The Flipkart logo outside one of its offices in Bengaluru. (Source: Bloomberg)

Ownership, Control, And Protection

BloombergQuintOpinion

The need and desirability of the government to protect Indian startups against global companies has been a matter of hot debate. In some ways, the Bengaluru Club is a throwback to the infamous Bombay Club which argued for protection of Indian industry against the global giants rushing in post liberalisation.

The Protection Debate

The argument goes that global companies have had decades to perfect their business models, and with superior resources, these global companies will crush Indian rivals before the local companies get a chance to develop. Commentators espousing this line look enviously at China with its protectionist policies and their home-grown internet giants and proclaim the need for the Indian government to protect its flock too.

There is, however, a basic issue to settle first; as to what constitutes an ‘Indian’ company.

Most Indian startups are majority-owned by foreign investors, and in some cases domiciled abroad too. So what is really ‘Indian’ about them?

Is protecting a Flipkart or an Ola against an Amazon or an Uber really doing anything for Indians?

Isn’t it just ‘investors in Tiger Global or SoftBank’ versus ‘investors in Amazon or Uber’?

Bhavish Aggarwal, chief executive officer and co-founder of ANI Technologies Pvt., owners of ride-hailing service Ola, on May 7, 2016. (Photographer: Namas Bhojani/Bloomberg)
Bhavish Aggarwal, chief executive officer and co-founder of ANI Technologies Pvt., owners of ride-hailing service Ola, on May 7, 2016. (Photographer: Namas Bhojani/Bloomberg)

Phrased differently, we need to be clear about who we are trying to protect. For instance, today founders are talking about their innate Indian-ness but what happens tomorrow if their companies are sold to global players? Can they prevent that? Wouldn’t protection in this case only serve to enhance returns of their investors and do nothing for India?

The flip side of the argument is that there is a level of protectionism all around the world. Nation-states need to draw boundaries around what can be controlled by foreigners. ‘Sensitive’ assets need to be protected in the national interest.

Who Or What Needs To Be Protected?

But what is ‘sensitive’? Are digital startups really sensitive? The definition of sensitive varies by country – the U.S. tends to focus on ports and infrastructure while China is clear that anything that can reach a lot of people had better remain Chinese. It is useful to separate the prevalent situation on this between developed and developing countries.

‘Sensitive’ In The Developed World

The thirty-four members of the Organization for Economic Cooperation and Development (OECD), as well as twelve non-member states, have signed a non-binding commitment to treat foreign-controlled firms on their territories no less favorably than domestic enterprises. Governments, under this agreement, however, are provided considerable latitude to exempt sectors of their economies deemed essential to national security. As shown in the table below, countries define “critical infrastructure” in various ways.

Source: OECD May 2008 report on Protection of ‘Critical
Infrastructure’
Source: OECD May 2008 report on Protection of ‘Critical Infrastructure’

China's Definition Of Sensitive

China has a very restrictive policy with 93 sectors on several restricted or prohibited lists. In the 13th Five Year Plan (2016-20), this list is to be pruned to 62 sectors. However, they have ‘allowed’ one huge loophole - the concept of offshore holding companies that can have contractual agreements with mainland companies that entitle them to all economic benefits and effectively control the mainland entities. These so-called Variable Interest Entities (VIEs) are 100 percent owned by Chinese citizens, hold critical licenses but are effectively controlled by the offshore companies via a series of contracts.

To understand what this means practically, let’s explore who owns Alibaba...

Jack Ma of course! Or is it SoftBank, Yahoo and other investors with Jack Ma only owning 8 percent? Well, the answer is a bit nuanced and depends upon your frame of reference.

The entity listed on the NYSE (with a market capitalization of ~$240 billion) is called ‘Alibaba Group Holding Limited’ and is registered in the Cayman Islands. This company owns and/or controls the real entities that carry on the business in China. This company is owned by SoftBank, Yahoo, other investors with Jack Ma (he owns only an 8 percent stake).

Source: Alibaba FY15-16 Annual Report (20-F)
Source: Alibaba FY15-16 Annual Report (20-F)

While a detailed explanation of the above structure is beyond the scope of this note, we just need to understand that there is a significant part of the business which is not 100 percent owned by Alibaba but is effectively controlled via contracts. What parts of the business are these?

  • The key entities (Taobao, Tmall, Alibaba.com, Cloud Computing) are 100 percent owned by Jack Ma and Simon Xie while being ‘effectively controlled’ by Alibaba Group Holding Limited.
  • This ‘effective control’ is not always effective as the Alipay ownership change in 2011 showed.
  • In 2011, there was a change in laws and overnight the ownership of Alipay was transferred away from Alibaba.
  • There was an eventual resolution but by all accounts, it was on terms that Jack Ma offered and Yahoo/SoftBank had to take.
  • This was possible because Alipay was 100 percent owned by Jack Ma (and company) despite being ‘effectively controlled’ by Alibaba.

As is evident, this combination represents a very potent structure.

Foreign investors can pretty much own any asset but the state has the right to change the rules anytime, with or without the founder’s consent.

This has the dual benefit of keeping both the investors and founders in check! It also ensures that only Chinese companies (with or without foreign capital) can operate in large parts of the economy.

Billionaire Jack Ma, chairman of Alibaba Group Holding Ltd., arrives in the lobby of Trump Tower in New York, U.S., on Monday, January 8, 2017. (Photographer: Albin Lohr-Jones/Pool via Bloomberg)
Billionaire Jack Ma, chairman of Alibaba Group Holding Ltd., arrives in the lobby of Trump Tower in New York, U.S., on Monday, January 8, 2017. (Photographer: Albin Lohr-Jones/Pool via Bloomberg)

And Hence My Point Is…

I am sure that by now your eyes have glazed over, so let me summarise.

  • There is some protection everywhere but the Chinese have pioneered their own form of protection which has turned out to be quite effective.
  • They have companies with global scale in technology (befitting their numbers, and size of their domestic market), which are essentially Chinese owned and yet have been funded by global investors.
  • These companies are now among the leading technology companies in the world and are starting to spread their wings beyond China.
  • They are also emerging as innovators in cutting-edge areas like machine learning, augmented and virtual reality.
The Chinese experience certainly suggests that India should consider protection seriously.

There is a key difference between China and India in the approach to foreign investment. India tends to focus on continuing to ease rules and regulations to attract foreign investment, while China has taken the opposite stand of keeping rules very strict and spending effort instead on developing their domestic market to make it a very attractive investment destination, leaving a back door open for foreign investors which they can control.

What Should India Do?

It is clear that India must protect its critical infrastructure - both physical and digital. There is also merit in having an enabling environment to protect Indian companies as they mature allowing them to emerge as global leaders in times to come. However, we must also face the reality that India does need foreign investments for infrastructure and industry to improve the quality of life of its citizens. This capital will demand a return and the rules/regulations must protect that too.

The FDI genie is out of the bottle so no wholesale change in policy is feasible or advocated. In other words, copying China is out.

The regime has been in place for a while and the Prime Minister has spent considerable time and energy to build a favorable image of the country and squandering that would be ill-advised. It is also my belief that India has enough existing rules, regulations, and bodies. The general idea should be to develop solutions within existing frameworks rather than proposing entirely new ones.

My suggestion hinges around one simple but powerful idea – separate ownership and control. The focus should be on control and provide some level of protection to Indian-controlled entities. Ownership should be only tested for in very sharply defined sectors that pertain to critical national infrastructure and security like the OECD countries have.

How Is Control Defined In India? How Should It Be Defined?

There are multiple definitions which vary by regulator – Securities and Exchange Board of India, Competition Commission of India, Foreign Investment Promotion Board, and Insurance Regulatory and Development Authority of India, to name a few. There is an excellent discussion paper by SEBI which summarizes the various definitions and the global position. Control has been variously defined as the right to:

1. Appoint a majority of the board of directors

2. Control management

3. Control policies

Further, the right can be derived from ownership (shareholding), management rights, shareholders agreement, voting rights and contracts. The current definitions, while largely similar (especially to the untrained eye), have different nuances and can actually result in different views on who is in control!

The good news is that SEBI has recognised the need for having a simple, consistent and verifiable definition for control. In their discussion paper, they have suggested that control be defined in terms of voting percentage irrespective of other factors. This is the broad global position and would also make it simpler to assess who is in control.

I would strongly advocate that we push in this direction and decide appropriate voting control thresholds rather than thresholds focused on ownership.

Small Step For Man, Giant Leap For Mankind!

Separating ownership and control will allow Indian entrepreneurs to access global capital while still retaining control. This will also allow the state to offer appropriate incentives for ‘Indian-controlled companies’.

Let me add, this issue cannot be settled by the government alone. It is something that the entrepreneurs must address by pushing back on investors, keeping voting rights with them and in general showing that they are the right persons to control the destiny of the company. Larry Page and Mark Zuckerberg have shown the way and to be true global leaders. We need Indian entrepreneurs to step up too. As the old adage goes - ‘Power must be taken, it is never given!’

Sarbvir Singh is an experienced venture capital investor in India and was the founding Managing Director of Capital18. The portfolio of companies that he has worked with include BookMyShow, Yatra and Webchutney among others.

The views expressed here are those of the author’s and do not necessarily represent the views of Bloomberg Quint or its editorial team.