Taxing Our Startups

Much has already been written about a new proposal in the Budget, where a private company is required to "justify" the valuation it receives when an Indian resident investor buys shares in it. This doesn't apply to public companies, or those in which the investment is by a venture capital fund. It also doesn't apply if you buy shares at "par" — that is, at the face value of the shares.

When a company is created, shares are issued to the initial investors at face value, in proportion to their investment. For example, take a company started with 100,000 rupees, with two founders putting in Rs. 60,000 and Rs. 40,000. Each will get 6,000 and 4,000 will get shares of Rs. 10 face value, respectively, for a total of 10,000 shares.
The founders work for 6 months and build a prototype for a software to revolutionize online payments. They demonstrate this, with a business plan, to an angel investor, asking for Rs. 20 lakh as an investment to hire people, buy some equipment and for marketing.
At this point, the software company has nothing but a prototype. It might have talked to customers, identified people to hire, earmarked funds for purchases if they got the money. It has spent nearly 75,000 of the one lakh rupees the founders put in, on paying rent on a small office, travelling to meet prospective customers, and designing their web site. How do you value this company?
Do you say the value of the company is whatever is left in the bank account? That's just Rs. 25,000 or Rs. 2.5 per share. Let's be nice and say that the original valuation of Rs. 100,000 remains. So we'll value the company at Rs. 10 per share.
Now a fresh investment of Rs. 20 lakhs (2 million) at Rs. 10 per share (face value) will mean giving the new investor 200,000 shares. The equation is:
Founders: 10,000 shares (together)
Investor: 200,000 shares (new)
After the investment, the investor will own 95% of the company, and the founders a miserable 5%. Will they be motivated to work further? Without a reasonable stake, and with low salaries? (startups must scrounge to conserve cash, and founder salaries are very low. Angels also balk at providing market salaries to founders.)
You can then expect the founders to start submitting their resume for a job. Why bother with a startup with nearly no stake and low salaries?
The answer, then, is to provide an incentive in the form of a higher stake for founders. In the case above, the angel might understand that the founders done a lot of work on the prototype, and validated much of the idea by getting early interest from customers. That derisks the venture, and so the value of the startup is higher. Based on the angel's own knowledge of the industry or connections, the startup might, in his opinion, be worth Rs. 400 crores in 10 years. He might value the startup at, say, Rs. 40 lakh today. On a per-share basis, that is Rs. 400 per share. For his Rs. 20 lakhs, he gets 5,000 shares. So the equation is:
Founders: 10,000 shares.
Investor: 5,000 shares.
The founders together own 67% of the company, while the angel investor owns 33%. This leaves enough for founders to stay motivated, knowing perhaps that they may get diluted further in few rounds of venture capital financing, which will only happen when they see revenues. A far more equitable distribution and a "win-win" for everyone involved.
This is the most common way service or software statups are financed, because a large part of their value is intangible, a forward premium on what the investor believes they can achieve. Any attempt to value such a company at an early stage using just assets will fall flat on its face.
The new law penalizes exactly this kind of investment. A startup that receives a "premium" on its face value now needs to justify its valuation to a tax officer, who will use specific measures to value it, and those measures only include the sum of the value of its assets. If the valuation is not acceptable, the investment will be treated as income, and therefore, the income will be taxed. It's like making your investor your customer instead.
This serves a death knell to early stage investing, especially in the technology sector where valuations are based on very hazy numbers by founders. Who knew the potential of yet-another-search-provider when Google started? Would they even have access to capital if they had to justify those numbers to a tax officer, who is hardly knowledgeable about search-engine-valuations or how, after five or six years, an entirely new market was created around keyword marketing?
The tax officer's defense is that there has been abuse. Many times, black money is used to invest; and other times, such money is used to avoid income tax. For instance, if a customer pays you money, and you give him a very tiny percentage of the company in exchange for a large sum of money, you get to keep that money as share premium without paying any tax on it. When you offer a tiny shareholding, the risk of diluting your equity capital or losing control is also non-existent.
However, are these transactions so many that they override the general good of the economy? A substantial number of private companies are invested into, by friends and family, to provide start-ups the risk capital they need. The Small and Medium Enterprise (SME) sector is huge; it is by far the highest employing industry, the source of much of our GDP growth, and the "trickle down" effect. Without the friends-and-family network, such companies will have to try and get financing from banks, which, despite being given huge incentives to invest in the SME sector, don't want to lend to them. Looking at lending statistics, the amount lent to SMEs is a tiny fraction of what goes to large enterprises.
And will the scoundrels that abuse current laws not be caught by other changes in the same act? A change to section 68 now requires companies to provide the source of funds of their investors. The lack of such a source immediately taxes the company on that amount — therefore, no black money can be invested. The General Anti Avoidance Rule will easily detect a customer paying a company and masquerading as an investor instead — in fact, in such a case, there are penalties that can be levied on all parties. Additionally, if the rule was to avoid black money, then why exclude foreign investors from its ambit? Most "black" money is routed abroad anyhow, and comes back in as equity investment. By specifically excluding foreign investors, the rule allows a wink-nudge approval to the corrupt to continue their practice.
Why this rule then? All it does is to give a tax officer unlimited discretion on a tax that isn't logical, and that will prompt those that are corrupt to demand bribes in order to approve legitimate valuations. In the face of the recent corruption scandals, it is strange that the government would encourage discretionary overreach.
There is of course a way around, like there always is. Instead of taking investments in equity shares, use the concept of convertible debt instead — money that is taken as a loan which will eventually be convertible into shares. Hopefully, by then, the Finance Ministry would have realized its folly and reversed this draconian clause.