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Abstract: 

Venture capital (VC) investments are prone to information asymmetry and agency costs, and, like any other investment, they also attract capital gains taxes. We observe how venture capital firms can solve the problems of information asymmetry and capital gains tax. We derive various financing combinations from the literature to find out the best strategy to address both issues at once. The existing research predicted and observed that convertible preferred equity is the best form of finance to address the agency-cost problem. Furthermore, the literature on capital gains tax noted that VC investors use round-tripping with the help of tax treaties through tax havens to route the investments. We combine these two crucial insights and suggest that VC investors would use convertible preference equity routed through tax havens to solve both problems at once. We also present empirical evidence on observed financing strategies using the Indian data of 1,784 venture capital transactions from 1,100 companies between 1998 and 2015. This is affirmed by the facts that 43 percent of the VC investments in India have followed the convertible preferred equity route and more than 90 percent of the VC firms registered in India routed investments through two tax havens, Mauritius and Singapore.

Keywords: capital gains tax, venture capital, information asymmetry, tax treaties

Affiliations:  1: Indian Institute of Technology Madras; 2: Indian Institute of Technology Madras.