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In Depth

Well begun is half done

Siddarth Pai
31st Jan 2018
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A look back at how Startup India has started blossoming and eased the journey of Startups and Investors; and what are Investor Expectations ahead of Budget 2018.

It’s been two years since the fateful 2016 budget which recognised “Startups” as a separate breed of companies unto themselves, demanding bespoke treatment from the government and authorities. The clarity brought forth helped quell the nerves of both companies and investors, who had to otherwise resort to exotic exercises, supplementary structures, and platoons of professionals to keep their entrepreneurial dreams alive.

As we all await with bated breath for the slew of reforms expected of the Finance Minister, it behoves us to see how much further we need to proceed so as to have a multiplier effect on the ecosystem turning a billion dreams into a reality.

This article talks about a retrospective of the Startup India plan so far, and prospectively what we require. We explore how Startup India has eased the friction in the Startup ecosystem so far, from an investor’s perspective. This article also describes the need of the hour, which is not another set of Big Bang reforms, but a consummation and enforcement of existing policies leading to a multiplier effect on the ecosystem.

Flywheel of Funding

More often than not, any coverage about fundraising covers the journey of startups and entrepreneurs and the travails of raising their multimillion dollar rounds. But there exists another dimension to this story, that of fund managers raising their own funds. A large section of the investor community were elated that the government recognised this oft-ignored story and created the Rs 10,000 Cr (USD 1.5 billion) Fund of Funds managed by SIDBI which invests into SEBI registered AIFs and Venture Capital Funds.

This approach seeks to galvanise an ecosystem through a flywheel effect, instead of gardening it via direct intervention. The 10,000 Cr corpus can help seed AIFs worth Rs 60,000 Cr in India, which when fully deployed, is estimated to foment 18 lakh jobs and fund thousands of Indian startups. By contributing a maximum of 20% of the corpus of a fund, many fund managers can hasten their fundraise and concentrate more on helping their portfolio companies raise, instead of competing with them.

The Fund of Funds has invested into 88 AIFs so far, thus galvanising more than 5,600 Cr (USD 873 million) worth of investments into 472 Startups. 

Bringing back tax breaks, not a back-breaking Tax

The Government’s support of Indian investors found its way into the Income Tax Act, with several measures to incentivise investments into the Indian Startup ecosystem, such as:

  • Insertion of Section 54 EE, which exempts Long Term Capital Gains upto Rs 50 lakhs provided it has been invested in the units of a SEBI registered AIF.
  • Insertion of Section 54GB, which exempts Long Term Capital Gains of upto Rs 50 lakhs provided its been invested into the shares of a Startup which qualifies for Section 80IAC.
  • Clarifying that the conversion of debentures of preference shares to equity shares will not be considered as a transfer and thus subject to capital gains at the point of conversion (the entire Venture Capital industry is based on convertible debentures and preference shares and this move has settled long standing disputes regarding the instruments of investments).
  • Issuing a notification that the dreaded angel tax will not apply to shares issued at a premium to domestic investors by those startups who qualify under the DIPP scheme (although the scope of this needs to be extended to rid the spectre of angel tax that haunts various investors and entrepreneurs).
  • Clarifying that the stance of the assessee in categorising the sale of listed securities held for more than 1 year as Capital Gains or Income from Business can’t be questioned by the taxman.
  • Changing the definition of a capital asset to include any securities held by a Foreign Portfolio Investor, thus removing the friction arising from asset classification (a similar provision is sorely needed for domestic hedge funds and Category III AIFs). 

Capital without Borders

The Startup India scheme over the past few years has rolled out the red carpet to foreign investors while rolling back the red tape. The success of this is evidenced by the percentage of funding foreign capital represents in the Indian startup ecosystem, which is 9 times higher than domestic capital investment.

Some of the initiatives include:

  • Liberalising Foreign Direct Investment into most sectors including financial services, single brand retail, pharma, media and a host of other sectors upto 100% in most areas.
  • Abolishment of the Foreign Investment Promotion Board.
  • Relaxation of External Commercial Borrowings (ECBs) for Startups for up to USD 3 million.
  • Allowing for issue of shares for non-cash consideration to non-residents under the automatic route.
  • Marshalling foreign investment into Indian entities primarily for the purpose of investing into other Indian entities has been bought un der the automatic route as opposed to the previous government approval route.
  • Dismantling the approval mechanism for the transfer of securities by a Foreign Venture Capital fund to an Indian resident.
  • Moving most of the filings (FCGPR, FCTRS, etc) to an online window managed by the RBI (ebiz.gov.in). 

Well begun is half done

The government’s efforts to improve life for Startups and Investors has begun to bear fruit in tangible ways as evidenced by the reduction in the number of companies seeking to have a Delaware entity with Indian operations. The recent leapfrog in the “Ease of Business” rankings also stands testament to this.

The Government must now seek to consolidate all these gains and clarify its stance and the stance of the tax department on long pending issues which have been a bane to all startups. While we have miles to go before we sleep, we must look back and take note of what we’ve achieved before we seek to scale greater heights.

At the same time, we also need the next step of reforms which would have a multiplier effect on the ecosystem.

Raise capital, not Regulation

The current Companies Act allows two modes of raising capital: a rights issue, which is mainly for existing shareholders to invest and maintain their shareholding and a private placement, which allows a small group of external investors to invest. Due to the rigours and fines associated with the latter, the former has become the de facto mode of raising capital for a lot of startups.

The fine for any missteps associated with a private placement is the lower of the capital being raised or 2 crores. Combined with the special resolutions, filing of special forms (PAS 4, PAS 5 via GNL 2), valuation reports, strict timelines, a minimum face value of investment, inability to raise from more than 50 people or use any form of media to find investors makes this route dicey for startups to raise through.

What we require is rectifications to the existing regulations, such as to:

  1. Allow Startups to use angel networks and investor platforms to raise capital from Accredited Investors (more about that later on) without violating private placement norms.
  2. Change the minimum threshold of Rs. 20,000 of face value to a minimum investment size of Rs. 20,000 (startups always raise at a premium, not at face value).
  3. Reduce the compliance burden of multiple form filings to a simple form stating the details of the investor, proposed investment amount, and details of the securities being issued.
  4. Reduce the quantum of the fine for Startups and make it applicable only if the private placement is conducted in a manner that’s prejudicial to the investors and shareholders, not just for any lapse.

On the clipped wings of an Angel

2017 was brutal for angel investors in India, as witnessed by a 63% contraction in angel funding compared to the previous year. Not only were the companies they invested in subject to the dreaded Angel Tax , but it also witnessed several Angel Networks receiving notices from the Securities Exchange Board of India (SEBI) about being unregulated stock markets and violating private placement norms. The private placement norms under the Companies Act, 2013 prohibits companies from canvassing for capital on any media and from sourcing funding from more than 50 people at a time.

Angel Networks, which are mainly groups of entrepreneurs, businessmen, executives, professionals, and others who want to give back to the ecosystem by cutting the first cheque to early stage ventures. They then go on to mentor these startups by helping them finesse their business models, craft strategy, win clients, and ultimately, raise their next round. Most early stage ventures around the world – Facebook, Google, Amazon, Flipkart, Ali Baba, Uber, etc owe their first capital infusion to these angels. The flywheel of value startups generate owe their first spark to these angels.

Countries like the US, UK, etc. recognise these angels by creating an "Accredited Investor" badge, which acknowledges these angels as sophisticated investors who are wholly aware of the risk they're taking and have a financial cushion in place in case anything goes awry. The details of this have been proposed by several stakeholders and are modelled on the same lines as the US structure.

What we need is to:

  1. Recognise the contribution of Angel Investors and foster the flow of domestic capital, which constituted a mere 10% of all investment into the startup ecosystem in 2017. Angels are a vital component of a healthy startup ecosystem, and the context must be set for them to be encouraged to participate in strength if Indian startups are to continue the momentum they have generated so far.
  2. Allow Angel Networks to continue as they are: as a group of willing individuals coming together and investing of their own volition; instead of scaring them with notices and marshalling them into structures subject to cumbersome compliance.
  3. Create an Accredited Investor scheme which defines an Accredited Investor as having a minimum income or minimum net worth, and having them declare that they are aware of the risks of investing in early stage Startups. This is similar to the HNI (High Net-worth Individuals) scheme SEBI has for public markets, which stipulates a Rs. 10lakh investment amount to qualify as an HNI.
  4. Expand the allowances made for other institutions in the private placement norms and angel tax to apply to these Accredited Investors who invest in Startups

A tax is not the best form of Defence

2017 saw the entire Startup ecosystem galvanise against the tyranny of the angel tax, a draconian measure that seeks to tax as income any securities issued at a premium and at a price greater than the Fair Market Value. Although the law says that the Fair Market Value is the higher of the valuation report or the value determined by the taxman on the date of issue, many startups have faced demand notices in spite of having followed the law and having issues securities at the price justified in their valuation report. Those who seek to fight this may ultimately prevail, but the upfront deposit of 20% of the tax payable, the time it takes to fight these matters and the sword of Damocles hanging over their head makes many entrepreneurs throw their hands up in frustration.

Even investors have to suffer adverse tax consequences, be it the inability to set off or carry forward their share of fund expenses, the differential tax treatment of domestic hedge funds (Category III AIFs) vs foreign hedge funds and Foreign Institutional Investors (FIIs), lack of clarity on the categorization of Short-Term Capital Gains as Business income or Capital Gains, or the unfavourable tax treatment meted out to domestic investors as opposed to foreign capital.

What we need is to:

  1. Remove the applicability of the dreaded Angel Tax from companies who raised capital prior to the Startup India Scheme and who qualified as startups during their raise.
  2. Remove the discretionary powers allowed to the taxman to disregard a valuation certificate and allow for the current law, which measures the FMV as the higher of the valuation report or the present value, to prevail.
  3. Clear all pending cases of angel tax levies for companies which have a valid valuation report and not subject them to the Byzantine appeals process.
  4. Categorise securities held by a domestic fund as a capital asset only, along the lines of the allowance made to FIIs during Finance Act 2014, this removing the disadvantage placed upon domestic funds.
  5. Relaxation of Place of Effective Management (POEM) rules for Fund Managers, thus ensuring the flow of USD 12-16 Billion in management fees coming into India (assumed at 2% fees of 600 billion dollars in FPI, 200 Billion in venture investment, which currently invests into India but is managed from outside India for tax planning purposes).
  6. Allow for investors in AIFs to set off or carry forward their proportionate share of expenses incurred by the AIFs.

Well begun is half done, but not Complete

India is the third most vibrant startup ecosystem in the world, behind the USA and China, and is still growing in a furious space. The startup phenom has seen thousands look upon entrepreneurship as a viable life choice; thousands of jobs are being created in the country and millions of dollars of value are being created in India. The Indian Government has done its fair share in easing this journey and supporting the ecosystem, which also needs to be acknowledged and celebrated by all of us.

At the eve of the upcoming budget, as many look closely at the change in tax rates or the panacea to the NPA challenge, a small group of us will be sifting through the details to discern the subtle changes, which like the beat of a butterfly’s wings, will have far-reaching ramifications for us all.

(Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the views of YourStory.)

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