On 16 January 2016 Prime Minister Narendra Modi launched “Startup India”, a scheme targeted at building a strong ecosystem to nurture innovation and start-ups in the country. A year on, it is a good time to assess how it has performed. Broadly speaking, the scheme consisted of four types of incentives. The first was to reduce the compliance burden for start-ups by allowing self-certification, removing inspections for the first three years and simplifying the intellectual property rights (IPR) regime.

The second was to give tax incentives by removing income tax on profits for the first three years and exempting personal property sold to invest in a start-up from capital gains tax. The third was to provide infrastructure support by setting up 500 tinkering labs, 35 public-private incubators and 31 innovation centres at national institutes. The fourth, and most important, was to provide funding via a dedicated fund of Rs 10,000 crore to promote start-ups.

The effect of the first two types—compliance and tax—was immediate. Start-ups are largely free from bureaucratic interference for the first three years of their lives. Exemption from income tax on profits and capital gains tax has eased the financial burden on start-ups and their founders. The progress on the third type—start-up infrastructure—has been encouraging as well. The government has already set up more than 100 incubators and selected 257 schools to host Atal Tinkering Laboratories under the Startup India scheme.

However, there has been little progress on the fourth: start-up funding. Six months after Startup India was launched, the Central cabinet cleared a Rs10,000 crore fund-of-funds to invest in Securities and Exchange Board of India (Sebi)-registered Alternative Investment Funds (AIFs) which, in turn, will invest in start-ups. It was announced that the fund would be managed by the Small Industries Development Bank of India (Sidbi).

However, further details have not been released and the fund is yet to make any significant investments. Importantly, the creation of a fund-of-funds implies that the government will ultimately depend on existing AIFs to boost start-up funding.

So have AIFs done well in funding start-ups? Not at all. According to Venture Intelligence, in 2016, AIFs invested around $16.7 billion across 552 deals. Less than 5% was invested in “early-stage” ventures or start-ups. In fact, in the last five years, less than 5% of investments made by AIFs have been in start-ups. To understand why, we need to have a closer look at Sebi’s AIF regulations.

In 2012, Sebi announced AIF regulations to create a structure where a regulatory framework is available to all shades of private pool of capital or investment vehicles. Under these regulations, AIFs are divided into three categories according to their target investments. Category I is for funds which invest in sectors considered desirable by the government, such as start-ups, social ventures, small and medium enterprises, and infrastructure, to name a few.

Category II is a residual category meant for multi-sector funds which do not fit into category I or category III. Just like category I, these funds are restricted from undertaking leverage or borrowing, except that needed for daily operations. Category III is for hedge funds which employ complex trading strategies and undertake leverage via investments in derivatives.

In order to separate funds which invest in early-stage companies or start-ups, a sub-category of category I funds called venture capital funds (VCFs) has been created. According to the regulations, a VCF is defined as an AIF which invests primarily in unlisted securities of start-ups, emerging or early-stage companies mainly involved in new products, new services, technology or intellectual property right-based activities or a new business model. After registering as a VCF, an AIF has to invest a minimum 66% of the corpus in unlisted securities of early-stage companies, excluding non-banking financial companies and gold financing.

However, these start-up-focused VCFs are few and have been able to raise very little money. As of November 2016, only 23% of registered AIFs were “Category I – VCFs”, according to Sebi. When it comes to raising funds, their share was even lower. As of September 2016, registered AIFs had raised around Rs29,000 crore, out of which only 7% was raised by VCFs. This is the main reason why AIFs have failed in boosting start-up funding significantly.

The key question then is how to get more money into VCFs. Two key suggestions come to mind. The first is simple: Dedicate a significant portion of the fund-of-funds created under the Startup India scheme to VCFs. A mere 20% allocation, Rs2,000 crore, will increase the capital base of start-up-focused AIFs by more than 100%. Second, the government can do what was originally announced in Sebi’s AIF regulations: Provide special incentives for VCFs which make them more attractive for investors and fund managers. More VCFs will encourage competition and boost activity in the start-up ecosystem.

The Startup India scheme has tremendous potential to propel India to a higher level of sustainable growth. It is also one of the best ways to take India away from the jobless growth. However, the scheme can succeed only if sufficient capital is available to upcoming start-ups, along with other incentives. The government and Sebi can kick-start the next phase of start-up funding and employment growth in India by using the AIF regulations to their advantage.

(Rohan Chinchwadkar is an assistant professor of finance at the Indian Institute of Management, Trichy)

Source: Mint