Striking a Balance: SEBI’s Regulatory Intent vs. India’s Startup Ecosystem Needs

SEBI’s recent consultation paper risks undermining the dynamic role of Angel Funds in building India’s startup ecosystem. A balanced approach will ensure that Angel Funds continue to play their transformative role.

Pingal Khan and Deepti Jayakrishnan

SEBI aims to enhance transparency and investor protection through its Consultation Paper on Review of Regulatory Framework for Angel Funds in AIF Regulations, dated 13 November 2024.  SEBI’s Alternative Investment Policy Advisory Committee proposes stricter regulations, including return benchmarks, restrictions on non-accredited investors, and increased operational requirements.

Angel Funds are crucial for early-stage funding, providing startups with capital and mentorship.   Operating with lower fees, they connect founders to experienced professionals.  However, the proposed changes risk undermining the dynamism that makes these funds effective.

 

KEY PROPOSALS AND STAKEHOLDER CONCERNS

1. Accredited Investor Framework

 SEBI seeks to limit Angel Fund participation exclusively to Accredited Investors or AIs (proposal #2).  This approach excludes seasoned professionals with deep industry experience who are sophisticated investors but do not meet the AI criteria.

Angels’ sophistication often stems from a deep understanding of financial markets and a track record of significant investment experience.  Excluding sophisticated but non-accredited investors risks stifling valuable partnerships and hindering the growth of the startup ecosystem.  To include such investors, the criteria for individual angel investor in Rule 19A (2)(a), SEBI AIF Regulations 2012 may be expanded as follows:

• certain professional qualifications, or
• substantial investment portfolios,^[1] or
• self-certification of investment acumen, without relying on standard investor protections.^[2]

A mix of Accredited Investors and Non- Accredited Investors in regulated collective investment vehicles has found room in the United States and United Kingdom securities regulations.^[3]  In fact, inadequacy of a wealth and income focused-criteria paved the way for new legislation permitting non-accredited investors to invest in less regulated investments in the U.S. in 2023.^[4]

 

2. Benchmarks for Returns

SEBI plans to mandate performance benchmarks for Angel Funds (proposal #22).   This overlooks the fact that angel investments are typically sector-agnostic, involve high risks, and target nascent businesses often in pre-revenue stages.  Therefore, standard benchmarks used for traditional asset classes fail to capture the unique nature of these investments.

If Angel Funds are compelled to safeguard return on investment with IRR hurdles, fund managers will be more prone to downside protection than upside risks.   Eventually, this will create artificial capital entry barriers in the thriving start up eco system. These are the very entry barriers that the angel fund eco system dismantled to enable the flurry of innovations and start-ups in India today.  Developing bespoke performance benchmarks that consider innovation, risk, and the long-term horizon of early-stage ventures is more appropriate.

 

3. Operational Costs and Compliance

SEBI mandates the filing of Private Placement Memorandums (PPMs) through merchant bankers (proposal #19).  This mandatory requirement will significantly increase costs, could deter participation and reduce the capital available for startups.  An alternative, to simplify compliance, is to standardize templates and allow certifications by practising chartered accountants.

 

4. Flexibility in Investment Offer, Allocation and Fund Structure

SEBI requires that an investment opportunity be offered to all members of an Angel Fund (proposal #14).  This publicises the same to more people than necessary or relevant; and violates the spirit of Section 42(7), Companies Act.  Standardizing investment allocation as per methodology specified in PPM is counterproductive.  In essence, it effectively discourages direct engagement between founder and investors.

The current pooled investment model helps Angel Funds streamline decision-making and governance.  SEBI’s proposal (#15) to allocate individual rights to each investor could fragment this structure, complicate management, and dilute the unified and strategic support these funds offer.   Therefore, it is recommended to retain the collective investment model or introduce majority consent mechanisms for key decisions.

 

5. Grandfathering Existing Commitments

Lastly, SEBI recommends the removal of previously permitted investment opportunities over a 5 year commitment period, within a limited glide period of a year (proposal #24).  This would constitute a gross violation of both the letter and spirit of SEBI’s mandate, as investors made those investments in good, faith based on then established regulations.  To protect the legitimate expectations of investors, it is recommended to increase the glide period to 5 years to allow investors to fulfil obligations under the current framework, ensuring continuity and minimizing disruptions.  This suggestion ensures proposed amendments respect constitutional safeguards, like Promissory Estoppel, protecting individuals relying on existing laws. Changes disrupting original investment commitments could violate legitimate expectations and equality under Article 14 of the Constitution.

 

All twenty-four of SEBI’s proposals are premised on the pre-determined assumption that all investments through Angel Funds should be restricted to Accredited Investors.  This approach undermines the purpose of a consultative process.  To preserve SEBI’s reputation as an inclusive yet stringent regulator, it is crucial that the consultation process genuinely reflects diverse viewpoints and accommodates the broad spectrum of stakeholders involved.  Angel Funds are more than investment vehicles; they drive innovation and entrepreneurship.  A balanced approach as suggested above, will ensure that Angel Funds continue to play their transformative role in building India’s startup ecosystem.

——————————————————————————————————————————————————————————-

[1] Refer an instance of international practice in Rule 506, U.S. Securities and Exchange Commission (S.E.C.) Regulation D.

[2] Refer an instance of international practice in requirements set out for certified sophisticated investor in Article 23 of the U.K. Promotion of Collective Investment Schemes Order, in Article 50 of the Financial Promotion Order or in Conduct of Business Sourcebook 4.12B.39R.

[3] In Rule 506(b) of U.S. S.E.C. Regulation D, for example, private offerings are restricted to an unlimited number of accredited investors and a limited number of non-accredited sophisticated investors, defined as those investors with sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment.

[4] See Equal Opportunity for all Investors Act of 2023. It paves the way for more non-accredited investors to become eligible to invest in less-regulated private real estate investments. The Act directs the SEC to establish an examination program within one year, administered by the Financial Industry Regulatory Authority.