issue further shares, transfer shares from the founders, or suitably adjust the conversion ratio of the CCPS to protect the investor from dilution.
• Under law, any proposed change or variation in the rights attached to CCPS require the consent of three-fourth holders of such CCPS.

Other types of securities preferred by investors for early-stage financing include compulsorily convertible debentures (CCDs), and venture debt in the form of optionally convertible debentures (OCDs) and non-convertible debentures (NCDs). Under the FDI Policy, only the issuance of equity shares or securities compulsorily convertible into equity is permitted. Furthermore, recognised start-ups may issue a hybrid security known as convertible notes, which are convertible in equity or repayable within a period of ten years. Convertible notes may be issued to investors subject to a minimum investment of INR2.5 million in a single tranche.

Typically, the following key documents are executed by a growth company in a financing round:

• a term sheet, a document that sets out the broad terms and conditions of the transaction agreed between the parties, which is typically non-binding;
• a shareholders’ agreement, which sets out the inter-se rights and obligations of the shareholders and management, and the governance principles of the venture;
• a share subscription agreement, which records the terms of subscription of securities by the investor;
• a share purchase agreement, which records the terms and conditions of purchase of securities from existing shareholders; and
• a disclosure letter which contains critical information regarding the affairs of the venture, and shields the seller from indemnity claims in future arising from any breach of the representations and warranties. 

Contrary to the model agreements made available by the National Venture Capital Association in the USA, in India there are no standard templates as such; however, over a period of time, a broad range of standard terms have emerged based on market practice.

Liquidation Preference

Typically, liquidity events (including winding-up, change of control, sale of all or substantially all assets) are subject to the affirmative voting right of investors – ie, prior written consent is required from investors to trigger the liquidity event.

In terms of the distribution of liquidation proceeds to shareholders, investors contractually agree to a liquidation preference whereby investors holding preference shares take precedence over equity shareholders and are generally entitled to a higher of 1x their investment or an amount which is pro rata to their shareholding, on a pari passu basis with other preference shareholders.

Liquidation preference may either be participating (in addition to the pre-determined payout, the investors participate in the pro-rata distribution of the remaining proceeds of the venture) or non-participating (investors are entitled to receive the determined payout only).

Anti-dilution and Pre-emptive Rights

Protection of VC investors’ interests in the form of anti-dilution clauses and pre-emptive rights is standard practice in India. These provisions are contractually agreed between the parties in the shareholders’ agreement.

Anti-dilution

An anti-dilution right enables VC investors to maintain their shareholding in the venture in the event of a down round.

Types of anti-dilution protection include:

• the full ratchet anti-dilution (the existing investors’ shareholding is adjusted based on the price of the down round);
• broad-based weighted average anti-dilution (which takes into consideration the price of the last round and the down round, the number of shares to be issued, etc); and
• narrow-based weighted average anti-dilution (a narrower approach compared to the broad-based weighted average, wherein the unissued stock options and shares to be issued upon conversion of debt are not taken into account).

In India, the broad-based weighted average anti-dilution is the most preferred type of anti-dilution protection.

Pre-emptive Rights

Pre-emptive rights entitle existing shareholders to purchase additional shares, on a pro-rata basis, to maintain their shareholding, in a fresh issuance to third parties. Sometimes, it is contractually agreed that in the event a pre-emptive right holder does not exercise its right, such non-exercising pre-emptive right holder’s shares will be offered to other pre-emptive right holders who have exercised their right, also known as a “mop-up right”.

Typically, VC investors are not engaged in the management of the day-to-day affairs of a venture. However, investors may influence the management/governance of the venture by exercising the following rights:

• Board nomination rights: VC investors are entitled to appoint an observer (ie, having no voting right on the decisions of the board) or their nominee director to the board of venture.
• Quorum rights: The quorum of any board meeting and shareholders’ meeting must mandatorily include the investor’s nominee director or observer and investor’s representative, respectively.
• Affirmative voting matter (AVM) right: AVM rights require the company to obtain prior written consent from the investor prior to taking decisions on critical matters – eg, alteration of charter documents, acquisition of other businesses and amendment of the annual business plan.
• Information covenants: To monitor the performance of the investee venture, investors are entitled to seek periodic information and details from the management/board.

Investors

Primary issuance

During a primary issuance, investors, as standard market practice, represent and warrant that they have the authority and due capacity to execute and perform the transaction. While no indemnity is sought from investors, the breach of warranties by an investor entitles the investee venture to claim damages.

Secondary transaction

Secondary transactions, where investors are sellers, involve such investors providing additional warranties on the title and tax aspects of the sale of shares. For any breach of such warranties, the purchaser is entitled to seek indemnity.

Investee venture and founders

Set out below are the standard representation, warranties, and covenants provided by investee entities and founders:

• Fundamental warranties: These are most critical to the business of the venture and the consummation of the transaction, and include warranties on the authority/corporate power to enter into transaction documents, no encumbrance on the share capital, etc.
• Business warranties: These representations and warranties are given by the investee venture and founders on operational and financial matters, which include, inter alia, compliance with applicable laws, maintaining requisite licenses and statutory registers, making adequate payments to employees, and no pending liquidation proceedings.
• Tax warranties: These warranties pertain to the investee venture’s compliance with the applicable tax laws.
• Covenants:
1. Investee ventures undertake to conduct their affairs in compliance with applicable laws, good industry practices and governance norms.
2. The founders undertake to devote their time and attention in rendering services to the investee venture, and not set up any separate entity to carry out a competing business during their engagement with the investee venture.
3. Typically, foreign investors insist that the investee ventures comply with the applicable anti-corruption, anti-money laundering, and sanction laws.
• Investee entities have an obligation to provide an exit to investors by a certain pre-defined date, either through an IPO or secondary sale, failing which the investors have a drag right on the shares of founders and other shareholders.
• Events of default: Investors are entitled to an accelerated exit from the investee venture and other rights upon the occurrence of certain contractually identified default events, such as breach of critical provisions of the transaction documents, the founders committing an offence involving a moral turpitude, or the founders being found guilty of sexual harassment, etc.

For any breach of the representations and warranties by the investee venture/founders: (i) prior to closing, investors may terminate the transaction; and (ii) post-closing, investors shall have recourse to indemnity.

The Indian government is committed to making India an attractive destination for investors, especially for start-up funding, by promoting ease of doing business and reducing the compliance burden.

To incentivise fundings in growth companies, the Indian government has:

• introduced a single window clearance system, namely the “National Single Window System”, a one-stop platform for obtaining approvals/licenses from government authorities.
• simplified the reporting and registration process for companies and LLPs by, inter alia, introducing a single Form SPICe (doing away with the need to file multiple forms while incorporating companies/LLPs), and providing a one-stop destination for foreign exchange reporting, namely the Foreign Investment Reporting and Management System (FIRMS) portal for making foreign exchange reporting to the reserve bank of India (RBI);
• executed Bilateral Investment Treaties (BITs) with several countries to foster investor confidence and attract foreign investments; in 2023, the Indian government signed and ratified a BIT with the UAE;
• introduced Production-Linked Incentive (PLI) Schemes across 14 sectors, with an investment outlay of USD26 billion; entities setting up manufacturing plants in India are entitled to rebates and benefits under such PLI schemes;
• relaxed the sectoral caps in the FDI Policy for the space sector, permitting foreign investments via the automatic route up to: (i) 74%, for satellite manufacturing and satellite products; and (ii) 49% for launch vehicles and creation of spaceports;
• relaxed the taxation of sovereign funds, exempting them from the levy of angel tax; and
• exempted the import of electronics manufactured in special economic zones/for supplying to government agencies from the requirement to obtain import authorisation.

Typically, the taxation of investments made in start-ups/growth companies/VCF portfolio companies is dependent on a variety of factors, such as the structure of the transaction, the residency status of the investor, the nature and business of the investee venture.

Set out below are the key tax considerations for investments in India.

Double Taxation Avoidance Agreements

The amount of withholding tax that can be levied on remittance of investments made by non-resident investors is subject to the Double Taxation Avoidance Agreements (DTAAs) executed between India and the resident country of such non-resident investors, whereby foreign investors may be exempted from double taxation. Such relaxation plays an important part in selecting the jurisdiction for incorporating the offshore holding companies in externalised structures.

Angel Tax

Under the IT Act, an “angel tax” is levied on investee entities for any capital raised from the resident investors by issuance of shares at a value above their fair market value – ie, on the share premium. However, recognised start-ups meeting the eligibility criteria set out below are exempt from such angel tax:

• the post-issue aggregate paid-up share capital and share premium of the start-up must be below INR250 million; and
• the start-up should not have invested in loans and advances, share and securities or made a capital contribution to any other entity.

Recently, following an amendment, the provisions of angel tax and the exemption thereto have been extended to non-resident investors. This angel tax exemption to non-resident investors is subject to certain eligibility conditions, such as the non-resident investor being a resident of the 21 countries identified in the amendment notification (eg, Australia,  Japan, Russia, United Kingdom, United States, etc).

Place of Effective Management Risk

Under the IT Act, the tax liability is decided vis-à-vis the residency status of the entity – ie, a foreign entity’s entire global income may be taxed in India if the place of effective management (POEM) (the place where key management and commercial decisions are made) for such foreign entity is in India. Accordingly, in structuring the fund and investment, VC investors must also consider the effects of POEM.

Capital Gains Tax

Upon the sale of securities, a capital gain tax is charged to the investors on gains made from such sale. For listed securities, which have been held for less than 12 months, capital gains are taxed at 15%, and for securities held over 12 months, a capital gains tax of 10% may be levied (if the gains from such sale are more than INR100,000). Further, unlisted securities held for: (i) more than 24 months are taxed at 20%; and (ii) less than 24 months are taxed per the slab rates applicable to the holder of such security.

As part of the “ease of doing business” initiative of the Indian government, compliances required to be undertaken by start-ups have been significantly reduced, by, inter alia, fast tracking patent applications, providing a rebate on the application fees for intellectual property rights registration, and enabling self-certification for undertaking labour and environment compliances. Moreover, eligible start-ups are exempted from the applicability of angel tax (see 4.2 Tax Treatment).

To further boost the level of equity financing in India, the government has introduced the following initiatives:

• PLI Schemes, designed to incentivise entities to set up manufacturing and assembly facilities in India; so far, PLI schemes have attracted investments up to INR950 billion;
• liberalisation of the FDI framework, whereby foreign investments up to 74% are permitted for satellite manufacturing and satellite products, via the automatic route;
• the “Startup India” initiative, whereby start-ups recognised by the Department for Promotion of Industry and Internal Trade (DPIIT) have access to capital from the government via the FFS (a corpus of INR100 billion, providing capital to AIFs for investing money in Indian start-ups) and the Credit Guarantee Scheme for Startups (providing credit guarantees against loans granted to start-ups by banks and AIFs);
• decriminalisation of over 3,600 compliances, to improve India’s ease of doing business rankings; several online single window clearance portals have been set up to further ease the burden of regulatory compliance; and
• the Industrial Corridor Programme, which is aimed at developing futuristic industrial cities to create employment opportunities; as of 2023, this programme has attracted investments from companies based in South Korea, Russia, China, the UK and Japan.

In order to facilitate long-term commitment from founders/key employees, their employment agreements typically stipulate the following:

• non-compete, restricting the founders and key employees from setting up or working with a competitor of the investee venture;
• non-solicitation, restricting the founders and key employees from: (i) causing the existing employees, consultants, clients, vendors, etc, to severe their engagement with the investee venture; and (ii) soliciting employment/services to such employees, consultants, clients, and vendors;
• business exclusivity – ie, founders are not permitted to carry out any other business (including making any investments in such other entities) during their employment in the investee venture;
• reverse vesting, whereby the shares of the founders are released in tranches subject to their continued engagement with the investee venture and are subject to claw-back upon termination of their employment;
• lock-in on shares, which prevents the founders from selling their shares until the occurrence of a specified event – ie, an IPO, strategic sale, bankruptcy, etc;
• stock options, whereby the founders and key employees are awarded time-linked stock options for their continued engagement with the investee venture; and
• garden leave, causing the founders to avail indefinite leave while on the payroll of the investee venture; this right is exercised in the event the founders intend to discontinue their engagement with the investee venture.

Typically, investee entities award stock options, variable compensation and perquisites to founders/key employees to incentivise their performance.

Stock Options

Per the provisions of the Companies Act, employee stock options (ESOPs) may be issued to permanent employees and directors (who are not independent directors). However, the issuance of such ESOPs to founders/promoters or any director holding more than 10% of shares (either directly or through relatives) in the company is not permitted. That said, the Companies Act exempts recognised start-ups from the said restriction.

For founders of companies other than start-ups, management stock options/phantom stock options or SARs (defined below) may be issued as incentives.

The ESOPs issued are subject to a vesting and exercise schedule. Statutorily, ESOPs granted may vest at a minimum of one year from the date of grant. Typically, companies adopt a vesting schedule of four to five years, with ESOPs vesting in equal quarterly/monthly instalments.

Sweat Equity

Equity shares of a company are issued at a discount or for non-cash consideration, in lieu of the employee’s performance. Issuance of sweat equity is subject to the minimum lock-in of three years and requires approval from the shareholders.

Stock Appreciation Right

Stock appreciation rights (SARs) entitle employees to receive compensation, in the form of cash payouts or shares, to the tune of the appreciation in the value of shares of the company. Similar to ESOP, SARs typically vest upon the company meeting a pre-determined performance milestone.

Restricted Stock Units

These are a restricted form of equity incentive with a reverse vesting schedule. Similar to ESOPs, restricted stock units (RSUs) lapse upon the employee’s disengagement with the investee venture.

ESOPs

In India, ESOPs are, upon allotment, taxed in the hands of the employees. 

ESOPs are subject to double taxation – ie, ESOPs are taxed at two stages:

• at the time of exercise, as perquisites; and
• at the time of sale, as capital gains.

For the purposes of taxation as perquisites, the difference between the exercise price and fair market value is considered, and for capital gains, the difference between the sale price and the exercise price is considered.

SARs

Issuance of SARs is subject to withholding tax by the issuer company. Further, the amounts received upon the exercise of SARs (if cash-settled) are taxed in the hands of the employee as “income” at the applicable tax slab rates, and in case the SARs are settled in equity, the value of such shares are taxed as “perquisites”. Moreover, upon the sale of such shares, a capital gains tax is levied.

Sweat Equity

Similar to ESOPs, sweat equity shares are taxed to the allotee employee at two stages: (i) at the time of allotment, as perquisites; and (ii) at the time of sale/transfer, as capital gains. For the purposes of computing capital gains tax, the difference between the price of the shares at the time of allotment and at the time of sale will be considered.

In Indian start-ups, the implementation of an investment round and the setup of an employee incentive programme are often closely linked both in terms of process and dilution.

In early-stage companies, at the time of consummation of an investment round, investors typically require the implementation of incentive programmes to align the interests of employees with those of the company and its investors. The investment round often provides the necessary capital to implement employee incentive programmes such as transaction bonuses or a cash settled stock appreciation rights programme.

In terms of dilution, the investment round typically dilutes all existing shareholders, including employees who hold equity or stock options. Consequently, there arises a need to adjust their employee incentive programmes to mitigate the dilution impact or to align with the new valuation post-investment. This takes the form of recalibrating stock option grants, setting new performance targets, or restructuring the incentive programme altogether.

In terms of process, the investment round and the implementation of an employee incentive programme converge from a documentation and regulatory compliance standpoint. It is typically seen that the definitive documents for the funding round contemplate the implementation of an employee incentive programme as a condition precedent to closing of the investment round and relevant matters such as the vesting schedule and internal approval requirements around grant of stock options to employees, are captured within the restated shareholders agreement of the company.

Typically, investors’ shares in India are not tied to any transfer restrictions, other than the inability to transfer shares to a competitor until the exit date. Generally, investors are entitled to an exit by the company and promoters within four to five years of investment.

Exit in Indian venture capital transactions is typically structured as a waterfall, through various options, such as an IPO, third-party sale, or strategic sale, in a time-bound manner. If such exit is not achieved within the said timeframe, then, as a last recourse, the investors can drag other shareholders into an offer procured by the investors.

Exit of the investors is accelerated upon the occurrence of an event of default, which is typically defined to include a breach of critical provisions of the transaction documents, the founders being terminated for cause, and occurrence of fraud in the investee venture. In such an event the restriction on investors from transferring the shares to competitors also falls away.

IPO exits have notably increased in the past few years, specifically since the COVID-19 pandemic. Sectors like financial services, technology, and retail have gained traction in terms of IPO. Distinguished start-ups such as Mamaearth, Zaggle and Yatra have recently launched their IPOs. Other than this, various start-ups such as Mobikwik, Deltatech Gaming, Awfis, Oyo, Go Digit, FirstCry and OlaElectric are either lined up to launch their IPO or awaiting approval from the regulators.

IPOs are seen as the preferred way of exit for investors as they enable investors to monetise their investments in publicly traded markets, achieve favourable valuations and greater liquidity. In terms of timelines, an IPO typically takes between six to ten months from preparation to completion depending on the time taken to complete IPO diligence, obtain feedback from SEBI, and furnish information/responses to SEBI.

While there are various national and local trading terminals for companies to get their shares listed, the predominant stock exchanges in India are the National Stock Exchange of India and BSE Limited.

For Indian markets, there are two offering structures: (i) fresh issuance from the share capital of the company; and (ii) sale of shares of the company by investors.

With the Indian public markets becoming increasingly more mature, VC-backed companies are focusing more sharply on company fundamentals before going for an IPO and are taking more time in getting the company IPO-ready. The increased timelines for an eventual exit through an IPO is leading to the increasing need for more mature private companies to put in place a structured liquidity programme to allow for liquidity to a larger group of shareholders prior to the IPO (these typically include founders, employee shareholders and investors who backed the company at the early stages in the pre-seed or seed funding rounds). Such structured liquidity programmes would help in controlling rampant secondary transactions by smaller shareholders which can prove to be a major distraction for the company and may lead to the company having to deal with new shareholders with whom the company is not familiar with.

A structured liquidity programme could be implemented either as a company buy-back of existing securities or stock options by utilising the proceeds of an equity fund raise or through an investor directly purchasing existing shares from the shareholders. Typically, HNIs (high net worth individuals) and family offices invest in such privately held fast-growing companies that intend to go public in the next three to five years.

This would require compliance with the company’s charter documents, ESOP plans (specifically any transfer restrictions on sale of shares/options), the Companies Act and the applicable regulations governing valuation and taxation. The incoming shareholders would need to accede to the stipulations under the company’s shareholders agreement and charter documents, including those relating to transfer restrictions and exit.

Investments in private companies in India are carried out on a rights issue and preferential allotment/private placement basis. Consequently, such investments are regulated by the conditions and compliances set out in the Companies Act, inter alia:

• obtaining valuation reports, as well as board and shareholders’ authorisation;
• filing the return of allotment; and
• making entries in the register of members.

Moreover, venture capital investments by non-residents in India are also subject to compliance with the provisions of the FDI Policy read with the NDI Rules. The FDI Policy and the NDI Rules prescribe certain conditionalities and sectoral caps, which must be complied with to make a foreign investment in India (for restrictions, see 7.2 Restrictions).

Depending on the sector in which the investee venture is operating in, an approval may be required from the relevant sectoral regulator, such, the RBI, SEBI, TRAI (Telecom Regulatory Authority of India), etc. Further, sizeable transactions may also require clearance from the Competition Commission of India (CCI). Currently, the Competition Act 2002 prescribes a de minimis threshold for mergers and acquisitions – ie, if the value of the assets being acquired does not exceed INR4.5 billion or the turnover does not exceed INR12.5 billion, such transaction is exempt from notification to the CCI.

Given that all foreign investments in India are regulated in accordance with the FDI Policy and the NDI Rules, investments by foreign VC investors are subject to the restrictions and conditionalities stipulated therein. Set out below are the key restrictions under the foreign exchange laws of India:

• pricing guidelines, which prescribe that the: (i) issuance or transfer of shares to non-resident investors shall not be below the fair market value of such shares; and (ii) transfer of shares from non-resident investors to resident investors shall not exceed the fair market value of such shares;
• sectorial caps, which set out the limits of the maximum permissible foreign investment in a specific sector; the sectoral caps also specify if the investment into the venture is permitted via the automatic route (ie, without any permission) or the government route (ie, with prior approval from the relevant ministry body), for example, for the private security agencies sector, foreign investments up to 49% are permissible under the automatic route and above 49% and up to 74% is permissible under the government route; the FDI policy also stipulates the prohibited sectors wherein foreign investments are not permitted (eg, entities engaged in the manufacturing of tobacco, real estate business, and lottery business are not allowed to accept any foreign investments);
• landlocked border restrictions, which were introduced to restrict opportunistic takeovers/acquisitions of Indian companies by investors from the neighbouring (landlocked) countries; currently, such investments are permitted under the government route;
• a prohibition on the issuance of debt instruments under the FDI Policy and NDI Rules; foreign investors making an investment into India are permitted to subscribe to equity share or compulsorily convertible equity-linked securities only; and
• a bar on put and call options with assured returns under the NDI Rules.

In case of the acquisition of equity securities by way of secondary sale, foreign investors are not permitted to defer more than 25% of the consideration payable upon such acquisition for more than 18 months from the date of acquisition.

Over the years, the restrictions under the foreign exchange laws of India have been considerably relaxed to attract foreign investments and promote ease of doing business in India. For example, in 2023, the government relaxed several restrictions and the regulations prescribed under the foreign exchange laws of India, as set out in 4.1 Subsidy Programmes.

With India’s commitment to emerge as a global leader in securing foreign investments, it will be interesting to see the amendments and relaxations introduced by the government in the future.