Why funds don’t flow for startups in India
There are issues that need addressing if the sector is to fully mine its potential – particularly with regard to regulation and funding from domestic investors.
Despite the continuing Covid-19 pandemic, 2021 was a banner year for India’s startup ecosystem. A record 42 startups earned the coveted unicorn label and around $42 billion was invested in privately-held companies, an increase of over 200% from 2020 ($11 billion).
That took overall funding for the sector past the $100-billion mark as well.
India now has over 61,400 startups, making it the third-largest start-up ecosystem in the world. The sector has created over $350 billion in value and employs over 1.5 million people. India also celebrated its first-ever National Start-Up Day on January 16, 2022.
In short, the sector is trending in the right direction.
Yet, there are issues that need addressing if the sector is to fully mine its potential – particularly with regard to regulation and funding from domestic investors.
The ‘Angel Tax’ problem
The vast majority of funding for Indian startups still comes from overseas. As Mohandas Pai, the Chairman of 3one4 Capital, pointed out in an opinion piece in The Financial Express a few months back, this is in stark contrast to the United States and China – the only two start-up ecosystems larger than India’s.
The US invests over $100 billion annually in venture capital and startups, while over 60% of China’s startup capital comes from domestic sources.
One of the biggest obstacles is the so-called Angel Tax. This is a tax of 30.9% levied on any domestic investment in a startup that exceeds the “fair market value” of the company.
Say if a company raises, say Rs 100 crore by issuing shares, but the tax department decides the fair market value of those shares is Rs 70 crore, then the company has to pay Rs 9.27 crore in tax on the balance of Rs 30 crore.
The main problem here is the way “fair market” value is calculated. The tax department bases its calculations on the net assets of the company, but this does not take into account future revenue projections and growth prospects. The tax is also not levied on foreign investments.
Therefore, it penalises a domestic investor for valuing a company at a higher rate while simultaneously reducing the amount of money available to the company to invest in its business.
Admittedly, the government has created an exemption to the tax for companies that meet certain criteria, but in practice, the exemptions are limited. Only startups with a paid-up capital of Rs 25 crore or less are eligible.
Between August 27, 2019, and February 3, 2021, around 3,600 startups were eligible for the exemption – a small fraction of the overall number.
There are also stipulations on how the investment can be used, which constrain startups from deciding the best use of those funds.
Reducing the Angel Tax from 30.9%, consensus on using the Discounted Cash Flow method to value a startup and relaxing some of the stipulations (e.g., raising the paid-up capital limited to Rs 50 crore), would all benefit the sector.
Capital Gains Tax is inconsistent
In addition to the Angel Tax, capital gains tax on unlisted firms is levied at 20% compared to 10% on listed firms.
This discourages early-stage investors.
“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 told the Economic Times a couple of years ago.
Opening up funding sources
By and large, policymakers in India have erred on the side of caution, given India’s conservatism and comparatively lower appetite for risk and disruption. In practical terms, this means that potentially large domestic funding sources are off-limits to startups.
Examples of this are pension and insurance funds.
In the United States, pension and insurance funds routinely provide venture capital investment. However, in India, insurance companies can only invest in a “fund of funds”, which, in turn, makes investments in Alternative Investment Funds (AIF).
While this is obviously welcome, allowing pension and insurance companies to invest directly in AIFs would increase the pool of domestic capital available to startups in India.
Providing certainty when it comes to rules and regulations makes it easier for businesses to make decisions. When it comes to technology and the startup sector, it can sometimes seem like the rules are being crafted on the fly.
As an article in Inc42 details, one area where there is currently regulatory confusion is cryptocurrency. The government’s intentions remain cloudy even while money is being invested in the sector.
The article also points out that the sector is waiting for The Data Protection Bill, which would give it a clear idea of how to manage the data they collect from their customers or users.
Other areas where regulatory clarity would be welcome are EdTech, as well as CleanTech, which addresses climate change and other environmental issues.
Finally, the Competition Commission of India (CCI) is investigating Google Play and the Apple App Store for requiring app developers to use only their payment gateways, for which they charge a 15-30% commission.
Democratizing in-app payment gateways and breaking the duopoly of Google and Apple would be another welcome step towards making India a startup powerhouse.