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[Explained] Why SEBI Is Trying To Clamp Down On Blindpooling Of Capital By Angel Funds

[Explained] Why SEBI Is Trying To Clamp Down On Blindpooling Of Capital By Angel Funds

In a recent letter to LetsVenture, Sebi has clarified that the consent of each individual investor in an angel fund has to be sought for a deal

LetsVenture had sought to know last year if just the consent of ‘lead’ investors can act as proxy for approval by other investors

LetsVenture founder Shanti Mohan said that the clarification was sought not in an effort to circumvent the rules but so that the fund could tell participating investors that waiving off the consent clause isn’t possible

While most large angel networks have largely transitioned into angel funds under the purview of capital markets regulator SEBI, there are still remnants of an earlier time in their way of functioning. 

To bring more transparency to angel funds, regulations have targeted the blindpooling of funds — a practice where a fund manager stacks up a bigger number of deals with the money of individual investors without their consent on each investment. 

While blindpooling is still practiced despite the regulations, investments are being scrutinised increasingly and most angel funds are playing by the rules, according to lawyers, investors and funds that we spoke to. Many in fact already get the buy-in from all investors in the fund before making deals. 

Gerald Manoharan, a partner at law firm J Sagar Associates, said that regulations target those funds that use blindpooling to create bubble investments — deals that are implausible with respect to the financials and future prospects of a startup. These naturally have high risk and not all angel investors in angel funds would want to participate.

“A fund which has maybe 100 investors could become a pooling vehicle. Every pooling vehicle has structural and transparency problems and it could become like one of those earlier chit fund scams,” cautioned Manoharan.

For this reason, SEBI’s efforts to prevent blindpooling are seen to be in the interests of a minority investor — which in startup investment terms means a high net worth individual who bets INR 25 Lakh or more through an angel fund. Since the regulator has been doing a lot to protect small shareholders in the public markets, the practice of consent would bring the same level of transparency to the private market. 

LetsVenture, one of the prominent angel funds in the country, received a letter from SEBI on Wednesday (September 30) with a clarification on the consent clause, creating a buzz around how it will impact startup investments in the country, particularly seed-stage funding, where angel investors are most active.

However, LetsVenture had been following the same process of getting approvals from all the investors prior to closing the deal. The firm had asked for a clarification from the regulator for the same.

The capital markets regulator said in its letter that the consent of each individual investor in an angel fund has to be sought for a deal. This led to speculation on social media sites and news reports that deal flow in early stage startups might slow down as a result.

Utsav Somani, an angel investor who worked closely with SEBI in formulating the regulations that govern angel funds claimed that the rule has been followed from Day 0 on AngelList.

Somani is also a partner at AngelList India, a platform that enables investors to raise and manage capital for angel funds. Further, he said that the rule doesn’t really hinder the pace of investments since the platform has been facilitating an average of 2-3 deals a week even amid the Covid pandemic. 

When fund managers at angel networks or angel funds identify an investment opportunity, they cannot independently go ahead and make the deal with money from pooled funds. First, the investment has to be floated to the individual investors and then a scheme is drawn up depending on which investors consent.

The scheme, in the form of a term sheet, will include the name of all the angel investors who want to take part in the deal. It will also specify what amount of shareholding each individual investor would have on the basis of the size of their bet. 

“It will become problematic if as an investor you are not sure where your money is actually invested. Later if you are surprised and the issue comes to Sebi, the entire angel fund structure would come into question,” said Siddarth Pai, founding partner of 3one4 Capital, a VC firm that invests in early stage startups. Pai is also a member of tech startup think tank iSpirit and the co-chair, regulatory affairs committee of IVCA (Indian Private Equity And Venture Fund Association).

What Exactly Is An Angel Fund?

While SEBI’s definition of an angel fund is wrapped in a lot of legalese, it has two broad components — what an angel fund can do and who can invest in an angel fund.

By virtue of being a Category I AIF — the same as venture capital funds — an angel fund can invest in the same kind of companies and sectors as VCs. Interestingly, ‘angel funds’ is mentioned in a parenthesis as a subset of VC funds in SEBI’s regulation, rather than being chalked out individually. 

One key difference between the two is that while investors in VC funds are generally institutional investors who bet millions of dollars, angel funds can accept smaller investors. For this reason, while the minimum corpus of a VC was set at INR 25 Cr, this number was set at a much lower figure of INR 10 Cr for an angel fund.

The regulator however capped the minimum amount an angel fund can accept from an investor at INR 25 Lakh to ensure that only sufficiently liquid investors take part in such funds. Moreover, Sebi also defined qualifying conditions for being an ‘angel investor’ with multiple thresholds and parameters regarding the person/entity’s investment experience and net worth. 

The biggest departure however is that angel fund investors can’t vest their authority to make decisions with a fund manager whereas the basic premise of VC funds is that professionals would manage the money as they see fit. 

In this regard, the AIF regulations state that: “The manager of the angel fund shall obtain an undertaking from every angel investor proposing to make investment in a venture capital undertaking, confirming his approval for such an investment, prior to making such an investment.”

Protecting The Interests Of Individual Investors

This is one of the provisions on which LetsVenture sought clarification from SEBI — the other being whether investors that are individually qualified in terms of net worth to invest in an angel fund can invest together as a limited liability partnership that doesn’t qualify. The regular declined saying that a partnership and individual partners are distinct from each other and need to qualify in their own right.

LetsVenture also asked SEBI if angel investors can waive off their consent on each deal by vesting the authority in a few ‘lead’ investors. These leads would be certain investors within the fund whose acceptance of a particular deal would be assumed as an approval on others’ behalf.

LetsVenture founder Shanti Mohan said that a clarification on this was sought not in an effort to circumvent the rules but to be able to tell certain investors it wasn’t possible to do so.

“A lot of investors were telling us why are you being so conservative, why are you not letting us do it. So we went out to a few legal firms but they also had mixed opinions,” said Mohan.

Another angel fund manager called Ankur Fincom had the same query as Mohan and the regulator had replied in a similar manner with a clarification earlier this year.

Sanjay Mehta, founder and partner at 100X.VC, said that the ability of investors to not consent for a certain investment is a crucial factor as it allows them to commit capital and refrain from investing at any given time, unlike a VC fund where a commitment to invest has to be followed through no matter what. 

This flexibility is another benefit SEBI wanted to give to individual investors given that investing in a startup is a high risk affair and not knowing what investments they are getting into might hurt their portfolio in the long term.

“It’s a good practice. As an investor in an angel fund I might have committed INR 25 lakh but may not want to make any investments for 2 months. This allows me to decide from deal to deal if I want to invest or not,” Mehta added.

Last Updated: 3:15 PM, Friday
Some parts of the text have been updated for more clarity.