SEBI’s New Rule for Angel Investors! What It Means for Startup Funding in India

For years, angel investors have played a crucial role in nurturing early-stage startups, providing them with capital, mentorship, and strategic support. But what happens when a startup outgrows its early-stage classification? Can angel investors continue to maintain or increase their stake through pre-emptive rights? According to a recent informal guidance note issued by the Securities and Exchange Board of India (SEBI), the answer is no.

This decision could have significant implications for the Indian startup ecosystem, as it restricts angel funds from increasing their investment in companies that have matured beyond the government’s prescribed definition of a startup. 

Wondering how this decision will impact startups and investors? TICE breaks it down for you.

Understanding SEBI's Position on Angel Funds

SEBI recently responded to a query from FirstPort Capital Angel Fund, clarifying that angel funds are not permitted to exercise pre-emptive rights in investee companies that are no longer classified as startups.

To understand this ruling better, let’s break it down:

• What Are Pre-Emptive Rights? These rights allow existing shareholders, such as angel investors, to purchase additional shares in a company before they are offered to external parties, enabling them to maintain or increase their stake.

• Why Does This Matter? When a startup grows beyond the criteria outlined by the Department for Promotion of Industry and Internal Trade (DPIIT), it ceases to be classified as a startup. SEBI has now made it clear that angel funds, which fall under Category I Alternative Investment Funds (AIFs), can only invest in entities that meet the DPIIT startup definition at the time of investment.

• What Was FirstPort Capital’s Query? The fund sought clarification on whether an angel fund could continue to invest in an existing portfolio company, even if the company no longer met the startup criteria. SEBI categorically responded that such investments would not align with the AIF Regulations.

What This Means for Angel Investors and Startups

This ruling poses a critical challenge for both angel investors and the startups they back. Traditionally, angel funds have supported early-stage ventures with the expectation of maintaining their stake as these businesses grow and seek additional funding rounds. The inability to exercise pre-emptive rights means that angel funds may face dilution or be unable to further support their most successful portfolio companies.

For startups, this guidance could also lead to complications. Many startups rely on angel investors for follow-on funding, especially before larger institutional investors step in. With angel funds restricted from increasing their exposure, startups may need to look for alternative sources of funding at critical growth stages.

Can a Trust Be an Angel Investor? SEBI Clarifies

In the same guidance note, SEBI also addressed another key question: Can a trust qualify as an angel investor?

The regulator clarified that a trust cannot be an angel investor in an angel fund unless it is registered as an Alternative Investment Fund (AIF) or a Venture Capital (VC) fund. SEBI cited the AIF Regulations, which define an angel investor as either an individual with a net worth of at least Rs 2 crore or a body corporate with a net worth of at least Rs 10 crore. However, under Section 2(11) of the Companies Act, 2013, a trust does not fall under the definition of a body corporate unless explicitly specified by the Central Government.

Industry Reactions and the Way Forward

This latest guidance note has sparked concerns among angel investors and startup founders alike. Many believe that restricting pre-emptive rights could impact the long-term growth of the startup ecosystem, discouraging angel investors from backing startups in their early stages.

Industry experts argue that regulatory flexibility is necessary to ensure that angel investors remain engaged throughout the lifecycle of a startup. While SEBI’s clarification adheres to the letter of the law, it also raises questions about whether regulatory amendments might be needed to better support India’s growing startup ecosystem.

For now, angel investors will need to carefully assess their investment strategies, and startups will have to explore diversified funding options as they scale. With India’s startup economy expanding rapidly, it remains to be seen whether SEBI will revisit its stance in the future to accommodate the evolving needs of the investment landscape.

The informal guidance note comes with the usual disclaimer that it is based on the specific case submitted and does not serve as a blanket rule. However, its impact is likely to be felt across the industry, signaling a potential shift in how angel investments are structured in India.