SEBI's new valuation regulations for AIFs
Vikash Goel
Founder @ Omnifin | Valuation Expert, Consultant, CA Business Leader 40under40, CA, IIM-Cal
Imagine this. You're an #angelinvestor investing money in a promising #startup through an #Angel Fund. You see the #founders ' pitch, believe in their idea and business model and end up funding the startup with a seed stage funding of INR 10,00,000 at a #valuation of INR 1,00,00,000 (i.e., 10 percent stake). While the startup has improved its business, the Angel Fund gives you the value of your investment at INR 10,000 at the end of the year.
Alarming isn't it? But this is not some malpractice of the Angel Fund. That's what SEBI's new AIF regulations may end up with, if not clarified or amended soon.
Securities and Exchange Board of India ( #SEBI ) has just come up with the new #valuation regulations for Alternate Investment Funds (AIFs). AIFs are privately pooled investment vehicles which collect funds from investors to invest in private companies. Usually, Angel Funds and Funds other than #MutualFunds have been set up as AIFs.
In the recent past, SEBI has increased steps to regulate AIFs such as putting minimum investment criteria for investors, asking AIFs to disclose valuation methodology of investments, half yearly reporting of investments to investors among others.
AIF regulations have been positive with AIFs requiring to disclose the value of their portfolios at least half yearly along with details of #valuation methodology of investments. However, considering the challenges in valuing #privatecompanies , these funds have been following practices that was best suited under the circumstances. SEBI has been contemplating more transparent valuation methodology for AIF investment valuation for some time. It even came up with public consultation recently to invite suggestions for valuation rules for AIFs.
On 21st June 2023, SEBI has come up with a AIF Valuation guidelines that AIFs to value their investments as per SEBI Mutual Fund Regulations. This is where the problem begins. Mutual Funds usually invest in publicly listed securities and a small percentage of their investments lie in non-traded or privately held companies. AIFs are the opposite. A majority of them invest in private companies.
Since most Angel Funds invest in equity securities (or equivalent) of Startups, the regulation would require the AIFs to value the #equity #securities as follows:
"equity instruments shall generally be valued on the basis of capitalization of earnings solely or in combination with the net asset value, using for the purposes of capitalization, the price or earning ratios of comparable traded securities and with an appropriate discount for lower liquidity."
Source: Securities and Exchange Board of India (Mutual Funds) Regulations, 1996 > 8th Schedule > Valuation Guidelines
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This means that the Equity Securities should be valued using #Profits as a base or simply at their #NetAssetValue. [Net Asset Value is arrived at based on Balance Sheet and is calculated as Value of Assets, Less Liabilities] For most startups, there are no profits. Thus, valuation using profits as a base would not be applicable. Neither Capitalisation of Earnings nor Price Earnings Multiples would be applicable in most startups. Also, considering the amount of innovation in StartUp ecosystem, there are many for whom a comparable listed company is hard to find. Further, valuing the Startups at Net Asset Value would mean there is no premium in the business and no value for future potential. Startups all over the world seek investments from investors where they pitch their idea at an early stage and investors provide a premium for taking the risk, coming up with innovative idea and starting up a scalable business. These are usually not profitable at this stage. Creating a regulatory mechanism to value them using profit or balance based matrices will be a huge discouragement to the entire startup ecosystem, even if it is only for reporting purposes.
SEBI Mutual Fund Regulations also have broad guidelines for valuation of Convertible Securities.
To be fair, SEBI's circular does mention that AIFs must mention the need for timely audited financials of investee companies in their investment agreements. A much needed push to enable timely valuation of investments. However, in the absence of any specific consequence, this requirement does not appear to have any teeth. Already investee companies are usually Private Limited #Companies or Limited Liability Partnerships (#LLP) who are required to file their audited financials within a stipulated time under Companies Act. SEBI's circular does not accelerate the timelines for investee companies. Thus, valuation of AIF investments may be delayed unless the investee companies do not submit their audited financials for the year ending March (the official financial year end in India).
On a side note, interestingly, the Income Tax Department has been working on a mechanism to expand the valuation approach for private companies (specifically Startups) under Rule 11UA of #IncomeTax Rules. The proposed rules allow companies to adopt some of the commonly used methods as per internationally accepted valuation practices.
So just when we thought that rules for private companies and startups were beginning to rationalise, here we have another complication that is bound to confuse the market participants. From valuation by #RegisteredValuers #CharteredAccountants #MerchantBankers and prescribed methods, there's need for unified set of regulations that make the lives of startups and investors easier.
Vikash Goel , is a Professional Valuer, Director of Omnifin Valuation Services and is a PhD Scholar.