There's a famous Aesop fable about a farmer with a hen laying a golden egg daily. Driven by greed to get all the eggs in the fowl's belly, he killed the animal, only to be left with squat.
Things are playing out in a similar vein in India's start-up sector.
Last week, the Income Tax (IT) department notified the latest angel tax rules, laying out the procedure to evaluate the shares issued by unlisted start-ups to investors. As per these rules, if non-resident investors received consideration for the issue of shares by an unlisted start-up that exceeded the Fair Market Value (FMV) of the shares, then it would be taxable as income from other sources.
The angel tax on start-ups has been under discussion for almost four years as many industry stakeholders voiced their concerns that it would completely shut off the funding tap, which has trickled down in recent months.
One of the biggest contentions with the new rules to tax start-ups is determining the fair value. Some argue that it is just not about the numbers. With fears of more paperwork and compliance burden on start-ups, questions have been raised about whether the move is the right one for the ecosystem amidst a funding winter.
A True Reflection?
To bring clarity and transparency, the tax department has announced the various applicable methodologies for calculating the FMV in each case. Professionals like merchant bankers and chartered accountants (CAs) will determine this FMV, considering a start-up's growth prospects.
However, this mechanism may only partially mirror a company's true potential due to the inherent uncertainties in the start-up landscape. This is because start-ups are subject to rapid changes influenced by market dynamics, competition, and regulatory shifts.
Vittal Ramakrishna, founder and CEO of POD World, a fundraising platform, notes that determining a start-up's FMV is not just about the numbers. "It also involves understanding the market, potential target customers, future projections, intellectual property (if applicable), and revenue. So, it's a more comprehensive assessment rather than solely relying on numbers," he says.
The flexibility introduced in the valuation methods for unlisted shares is designed to prevent start-ups from getting entangled in the angel tax web, aiming to facilitate smoother investments. However, like any policy, the effectiveness of these changes will only be proven with time and implementation.
Ashish Bhatia, founder and managing director of India Accelerator, states that these valuations involve negotiations between founders and investors, introducing subjectivity. Founders may seek higher valuations, while investors prefer lower ones for reduced risk.
"FMV determination is essential but not an exact science. It offers a reasonable estimate but may not capture the full scope of a start-up's potential," he explains, adding, “Stakeholders should consider multiple factors, conduct due diligence, and maintain transparent discussions during the valuation process for a more comprehensive understanding."
Noting that this angel tax has been a persistent concern, Dr Sunil Shekhawat, CEO of SanchiConnect, feels it could complicate the already intricate investment process for many. While FMV has emerged as a major concern, the new rules are expected to bring clarity to some longstanding issues raised by start-ups. "The recent amendments to the angel tax rules by the Central Board of Direct Taxes (CBDT) are, therefore, noteworthy," he stated.
Resolving Longstanding Issues
The attempt to level the playing field for both resident and non-resident investors is evident in the new rules. The new valuation method for Compulsorily Convertible Preference Shares (CCPS) and a buffer for valuation discrepancies is expected to address some longstanding concerns in the start-up community.
Shekhawat concedes that the recent amendments to the angel tax rules by the Central Board of Direct Taxes (CBDT), with the redefined Rule 11UA, bring some clarity to the valuation of unlisted shares and the ensuing calculation of angel tax.
"Introducing terms like 'balance-sheet' and 'restated balance-sheet' might seem like minor tweaks, but they are crucial for easing the compliance burden on start-ups and investors," he opines.
In short, it is a step in the right direction because many investors directly invest in unlisted shares with start-up founders through networks, platforms, and even friends and family. The new law strengthens the shining start-up ecosystem by providing more liberty to resident and non-resident investors, hopefully resulting in increased global investment in the domestic market.
Moreover, the increase in the valuation methods, including five more options, provides enhanced flexibility, which could help start-ups attract global investment and sustain growth. According to Bhatia, introducing a 10 per cent variation in value demonstrates a prudent approach, allowing for minor fluctuations and ensuring a more accommodating and stable investment environment.
Who Will Watch The Watchguards?
History has proven, repeatedly that no system or methodology is foolproof. Valuation, a subjective aspect of the start-up world, is often based on many factors that aren't always clear-cut. This is especially true in the case of new entities focusing on new-age technologies, wherein accurate matching comparisons or estimates of future cash flows may not be easy.
For instance, in some cases, a company might be undervalued to increase shareholding for strategic or investment purposes. Overvaluation doesn't occur as frequently as undervaluation.
While the provision of a 10 per cent safe harbour clause could partly take care of this issue, Bhatia yields that the method of determining the FMV of start-up shares involving valuers and tax authorities can be subjective and susceptible to manipulation.
"Assumptions and projections about future growth, market conditions, and more can vary among valuers due to biases and interests, leading to subjectivity. Start-ups' limited historical financial data makes traditional valuation methods challenging to apply accurately, relying on estimates and leaving room for interpretation," he states.
Similarly, negotiations in the valuation process introduce subjectivity; founders seek higher valuations for ownership preservation, while investors aim lower to mitigate risk. Valuations can be manipulated for tax purposes, affecting tax liabilities and revenue.
And then there could exist regulatory ambiguities, unclear guidelines, and limited industry oversight, which create opportunities for manipulation by valuers or tax authorities.
To address these concerns, transparency, clear regulations, robust oversight, and ethical responsibility among all involved parties are crucial. A well-documented and comprehensive evaluation process is essential in the start-up ecosystem to foster fairness and trust among stakeholders.
Burdened With Compliance
The requirement for founders to obtain a certified FMV report from a valuer and submit it to the tax department can increase the compliance burden and cost for start-ups, potentially leading to uncertainty and delays in closing deals.
Firstly, the costs associated with hiring professional valuers for FMV determination can be substantial, posing a challenge for start-ups that often operate on limited budgets. Secondly, the valuation process itself introduces time delays, as it involves gathering financial data, due diligence, and report preparation, which can be especially problematic when start-ups urgently need access to capital.
Ramakrishna claims compliance can be either the best friend or the worst foe for a start-up. As they grow, start-ups must adhere to certain early-stage requirements. While it might feel burdensome when raising small amounts of funds initially, it can also better prepare the start-up for subsequent funding rounds.
"Agreed that there will be additional costs for start-ups, and they must plan accordingly. Typically, fundraising takes around three to four months to close a round. With the valuation certificate, this period may be extended by another month. However, it's important to note that a valuation certificate from a merchant banker is already mandatory for compliance filings even today," he says.
Furthermore, the FMV report's influence on negotiations between founders and investors can lead to protracted discussions if the valuation figure doesn't meet expectations. Delays in obtaining the report also introduce uncertainty into transactions, making it difficult for start-ups to plan their financial needs or for investors to commit to deals.
Jyoti Prakash Gadia, managing director at Resurgent India, says that lengthy and expensive litigation can deter investments. Of course, the ability and willingness of each potential foreign investor will vary on a case-to-case basis, taking into account both the financial aspects and the expertise and network they offer in a particular field.
"Therefore, the tax authority will need to be pragmatic and work in professional and transparent mechanism to avoid any undue litigations," Gadia suggests.
Compliance complexity and the associated administrative tasks can divert founders and key team members from strategic operations. To address these issues, careful resource allocation, engagement with experienced professionals, and streamlined regulatory procedures are crucial to balance transparency and compliance, fostering a thriving entrepreneurial ecosystem.