Anomalies that need to be fixed in India’s startup regulations

Anomalies that need to be fixed in India’s startup regulations
  • The government taxes capital gains from unlisted firms at 20%, whereas the same is taxed at 10% for listed firms.
  • Even though the government of India introduced Angel Tax exemption nearly three years ago, conditions around it continue to be tough.
  • Meanwhile, an angel investor needs a networth of at least ₹2 crore before they can start investing formally.
Investors like Tiger Global, Accel and SoftBank turned a startup into a billion dollar enterprise at an average of one every eight days in 2021. Industry insiders argue that the new year could see a lot more money than the $42 billion raised by Indian startups last year, if the government would fix some of the anomalies in taxation, processes and regulations.

A unicorn, in startup parlance, is a company veiled at over a billion dollars. And there were 44 of them in 2021, taking the total tally to 81.

Anomalies that need to be fixed in India’s startup regulations
BI India

The regulatory clamp down on similar segments in China helped the valuations of Indian startups last year. However, India still has a long way to go before its startups and venture capital ecosystem can scale up to the level of China. And, this is where change in rules and regulations can help.

Prime Minister Narendra Modi would be interacting with 150 startups from multiple domains — agriculture, health, enterprise, space and more — today (January 15) at 10:30 am.

Ahead of the upcoming budget 2022 on February 1, Business Insider spoke to a bunch of industry participants to understand what are the fixes they would like to see sooner than later. These are the top takeaways.

“Investors cannot be taxed more for taking higher risk”

The government taxes capital gains from unlisted firms at 20%, whereas the same is taxed at 10% for listed firms. This is too high, says Devender Agrawal of Dexter Capital.

The disparity in the capital gains tax between on investment in listed and unlisted has pushed more angel investors and early-stage investors into the shell.

Sadly, Indian startups — or rather investors’ community — has been recalling this out for the last two years but no action has been taken so far. TV Mohandas Pai, along with a few startup entrepreneurs, had raised the issue before finance minister Niramala Sitharaman two years ago.

“Equity investments in unlisted firms carry higher risk due to lack of liquidity and lack of proper price discovery. Investors cannot be taxed more for taking a higher risk,” Pai was quoted as saying by Economic Times in 2019.

Despite Sitharaman’s assurance there have been no updates in this regard so far.

To get away with Angel Tax one has to give up a lot

Angel tax is an income tax imposed on funds raised by a company from wealthy individuals called the ‘Angels’. The tax of 30% is imposed on the premium paid for the shares of the unlisted company over and above the fair market value (FMV).

In 2019, the government of India decided to offer Angel Tax exemption to companies provided they met a set criteria. But it’s not an easy set of requirements. They define everything from how the startup is valued to how the funds are used, and both founders and investors hope that some of these would be relaxed.

Condition set forward to apply for Angel Tax exemption
Startups cannot invest in land or buildings, shares and securities, capital of other entities, mode of transportation over ₹10 lakh.Seven years from latest fiscal yearNo restricted end-use for assets
No loans or advances should be extending, unless lending is ordinary course of business (Includes advance salary to employees)Seven years from latest fiscal yearLending could be an option.
Paid up capital should not exceed ₹25 crore Up to 10 years from the year of incorporation.The monetary limit could be extended to ₹ 50 crore or ₹75 crore
Startup valuation is determined by net asset value (NAV) method, which is the next value of an entity.N/AValuation should be determined by future earnings through the Discounted Cash Flow (DCF) method.

Over 3,600 startups were considered eligible for the exemption between August 27, 2019, to February 3, 2021. This would be a small fraction of the estimated 60,000 startups in the country.

The restriction on deployment on funds is not just intended for funds raised from Angel investors, but the capital subsequently raised from venture capitalist or venture capital fund. Failure to meet these restrictions would lead to a 200% penalty on such an amount.

“Even though the intent of the government to prevent misuse and abuse of the provisions is understandable, relaxation of certain conditions and bringing the timeline down would go a long way in ensuring that the genuine start-ups are not affected by the regulations,” Divakar Vijayasarathy of DVS Advisors LLP says.

Some leniency can produce more ‘angels’

If there is one thing that is common in the issues raised above, it is the involvement of angel investors. Up until a year ago, very limited individuals were willing to risk their personal assets to be part of a startup that may ‘make it or break it’.

The number of angel investors in India have grown 10X thanks to 2021 and the startup boom.
But there are more who would be willing to join the bandwagon and ignoring them would not be a great idea, Gaurav VK Singhvi of We Founder Circles believes.

However, SEBI may be getting a tad bit too demanding with its angel investors. An Angel investor must have a net tangible asset of at least ₹2 crore, excluding the value of their principal residence. An early stage investment experience, serial entrepreneurship and 10 years of work experience as a senior executive may come in handy too.

The said investor, in case investing through an angel fund, needs to commit ₹25 lakh rupees over a period of three years.

“Now if I [angel investor] wants to invest in four startups of four different funds [Angel Funds], I need to commit ₹25 lakh to each of these funds. I have to commit ₹1 crore to four startups whereas I will be only investing ₹3-5 lakh in each startup.That interchangeability is required,” Singhvi added.

Requirement Demand Why change is needed
Minimum net worth of ₹ 2 croreReduction of networthYoung working professional will not be able to fulfill this requirement
Need to commit ₹25 lakh to an angel fundThe commitment should be reduced to ₹10 lakh and one should be able to commit this amount across angel funds, instead of focusing on oneInvesting ₹25 lakh is capital intensive and it becomes an issue if one has to commit at least ₹25 lakh in multiple funds to grab deals they prefer.

“India has become the third largest ecosystem for startups and will be a key segment to make India a $3 trillion economy. With an enormous amount of capital flowing in Indian startups, the government needs to focus on higher ease of business, for both investors and startups,” Ankur Bansal of Blacksoil says.

The Indian startup ecosystem has finally come of age and it will no longer have a passing mention in India’s union budget, Anil Joshi of early-stage investment firm Unicorn India Ventures tells Business Insider.

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