Venture Capital: Concept, Features, Regulation and Development

By | August 17, 2019
venture capital

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Venture Capital: Concept, Features, Regulation and Development | Overview

Venture capital is one of the forms of private equity. It is a type of financing which is offered by firms or funds to emerging, small and early- state firms that had already given a manifestation of high growth or are expected to possess high growth potential with regards to both the employees and annual revenue or both. These venture capital funds or firms look forward to investment in such above mentioned emerging firms for an exchange of equity in the company.

Such quid pro quo investment gives provides an ownership stake in the company these venture capital firms target to invest in.

Sometimes, these venture capital firms give support to risky start-ups by financing in them with the belief that by extending their monetary support, these risky startups can get stable in the market. Most of the startups find their basis on any of the innovative business model or technology and they belong to the high level in the technology industry such as biotechnology, social media or information technology.

There are various newly established companies in the market who typically finds it’s very difficult to convince the investors and raise a fund with the help of old conventional modes. The venture capital invests their money in such companies which are in dire need of finance and which are also looking forward to the guidance from the committee of expert management. KB Chandrashekhar Committee was formed to demonstrate the nature of the funding done through capital ventures. This committee noted as follows :

There are various innovations and ideas in the market with a lot of uncertainties but possess the potential to get very high growth. Such ideas and innovations are given wings with the help of the financing done by the venture capitalists.[1]

STEPS OF INVESTMENT FROM VENTURE CAPITALIST FUNDS

Initially, a ‘seed funding’ round takes place and after this round, a typical investment from these venture capital is done. When institutional venture capital seeks to fund the growth of any start-up, the first round that takes place for the same is Series A round. This financing is done by venture capitalists in the interest of creating a return trough the mode of an eventual exit event. For instance, a company undergoing any merger and acquisition with some other company (known as ‘trade sale’), a company selling its shares in the market for the very first time by issuing them in an initial public offering and so on.

Those individuals who have accumulated their wealth from various diverse sources and look forward to investing their money are known as angel investors. The major chunk of such individuals is themselves, entrepreneurs. On the basis of their knowledge and experience, these entrepreneurs invest in the venture available in the market.

In spite of the equity crowdfunding, angel investing and other seed funding options present in the market, there are various companies which are attracted to venture capitals. The attributes of such companies are that they are very small in nature that they cannot raise capital in the public market, they have limited operating history and they have not yet reached to that stage from where they can easily complete a debt offering or secure a bank loan.

Typically, a venture capitalist is provided not only with significant control over the management of the company but also with the significant ownership in the company for investing their money in spite of the risk in early-stage and smaller companies. The investors also give their strategic advice to the executives of the firm on its marketing strategies and business model followed by them.

For instance, start-up like ReviewAdda, Didi Chuxing, Xiaomi, Airbnb, Uber, Flipkart is some of those startups which are very highly valued and the venture capitalists make a contribution in such startups which is more than just financing.

FEATURES

  1. Highly Risky: the amount of return and the level of risk shares a directly proportional relationship with each other. There is a well-established fact of the market that the more amount of return an individual wants to seek from any investment, the more amount of risk he/ she should be ready to face. Most of the venture capitals seek to invest in such business which is high growth-oriented in nature. Not only this but the level of risk in such business is higher in comparison to that of those businesses which are well established. So is someone is planning to explore the field of the venture capitalist, he/ she should be well prepared for facing the risk involved in the investment.
  2. The moderate financial burden of the startups: there are 50- 50% chances for getting a business successful at its initial stage. Therefore, the investment made by the venture capitalists proves as a great help to the startups during the initial time period of the business, which is also known as the gestation period. The financial statement of the entity during this gestation period consists of only costs.
  3. Probability of getting finance-based as real-time needs: venture capitalists help the newly established business by making capital available to them after taking their real-time situation needs into consideration. On the other hand, banks and other financial institutions that are prevalent in the market, one may not be able to arrange the amount sufficient for backing up the enterprise.
  4. High return: once a business, in which venture capitalists had invested their money, become successful, it becomes very easy for such capitalists to earn a lot of return. Typically, a venture capitalist is entitled a huge amount of profits due to the tremendous rate of success of the startups, which have been financially backed up by them.

ADVANTAGES

  1. Business Connection: there is an inherent benefit of business connections to those startups, which got financial assistance from those venture capitalists which are already well established in the market. Such well-established venture capitalists have a lot of connections with respect to the business in the market and these startups are not required to spend any of their pennies on creating connections.
  2. Opportunity to get the business expertise of venture capitalists: venture capitalists possess business knowledge and expertise, which will prove a boon to those new, young and aspiring entrepreneurs, who have no experience how to deal with the various dimensions present in a business. There is a group of many trained and professional individuals in the venture capital firm. Henceforth, they can immediately take advantage of the experience and expertise of the venture capitalists.

DISADVANTAGES

  1. Uncertainty: there have been many instances where the venture capitalist did not find the decision taken by the business owner appropriate anymore and due to which, he/ she is no more interested in investing any additional funds to that business.
  2. Chances of losing control: most of the times when the risk rate is very high, venture capitalists try to control the business significantly. This may lead to their dominance over not only business but also a business owner in terms of the management and administration of the business.

REGULATIONS PASSED BY SEBI

There is a lot of difference between angel funding and funding by venture capitalists. This is so because venture capital is made available to the business only when its concerns have grown a lot in comparison to just a mere idea but this form of development is not factored per se in the legal rules and regulations that are used to govern venture capitals in India.

SEBI has come up with two different sets of laws that deal with venture capital companies/ funds. These regulations are as follows:

  1. SEBI (Foreign Venture Capital Investors) Regulations, 2000 (“FVCI Regulations”), which got notified on 15.09.2000 by SEBI
  2. SEBI (Venture Capital Funds) Regulations, 1996, which got notified in December 1996 and has an application on the domestic venture capital funds.

SEBI (Foreign Venture Capital Investors) Regulations, 2000 (“FVCI Regulations”)

The report submitted by KB Chandrashekhar Committee proposed for bringing the FVCIs on the basis of the pattern followed by FIIs for addressing the need of India that there is a requirement of a large pool of risk capital both from abroad and home. In light of this recommendation, SEBI framed FVCI Regulations and introduced them to the market.

In addition to this, Securities Exchange Board of India also started to act as a nodal regulator of venture capital funds, both for foreign as well as domestic on the basis of the recommendations given by the Chandrashekhar Committee. Subsequently, SEBI had repealed the then-existing guidelines on Overseas Venture Capital Investments, which were issued by SEBI itself in 1995.

SEBI (Venture Capital Funds) Regulations, 1996

Venture capital funds can be defined as a fund which got established in the structure of a trust or company which is inclusive of a body corporate.[2] It has to be registered under these VCF Regulations. The venture capitalists has three basic elements which are as follows:

  • money has to be raised by them in a way which is specified in these regulations
  • it should have a pool of capital specifically dedicated for startups
  • the fund is invested by the capitalists as per the regulations.

On the other hand, an investor who is established and incorporated outside India but got registered as per the FVCI Regulations is known as foreign venture capital investor.[3] Such investors have to make the investment as per the provisions specified in the Regulations.

SEBI acts as a regulator for both the entities and prescribes all those undertakings where FVCIs and VCFs can make the investment as well as the upper limit until which these entities can invest their money in the market. There are various restrictions and conditions prescribed under the Foreign exchange law, which are also used to govern the investment made by FVCIs.

DEVELOPMENT IN VENTURE CAPITAL INDUSTRY

In order to scrutinize the development made by the venture capital industry in India, a committee headed by Dr Ashok Lahiri was formed.[4] The report of Dr Ashok Lahiri Advisory Committee on Venture Capital was submitted in 2003 and addressed the operational issues with respect to investment and functioning made by VCFs and FVCIs in a very detailed manner. Inter alia, this Committee had noted that “ in some of the countries such as India, a firm can never gain some specific kinds of benefits if it is not registered with any regulator even though if the activities of venture capital are carried on by the firm”. [5]

The observations made by the Dr Ashok Lahiri Advisory Committee may get slightly misplaced due to section 12 (1B) of the Act. This section states that till the time an individual is not able to obtain the certificate of registration from the Board as per the provisions of the regulations, he/ she is not entitled to carry on or cause to be carried on or sponsor or cause to be sponsored any fund relating to the venture capital.

As stated by the Commentary on ‘Foreign Institutional Investors’ under sec 11 (2) (ba), a group that was headed by Shri U K Sinha was constituted. This group has inter alia gave its recommendations to do away with the regulations on FIIs and FVCIs that were prescribed by SEBI and introduce new regulations which will be helpful for regulating the qualified foreign investors because of the presence of the undesired regulatory arbitrage and legal complications which are provided by these two different types of routes.[6]


[1] Para 2.1, KB Chandrashekhar Committee on Venture Capital, 2000

[2] Regulation 2(m) of SEBI ( Venture Capital Fund ) Regulations, 1996

[3] Regulation 2(g) of SEBI ( Foreign Venture Capital Fund ) Regulations, 2000

[4] Report of Dr Ashok Lahiri Advisory Committee on Venture Capital, 2003

[5] Para 1.5, Report of Dr Ashok Lahiri Advisory Committee on Venture Capital, 2003

[6] Report of the Working Group on Foreign Investment, 2010 issued by the Department of Economic Affairs, Ministry of Finance, Government of India


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Author: Akriti Gupta

Akriti Gupta is a student at Symbiosis Law School, NOIDA. She is a research enthusiast and possesses capable draftsmanship along with this, Akriti is a holder of various renounced publications and participated in prestigious national moots.