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Jayant M Thakur
This is the concluding part of the article "Real cost of venture-capital funds is high".
Yet another tricky area is the requirements of management sharing and reporting. As can be expected, the venture capitalist often seeks to work very closely with the entrepreneur in the running of the company and even its day-to-day management. At the bare minimum, a certain number of seats in the board of the company will have to be given to the venture capital fund. The requirements of different venture capitalists, of course, may vary as also the peculiar facts of each proposal. Regular reporting of the performance of the company will enable venture capitalist to keep up with the developments of the company and its performance in comparison to the set targets.
Venture capitalists are certainly not life-long partners - in fact, they would like to quit at the earliest and in any event they would like to quit at the time when the cumulative annualised returns are maximum. This does not, of course, mean thatthey would like to quit when the last return is the highest.
However, this is a decision they would make considering the additional returns as compared with alternative returns, the risk profile and other factors. The venture capitalist would like to make arrangements for separation in advance and either a buyback arrangement or a public offer or other form of divestment is considered. A recent amendment in the Companies Act, 1956, whereby buyback of shares is permitted provides yet another convenient option of giving an exit option to a shareholder group. Of course, the provisions of law, regulations and the guidelines would have to be followed.
The capital structure of the company poses another challenge to the parties concerned. As is obvious, in such a situation, the entrepreneur typically does not have any significant amount of finance to invest in the company and what he has are his saleable and workable ideas and his commitment to put in the maximum effort to make them a success.
In comparison,the venture capitalist puts in actual funds in the form of cash. In the normal course, the entrepreneur gets at least 50 per cent of the stake of the company but since he can put in only his intangible assets and not cash, the question that arises is how his share will be capitalised. While there can be very many ways to do this, a recent amendment in the Companies Act, 1956, whereby shares can be issued against intangible assets provides some help.
What is provided is that a company can issue shares against intangible asset such as patents, knowhow, and other value additions. However, these provisions, despite the fact that almost a year has passed, have not been made effective since guidelines/regulations are awaited.
Another recent amendment that would help the structuring of the company is guidelines relating to ESOPs-that is, employees stock options and stock ownership plans. This is particularly useful for rewarding those stakeholders who have relatively a smaller role to play. However, these maynevertheless be part of the original promoter team and who need to be encouraged and they may work with greater motivation for the success of the company if they have a stake in it.
Issues relating to income-tax need also to be planned for and, at the very least, have to be considered at the time of structuring or implementing the transaction. One may wonder what would be the relevance of income-tax when the company would not even have started and it would be years before there are profits. However, even at the time of raising the finance, several issues arise. Firstly, the entrepreneur would be issued shares against assignment of intangible assets by him to the company.
Will this transaction attract tax? Further, he may license his knowhow patent to the company again payment of royalty. What would be the tax treatment of such receipts? The answers to these would depend the facts of each case. Even otherwise, the transaction as a whole should be structured so as to provide optimal tax treatment for theentrepreneur, venture capitalist and the company itself. Finally, at the time of separation, what would be the tax treatment in the hands of the buyer and seller of the shares? The venture capitalist typically would be eligible to special treatment under tax law whereby, subject to compliance of conditions, his profits would be free of tax.
The entrepreneur has to be prepared for a peculiar eventuality becoming more and more common. What usually happens or is expected to happen is that the venture capitalist is too eager to exit from the company by encashing his stake and thereby earning as high returns as possible. He sells the stake either to the entrepreneur himself or in the market or to another buyer or in some other manner.
The entrepreneur typically carries on the business either himself or with some other partner or as a listed company. However, it is becoming more and more common that the venture capitalist buys out the stake of the entrepreneur and thereafter either runs the company himself withthe help of professional management, or, after making an offer to the public or selling the stake one other partner, runs the company accordingly. The entrepreneur of course may get a handsome price for his stake but he loses the control of a business which he has started.
In conclusion, one can say that, after a hesitant start, venture capital is expected to be seen to be an important source of finance. However, being a comparatively newer area, and more so considering the fact that the entrepreneur is usually not experienced in the commercial aspects of setting up this unique form of venture, he or she needs to pay attention to a host of issues before signing on the dotted line whereby his medium term future is committed.
The author is a Mumbai-based chartered accountant
Copyright © 1999 Indian Express Newspapers (Bombay) Ltd.
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