You’ve heard the one about killing softly with a song ? Well, the Finance Ministry seems bent on killing foreign venture capital investments with a clause. Or, so it would seem from the Securities and Exchange Board of India’s recent announcement that venture capital funds incorporated in India will have to exit a company within a year of its going public. Of course, there’s a proviso  isn’t there always when it comes to government guidelines ? VCs can retain their holdings in the company if they are willing to pay real tax on the notional appreciation in their investments.

Members of the SEBI are scrambling to dissociate themselves from the decision and pass the buck onto the Finance Ministry. According to recent reports, Department of Company Affairs Secretary P L Sanjeev Reddy, Reserve Bank of India’s Deputy Governor S P Talwar and Aditya Birla Group Chairman Kumar Mangalam Birla all opposed the idea and threatened to place a formal dissent note. But nothing of the sort eventually happened.

In fact, the board approved the move though the Finance Ministry’s nominee to the SEBI, Dr. Shankar N Acharya, was not even present at the meeting. The sad truth is that the SEBI allowed Finance Ministry mandarins who are clueless about how venture capitalists function to overrule expert recommendations. The SEBI itself had constituted a committee headed by Mr. K B Chandrasekhar to suggest norms to facilitate increased VC investments into India.Mr. Chandrasekhar, incidentally, is a co-founder of Exodus Communications and one of the Indian stars to have lit up Silicon Valley so he knows a thing or two about what he’s talking about. May be someone forgot to tell the Finance Ministry, but venture funds are quintessentially long-term players. They may offload part of their holdings before an initial public offer but only make their final exit when they are able to realise the maximum returns on their investments, or if they feel the project is becoming unviable.

The Chandrasekhar Committee had recommended “resource raising, investment, management and exit should be as simple and flexible as needed and driven by global trends”. Comparing foreign venture capital investors with foreign institutional investors, it had argued that India has successfully roped in FII investments of over $10 billion because these investors can freely invest and disinvest without taking approvals from either the Foreign Investment Promotion Board or the Reserve Bank of India.

All sound, logical observations. So, what did the Finance Ministry do ? Well, they have made all the recommendations stand on their heads by telling venture capitalists that they must spend time, effort and most important, money, nurturing a project and then get out just when it is beginning to pay off. Bear in mind that typically, only one in five investments actually pays off for VCs and you begin to get some idea of how brutally the bureaucracy has hamstrung venture capitalists. As is now par for the course, the directive was accompanied by much confusion. So, foreign venture capital investors were initially convinced that the directive pertained only to India based venture hands, which constitute less than 20 per cent of total venture capital inflows into India. This smugness quickly gave way to panic after the SEBI clarified that all venture funds investing in India would have to fall in line, regardless of whether they are based offshore or in India. Having wielded the stick, the SEBI-MoF combine is now dangling a carrot. Venture funds that register with the SEBI and exit their investments within a year will enjoy the tax ‘pass-through’ benefit for the first year under the Finance Act.

Under this benefit, no tax is levied on income distributed or retained by venture capital funds or venture capital companies. To the bureaucratic mind, it doubtless makes perfect sense : you register yourself, you abide by the rules and you avail of the benefits. But the real world works differently. The proposed tax benefit will be of little use to VCs if there is little chance of their making a profit in the first year. What is much more likely to happen is that foreign VCs will simply fold their tents and move onto greener pastures. Of course, some VCs will also try to exploit the loopholes in the law. A category of venture capitalists operates in partnership with the chosen start-ups, with their participation in the ventures concerned going beyond pure financial investment. It is not uncommon among the venture capitalists to adopt this strategy of imparting technical know-how along with funds to their start-ups. They will definitely try to use this avenue to circumvent the problem; the SEBI and the ministry will then come up with another set of directives and the cat-and-mouse game will go on. The real tragedy though is that the government stubbornly refuses to learn from the past mistakes. Earlier this month, a smart bureaucrat in the income tax department had suddenly woken up to the fact that some foreign institutional investors had incorporated subsidiaries in Mauritius as shell companies to take advantage of India’s tax-treaty with the country. The income tax department argued that since this was in violation of the tax-treaty, FIIs should pay their taxes in India. In the process, they overlooked the fact that the Indo-Mauritius tax-treaty was already a decade old. The result was there for all to see; the Bellwether Sensex tumbled by more than 200 points in response to the taxmen’s plans and the Finance Minister was forced to intervene and placate the FIIs. Contrary to what the denizens of North Block seem to believe, there is no mad rush among the foreign investors to invest in India. And their short-sighted decisions and subsequent knee-jerk crisis management measures don’t make things better. The latest move by the Finance Ministry-SEBI combine is a classic example. By stipulating a time period for venture funds to exit from companies, the policy-makers will end up achieving the exact opposite of what they should be actually doing : luring venture capital funds to invest more and more in India. The good news is that there is already a move within the government to make the Finance Ministry see reason and exclude the forced exit clause from the SEBI’s venture capital norms. The bad news ? Well, you can be sure that there will be some before long.

According to SEBI’s decision, under which condition can a VC continue to retain its holdings in a company even one year after its going public?