Funding winter: VC firms struggle to step up investment

VC, PE firms face start-up funding winter
Start-ups left in lurch as capital gains ruling sends shockwaves through India's VC ecosystem.

Private equity and VC firms are finding themselves in a tight spot after an ITAT Mumbai order which states that the forex neutrality provision cannot be applied to non-resident investors when calculating capital gains on sale of assets such as shares and debentures. Following this, there has been a rush towards tax advisors as firms looked to gauge the potential impact on their exits. The point of contention is that investors, both strategic and PE/VC, will not be able to mindlessly engage in transactions which involve shares and debentures and will be forced to analyse tax implications first.

The ruling may also have an impact on previously made positions, and these firms are now seeking guidance to determine if they need to reassess previous transactions. The ruling sets a new precedent which may be in conflict with such transactions.

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As India is tightening rules regarding such investments, companies are finding it harder to get breathing space, which has even caused a whopping $24 billion in exits in the past year. VC firms typically expect start-ups to provide an exit within a certain timeframe, either through an IPO or acquisition.

In fact, VC investments in Indian start-ups have dipped by nearly 40% in 2022, according to GlobalData. A total of 1,726 VC deals were announced inIndia 2022 and this was worth $20.9 billion. The same stood at 1,715 deals in 2021 with a valuation of $33.8 billion.

The country’s regulatory environment is already riddled with complexities. In fact, regulatory challenges are the foremost hindrance in the start-ups ecosystem. In the absence of clear guidelines from the government or regulatory bodies on issues related to the ecosystem, including foreign investment, taxation, compliance requirements, etc., investor confidence has been dampened, and the growth of start-ups, particularly in emerging sectors such as cryptocurrency and blockchain, is also affected.

VC firms will only stick around if they are provided with stability and predictability to make long-term investments. With stricter rules, the country may end up scaring away investors, killing the budding start-ups ecosystem.

The current ITAT story began with the Legatum case. In 2018, the Dubai-based fund filed a tax return reporting no income for the assessment year 2018-19. However, after the tax authorities scrutinised the return, they subsequently issued a notice to the firm. The Assistant Commissioner of Income Tax (International Taxation), Mumbai, had then assessed the total income of Legatum’s appellant at Rs 17.136 crores.

Simply put, the ruling will now lead to capital gains on the transfer of shares in unlisted companies to attract higher tax payments. Non-residents consider their gains in dollars and not rupee terms. However, the rupee has depreciated a lot in the past few years, and analysts believe that the government must extend immunity against rupee volatility beyond non-resident investors. Otherwise, the country will struggle to attract Foreign Direct Investment.

The timings could not be worse for the start-ups industry, which is already reeling from the aftershocks of Silicon Valley Bank’s fall. SVB was a leading player in the country’s VC ecosystem, and its departure has left many startups and venture capital firms in a lurch as these startups are left without access to the services that SVB provided. This has created a vacuum in the market and amplified some of the challenges facing the Indian VC ecosystem.

Need for a vibrant VC ecosystem

The venture capital funding ecosystem in India is important to the healthy growth of Indian start-ups. VC funding provides startups with the capital they need to grow and scale their businesses. This funding can help start-ups hire talent, develop new products, and expand into new markets and hence is the first wind beneath the wings of any startup. VC firms also provide start-ups with expertise, mentorship, and guidance which helps start-ups avoid common pitfalls and make more informed decisions. A credible force behind any start-up also attracts additional funding from other investors.

While the sector has seen remarkable growth and evolution over the past decade with the country becoming a hub for startups and emerging new businesses, current macro-economic circumstances are already bogging down the ecosystem. This includes the collapse of Silicon Valley Bank (SVB), which has had a significant impact on the Indian VC landscape as discussed above.

Due to a funding winter, a lack of early-stage funding is being seen, which means many start-ups struggle to raise seed and pre-seed funding. Another issue currently plaguing the sector is a shortage of experienced fund managers. The number of funds has increased significantly in recent years, but there is a shortage of professionals who can manage them effectively, especially when it comes to early-stage investments where the risks are higher and the need for experienced management is greater.

Investors are also concerned about limited exit options. While the number of exits has increased in recent years, the process is still slow and difficult, particularly for early-stage investments. With a limited ability of VC firms to generate returns for their investors, it translates into shrinking the volume of capital that can be invested in the ecosystem.

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