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This article is more than 2 year old.

Catch 22: The annoying funding conundrum that most startup founders face these days in India

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So, we’ve been trying to raise funds for our kicking off our startup. The last two months have been a revelation in how convoluted rules and regulations come together to create an incredible Catch-22 situation in raising funds.

Catch 22: The annoying funding conundrum that most startup founders face these days in India
So, we’ve been trying to raise funds for our kicking off our startup. The last two months have been a revelation in how convoluted rules and regulations come together to create an incredible Catch-22 situation in raising funds. Let me explain.
The Business Context
We are raising funds from our family and friends, some of whom are residing in India and some abroad. Some of them can afford cheques above Rs 25 lakh, while most of them can’t. Since anyone below Rs 25 lakh does not qualify as an angel investor, we are raising funds under the “private placement” process.
Actor 1: The Taxman
Section 56(2)(viib) of the Income-tax Act, 1961 — (in)famously known as the Angel Tax Act, but applicable to any individual (non-VC) investments — allows startups to raise money from investors BELOW the “fair market value” as determined by a merchant banker. If such money is raised, it is treated as income and taxed accordingly.
So, if we have to raise investments, we should:
  • Get a merchant banker valuation report that defines our startup’s valuation (say, a valuation of Rs. X crore)
  • Raise investments at a value below this valuation (ie. at a valuation less than Rs X crore).
  • I know you are saying the angel tax exemption will help, but it really doesn’t. I’ll come to that a little later. Hang on.
    Actor 2: The FEMA Fatale
    The FEMA Act — specifically Regulation 11 of the Foreign Exchange Management Act 20(R) — allows startups to raise money from investors abroad at a value ABOVE the “fair market value” as determined by a registered valuer.
    So, if we have to raise investments from abroad, you should:
    • Get a registered valuer valuation report that defines your startup’s valuation (say, a valuation of Rs Y crore)
    • Raise foreign direct investments at a value above this valuation (ie. at a valuation higher than Rs Y crore)
    • Who is a registered valuer, you ask? He is the new kid on the block, and has come into existence only since January 31, 2019. Here’s the lowdown.
      The Catch-22: Income Tax or FEMA? 
      Now, we are raising investments from both within India and abroad. So we need both the above actors to be satisfied. And here’s the catch — since it is the same round, we will have to get valuations from two different entities (merchant banker and registered valuer) and they have to be almost the same. Then, we will have to convince our investors to invest at that EXACT valuation.
      Scenario 1 (X > Y): Best-case scenario! We have to issue shares at a value below X, but above Y. That keeps both the taxman and FEMA happy.
      Scenario 2 (X < Y): Worst-case scenario! We are truly screwed. If we issue shares below X (the taxman is happy), we go to jail (FEMA kills us). If we issue shares above Y (FEMA is cool), we lose investor money as income tax (the taxman screws me over).
      Scene One Take Three
      It has been a fun time over the past two months, finding a registered valuer (they are in short supply because it is such a new concept), talking to the merchant banker and convincing our investors, all the while hoping that the sandwich falls on the non-buttered side. Given Murphy’s Law, that event is highly unlikely to happen.
      Curtains
      Meanwhile, time passes. The fledgeling startup is still waiting to launch. Employees have been identified, but hiring is on hold. Investors have committed, but are getting antsy and can’t wait forever. We missed the start of the year, so we have pushed it to a mid-year launch. And now, that is starting to seem too close.
      All this time, the only people who are earning their keep are the Company Secretaries, Chartered Accountants and Corporate Lawyers.
      And we continue to bleed. Death by halaal.
      Talk about the Ease of Doing Business.
      PS — Angel Tax Exemption: The Devil is in the Details
      Yes, the government announced the Angel Tax exemption and everyone cheered and went their own merry ways. But it seems the exemption doesn’t work for most startups, after all, it just sets them up for a harder fall afterwards. Here’s why:
      Startups cannot use the money raised to invest in securities or other such financial instruments. Which means the standard practice of parking surplus capital in liquid funds doesn’t work anymore. We will have to rely on FDs or government bonds which offer much lower interest rates and lock up the capital for a period, making it illiquid.
      Startups cannot make capital contributions to any other entities. This means we can’t setup and invest money into subsidiaries for business expansion like Flipkart did in E-Kart and WS Retail. We can’t make strategic investments or acquire other companies like Ola did with FoodPanda and Vogo.
      And if we do any of the above and become ineligible for the exemption, the Taxman can look back as far as 7 years and apply the rules retrospectively. When the startup is in the growth phase and getting “noticed”, we will get slapped with an Income Tax notice, and spend our time and effort responding to them instead of focusing on the business.
      Ease of doing business indeed!
       
      Ganesh Balakrishnan is an entrepreneur currently building a consumer brand in the footwear space. He founded two startups earlier – Momoe (mobile payments) and Windsleeve (retail tech).
      Startup Stories is a series of accounts by startup entrepreneurs on how they built their businesses and found success. Read them here.
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