How foreign VCs are sneaking past Indonesia’s ecommerce laws

Indonesian law doesn’t allow foreign direct investment in local retail ecommerce companies. This concerns online sellers who hold their own inventory and have a direct touchpoint with Indonesian customers. Online marketplaces that mediate between buyers and sellers are not affected by the ban. That’s why it was possible for Sequoia and Softbank to invest US$100 million in Tokopedia last October.

Many other Indonesian ecommerce companies do fall into the retail category. Just think of Muslim fashion estore Hijup, or Ralali, an online shop for tools and industrial equipment. Both have raised venture capital from abroad this year. How was this possible? It’s a question frequently raised by Tech in Asia readers.

I asked three VCs managing foreign funds – from the US and Japan – to comment. They requested their names and investments not to be revealed in this article, but agreed to shed light on some proven mechanisms to circumvent the ban.

Parallel debt and equity round

In the case of an investment in an Indonesian niche fashion ecommerce startup, both foreign and local investors were involved. The investment had to be finalized fast, because the startup was approaching the end of its runway.

“The simple answer on how to address this problem is to raise an equity and debt round simultaneously,” one VC told me. “Local investors invest into the equity round. Foreign investors invest into the debt round [in the form of a] convertible note. By investing into a debt round, we are able to fund companies without actually being shareholders, so we are not affected by Negative Investment List regulations. But during liquidation events we can sell our note as if we had equity ownership in the firm.”

If it comes to this arrangement, another VC added, typically a second agreement is set up that defines the foreign VCs influence on decision making processes. A convertible note itself would exclude the foreign VC from being involved in strategic decisions.

Create multiple entities

In cases when there is more time to finalize an investment, the preferred way is to split the companies into multiple entities.

“Some investors are more comfortable to hold equity,” I was told. “[We create] one holding company [that] sits outside of Indonesia, and investors will invest directly to that.”

One local company is established that handles fulfillment. It owns the inventory and handles everything related to delivering the product to the consumer, while a separate entity holds the IP and is registered as a web portal. The fulfillment company can have an exclusive contract with the web portal, which is legal by Indonesian regulations.

“[This process of setting up multiple entities in a number of countries] takes a lot of money and time,” the VC said. It can take several months, and requires close cooperation between the VC, the startup, and lawyers.

Some startups in Indonesia are aware of this issue and are taking matters into their own hands by creating a holding company headquartered elsewhere from the start.

“It is a waste,” one VC complained. “With these schemes, we have to move [the company] out of Indonesia. It’s a wasted opportunity [for the country].”

Direct investment through a local entity

A third way to circumvent the ban on foreign direct investment in retail ecommerce is to work with a third-party local entity. This entity acts as nominee – meaning on paper, this entity holds the shares.

Will the ban be lifted?