Investing in an Indian startup: FDI or VC – Which is the better route?

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The growth story of India is attracting foreign capital in increasing amounts. Foreign capital is being routed not only through stock markets, but it is also being infused directly into companies. This write-up is intended for venture capitalists which are looking to invest in India and it explains the routes of investment for companies which are not listed on the stock exchanges.

A foreigner looking to invest directly into India, who is a venture capitalist has two ways to invest in India – Foreign Direct Investment (FDI ) and Venture Capital( VC).

A venture capitalist would, of course, choose the route that is most profitable. Profitability is determined by the rate of taxation on the returns of the VC, the freedom which the VC has to choose its investing policies, and the limits (if any) imposed by law on the prices at which a VC can invest into and exit out of a company. This write-up compares the VC and the FDI routes on these aspects.

A venture capital investment has two advantages vis-à-vis an FDI investment:

1. Exemption from Pricing Guidelines of RBI

RBI has issued certain guidelines stipulating the minimum price a foreigner must pay when purchasing the shares of an Indian company from a resident and the maximum price a person can receive when he sells to a non-resident.

A foreigner investing through the FDI route is bound by these pricing guidelines.

For listed companies, this price is determined based on a relation to the listed price. For unlisted and private companies, this price is largely determined by the discounted cash flow method.

However, a Foreign Venture Capital Investor is not bound by the guidelines, and can sell or buy the shares at a mutually acceptable price.

2. Exemption from Lock-in if  VC is not a promoter

In the event the company goes for a listing, case of an initial public offer, the law imposes a lock-in on the pre-issue capital. For non-promoters, the lock-in is of 1 year. However, shares held by a foreign venture capital investor or a domestic venture capital fund (if they are held for a period of at least one year prior to the date of filing the draft prospectus with SEBI) will not have such a lock-in.

This gives an option to the VC to exit from the company even after a short time pursuant to completion of the IPO.

In case the VC had held convertible securities for some period of time within that one year, which it had then converted into equity shares, it can still avail of the exemption from lock-in, if:

  • The securities, i.e. debentures or preference shares were compulsorily convertible;
  • The securities were fully convertible, that is, the entire consideration payable on them was paid and no further consideration was payable upon conversion

Note, however, that if a VC is a promoter of the company, then this exception will not apply.

All promoters, including VCs will be subject to the post-issue lock-in. Lock-in on Promoter’s contribution is of two kinds:

1. On minimum promoter’s contribution (twenty percent for IPO), the lock-in is for 3 years.

2. On contribution in excess of minimum promoter’s contribution, it is of 1 year.

When can a VC be called a promoter?

The question of whether a person is a promoter is determined by three factors:

  1. If the VC is in control of the issuer company;
  2. If the VC is instrumental in the formulation of a plan or programme pursuant to which specified securities are offered to public;
  3. If the VC has been named in the offer document as promoter.

It is explicitly clarified in the law that merely because a VC holds ten percent or more stake is does not by itself imply that it is a promoter.

Investment limits of an Indian VC versus a Foreign VC

Note, a Foreign Venture Capital Investor can invest all of its funds in a venture capital undertaking. However, if it is a domestic Venture Capital Fund, it cannot invest more than twenty five percent of its aggregate commitments in any one undertaking.

Taxation of income of Venture Capitalists

Indian Venture Capitalists

As a venture capitalist, you want to realize maximum profits from your investment, and you do not want your income to be heavily taxed. Fortunately, tax law offers some benefits, if your investment fulfils certain conditions. Before moving onto those, you must know the methods by which you can have income as a venture capitalist. There are two ways in which a venture capitalist can earn money:

1. Dividend from the company he has invested in (Investee Company)

2. Sale of shares in the investee company due to appreciation in value of the share, that is, through a complete or partial exit.

Now, under Indian tax law (Income Tax Act, 1961) income of a venture capitalist is exempt from tax under certain cases. Income from investment in a company is exempt if:

1. The venture capitalist must operate as a venture capital company or a venture capital fund.

2. A venture capital company is one which has been granted a certificate of registration under the SEBI Act and Regulations (SEBI is the stock market regulator in India, like the SEC in the United States).

3) It must fulfill certain conditions which SEBI has specified with the approval of the Central Government.

In the event the venture capitalist is operating as a venture capital fund, in addition to the above conditions 1 and 2, it must also operate under a trust deed, registered under the Registration Act or operate as a VC scheme made by the Unit Trust of India under the Unit Trust of India Act, 1963 (most VCs are likely to adopt the former route of having trust deeds and not under the Unit Trust of India scheme)

The income of the VC is from investment in a venture capital undertaking, that is, a domestic company which satisfies the following 2 conditions:

1. Its shares are not listed on a recognized stock exchange in India. So, it can be a private company or a public company, and

2. The company is engaged in certain specified sectors only, namely —

  • nanotechnology
  • information technology relating to hardware and software development
  • seed research and development
  • bio-technology
  • research and development of new chemical entities in the pharmaceutical sector
  • production of bio-fuels
  • building and operating composite hotel-cum-convention centre with seating capacity of more than three thousand
  • developing or operating and maintaining or developing, operating and maintaining any infrastructure facility, such as a road, highway project, water supply project, port, airport, inland waterway, etc. (an exhaustive definition is present in Section 80-IA of the Act);
  • Or if the company is engaged in the dairy or poultry industry.

If the VC invests in these sectors, its own income is exempt from tax. It is treated as a pass-through entity.

Foreign Venture Capital Investors

Foreign Venture Capital Investors typically choose to route their investments through a base in Mauritius because of a bilateral treaty known as the Indo-Mauritius Double Taxation Avoidance Agreement (DTAA) which India has with Mauritius. As per the treaty, capital gains arising from selling shares are exempted from taxation in case of a Mauritius tax resident. This exemption will apply irrespective of the sector in which the FVCI invests.

Note that from April 1, 2012 India shall have a new tax law in force, known as the Direct Taxes Code (DTC). As per the DTC, it may be possible for tax authorities to levy tax even on Mauritian investors, if they are of the opinion that the Mauritius route has been undertaken simply for the purpose of lowering the applicable tax rate. Until then, the present exemption still applies.

Tax Treatment of Investors of a VC

A person investing into a VC fund or a VC company may want to know the taxability of his income. The VC should have an idea of this, so that when investors approach the VC, he is able to address their concerns on how their income will be taxed, at least at a basic conceptual level.

Under Indian law, income of the VC’s investors is taxable and the investor of the VC is treated as if he had directly invested in the venture capital undertaking. Therefore, the VC fund or company is treated as a pass-through entity.

Check out the Procedure for registration as a foreign venture capital investor and the Procedure for registration as a venture capital fund or company (domestic).

Contributed by Abhyudaya Agarwal, who heads the Research and Implementation team at iPleaders Legal Risk Management Services, a startup in the legal sector that he has co-founded.


  1. Gentlemen,
    We are seeking investment of Rs 6 Cr for one of our startup prject call Biryani paradise… Need your help and advise …plz do get in touch.

  2. Hey, So, whats the point – Govt has capped FDI % in various sectors but VC’s have as high as 90% stake in indian start ups. Can you throw some light?

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