As India stares down China in Ladakh’s Galwan Valley and retaliates with boycotts of Chinese companies, it is vitally important that our economic growth be driven by innovation-driven startups. These are the companies that rapidly increase overall productivity, jobs, wealth, and thereby tax revenues.
India now has the world’s third largest startup ecosystem with more than $5 billion being invested in 2019 across 1,500 or so startups. India also has some 30 unicorns, which are startups valued at more than $1 billion. However, more than 80 per cent of the money invested in these startups comes from outside of India. Over the past few years, the Chinese have invested more than $4 billion in Indian startups and are investors in 18 of 30 Indian unicorns. We urgently need to become aatmanirbhar (self-reliant) in startup financing.
To that end, we must be able to attract substantial domestic capital to finance our startups. Three major sets of reforms may be considered to unleash domestic capital. First, unlisted investments in startups must be placed on par with investments in listed securities. Second, major institutional investors, such as the National Pension System (NPS) and insurance companies, could dedicate at least 1-3 per cent of their funds for startup financing. Finally, permanent investment vehicles could be listed on public markets to channel capital to startups.
Startups raised close to Rs 40,000 crore in equity capital in 2019. For aatmanirbharta, we need domestic investors to invest at least 50 per cent of this or Rs 20,000 crore per year. As India grows and our capital needs increase, we must build a venture capital industry that can funnel lakhs of crores in both equity and debt securities to the startup ecosystem.
Startup financing is primarily through unlisted securities. While long-term capital gains on listed securities is 10 per cent, for investments in unlisted securities, it is 20 per cent. If necessary, securities transaction tax (STT) can be applied to unlisted securities so that there is complete tax parity between unlisted and listed securities.
Power up domestic capital
Second, with tax parity between unlisted securities, it will be possible for India’s large institutional investors (including NPS, other pension funds, insurance companies, and family offices) to participate more aggressively in startup financing. Currently, very few domestic institutional investors are active because of tax disadvantages and the unique skills required to evaluate startup financing. The various investment committees that set asset allocation policies for domestic institutions can consider investing between 1-3 per cent of their assets into startups.
Domestic institutional investors can invest through various venture capital funds to support the startup ecosystem. Domestic venture capital funds generally use the Alternative Investment Funds (AIFs) structure for investment purposes. All capital gains and income generated in privately pooled AIFs is passed through to their owners and taxed at that level.
Small Industries Development Bank of India (SIDBI)’s Fund-of-Funds scheme provides anchor investments to get domestic venture capital funds started. In this manner, new venture capital funds are able to raise about 25-30 per cent of their funds from SIDBI. However, they often struggle to find other domestic investors to invest. By establishing 1-3 per cent asset allocation policies across pension funds and insurance companies, venture capital funds will be able to secure more domestic funds and get going faster.
Expanding the venture capital industry
Domestic institutions will also have to build up their in-house capabilities to evaluate and select venture capital funds. Different venture capital funds follow different investment strategies ranging from seed stage financing to growth capital financing. Some provide equity financing, while others focus on debt- and asset-based financing. Many venture capital funds also choose to focus on certain sectors such as consumer internet, health care, or agri-tech. A fast-emerging group of venture capital funds seeks to deliver both financial and social returns (called impact investing). Startups benefit from this type of specialisation because venture capital funds provide both investments and expertise.
Finally, we could consider allowing venture capital funds (structured as transparent AIFs) to list on our capital markets. Currently, only sophisticated investors with annual income of Rs 50 lakh and minimum liquid net worth of Rs 5 crore are allowed to invest in AIFs. By creating a set of necessary SEBI regulations for allowing venture capital funds to list on the stock market, it will be possible to vastly increase the domestic investor base for startups. Naturally, only those mature venture capital funds with superior management and investment track records would be able to make an initial public offering (IPO). Venture capital funds are listed on several stock exchanges, including London and Singapore.
Startups are vital to India’s economic growth since they drive innovation, job creation, and wealth generation. To ensure that our startups are financed domestically and not subject to onerous influence from foreign investors, we need to build up a venture capital industry to channel lakhs of crores from our domestic investors into our startups. This will require tax, regulatory, and policy changes. More importantly, it will require that our investors are able to evaluate and assess the higher risk-return associated with startup investing.
Jayant Sinha is the Chairman of the Standing Committee on Finance in Parliament and a Lok Sabha MP from Hazaribagh, Jharkhand. Views are personal.