Reforming the Indian startup ecosystem
It’s been nearly a month since Hon. Finance Minister. Mr. Arun Jaitley delivered this Government’s fifth and last full Budget before the next General Elections. The budget was delivered amidst subdued economic growth, challenging fiscal situation and farm distress. According to various reports, Indian tech startups raised about $22 Billion in funding in 2017, in a $2.5 Trillion Indian economy this is a drop in the ocean (0.9).
Two most important reforms that can push ahead the Indian startup juggernaut are namely refinement of the Angel Tax and Accreditation of early-stage investors in India.
1. Angel Tax: The angel tax is a 30.9 % tax levied on investments made by external investors in startups/private companies. The tax is levied only on the amount that is considered above “fair value” valuation of the startup/private companies, classified as ‘income from other sources’ in the Income Tax Act of India. The challenge here is that startups are often valued on the basis of methods such as discounted cash flows which calculate the present value of future receivables. There is also an added intangible value provided to aspects such as the pedigree of the team, the maturity of the industry and brand value if any. This can cause differing interpretations of “fair value” which can expose the startups to Angel Tax when the investment is executed at a value higher than the fair value. Due to the application of Angel Tax, a significant portion of the fund raised is taxed rather than being utilized for growth despite dilution of the equity of subscription of a debt instrument.
The Angel Tax was introduced under the Finance Act 2012. In 2015, amid growing protests from Indian startups, entrepreneurs and investors, the Government proposed an amendment to exempt angel tax on investments not exceeding $1.56 Million. In 2016, the Central Board of Direct Taxes (CBDT) issued circulars to exempt startups from angel taxes, even if the funding raised by a startup was in excess of fair market value. The challenge here was the definition of a startup; a company must not be more than 7 years old and must have an annual turnover that does not exceed $3.9M.
India must take a leaf out of other globally recognized and successful startup ecosystems on how they’ve incentivized and encouraged angel investors to participate more actively. In China, besides launching State-backed venture capital funds, angel investors can deduct 70% of total investment into a startup from their taxable amount two years after the investment. In Singapore, initiatives such as cash grants, debt financing, and tax incentive schemes where up to S$200K of tax exemption is provided to startups for the first 3 consecutive years of assessment must be studied. Other Governments like France, Italy, Canada, UK, and Australia have excellent schemes encouraging startup investments. In this regards, the Angel Tax seems like a retrogressive step.
2. Investor Accreditation: In India, any person that has an appetite for high-risk investments can become an angel investor. While this is great from a startups perspective, there are serious ramifications to an open and unregulated system. India ranks third, after the US and UK in terms of the number of startups and also attracted about $22 Billion of venture capital funding in 2017 from the global infusion of $155 Billion, which is about 14% of global contribution. This euphoria has led to many inexperienced, but cash-rich investors enter the startup market. The potentially exponential returns on startup funding have undoubtedly brought in liquidity but also a dangerous trend of considering startup investments as a speculation rather than a value addition exercise. Inexperienced “angel investors” that entered this asset class in 2014-15, are now demanding exits from startups and fund managers realizing that the capital markets would have provided better returns and liquidity. Some of these investors are demanding exits in order to compensate their losses due to the demonetization exercise during November 2016. This immaturity and chaos can be avoided by ensuring that only qualified investors participate in such a high-risk asset class. India should take a cue from regulators in the US, Canada, EU, Singapore and other countries which require individuals to be certified as accredited investors before participating as investors in high-risk assets such as startups. For example, according to the SEC, an accredited investor must have a net worth of at least $1,000,000, excluding the value of one’s primary residence, or have income at least $200,000 each year for the last two years (or $300,000 combined income if married) and have the expectation to make the same amount this year. In Singapore, an equivalent requirement is net personal assets exceeding SGD 2 million (or equivalent in foreign currency) or income in preceding 12 months of not less than SGD 300,000. This validation will ensure that only those investors who not only have the appetite but also the ability to withstand failures in high-risk investments are allowed to participate.
There have been some positive signals with regards to angel tax from the government post budget, as the government is looking to provide some exemptions to the startups from the angel tax.
The new government reforms have shown a light at the end of the tunnel for the investors and startups alike. However, there are still more alterations and enhancements which needs to be implemented in the current form and regulations of the angel tax and the new regulations needs to be implemented by the government as soon as possible to enhance angel investment and make the space more secure than before.
Author: Mr. Ashwin Sanzgiri, Vice President, Cross Border Angels