May 31, 2023

Anyone familiar with the startup scene knows that money is very hard to come by for most projects. What seems exciting and innovative to the entrepreneur peddling the idea might not seem so to the person or fund putting his/her or its money in the project. It takes a lot of determination, an excellent idea and an airtight business plan to bring angel investors on board. Now, if after climbing all these mountains one has to contend with Section 56(2) of the IT Act, then innovation is sure to die a fast death in India. Startups often need funds from the seed stage itself. At that point of time, no venture fund will invest in them. It is angel investors who come to the rescue and prevent innovation from biting the dust. They are a breed of new age risk takers who invest in a company bringing out what they consider to be an innovative product that might be successful in future. Obviously, there is an equal chance of failure and more angel investors have lost money than made a killing. If these angel investors are willing to value a company at a high price, it means they feel that the product is going to succeed. Hence, the innovator deserves to use that extra money without having to pay any tax.

In any case, how does one calculate the fair market value of the shares of an innovative enterprise that has no peers? Yet, the section under contention says that any amount received in excess of the fair market value of the shares will be taxed at 30%. This is a highly discretionary provision which leaves scope for mischief on part of the assessing officers. Since the product is innovative, the valuation of the company or its shares solely depends on the assessment of the risk taker, viz. the angel investor. Any entrepreneur who brings in innovation on the table would always expect to get a value that is much higher than cold figures calculated through accounting principles. Since at that stage the company has no tangible assets or income, any valuation of the company must necessarily be on expected future income and cash flows. In case of innovation, future earnings must be factored in while valuing the company as investors can make a killing if the product clicks beyond current valuation. Hence, the current valuation cannot be made in conservative way. At best, the IT Act (and SEBI can simultaneously issue necessary notifications) can insert a clause which bars the company from taking the angel valuation as the standard for issuing shares at a huge premium in its IPO.

This is something tax officers and other bureaucrats can never understand. They always find something fishy in any valuation that is in excess of what accounting principles demand. Their view is that why should someone pay so much more for the shares of a company peddling an untried product. This has to change if the Prime Minister has any pretensions of making a success of his grandiose plans of Digital India and StartUp India. Innovative entrepreneurs and their angel backers must be spared the unnecessary tax burden for taking risks. Section 56(2) has to be suitably modified if entrepreneurs with an innovative bent of mind and their angel investors are to take risks which others cannot. Otherwise, the Indian startup scene will lose its buzz.

Carlos Eduardo Espinal summed up the valuation angle thus: “The biggest determinant of your startup’s value are the market forces of the industry & sector in which it plays, which include the balance (or imbalance) between demand and supply of money, the recency and size of recent exits, the willingness for an investor to pay a premium to get into a deal, and the level of desperation of the entrepreneur looking for money.” If one may add, there are many innovative tech products that come out of the blue, have no specific sector and are considered very useful by both innovators and angels. They do not fall even in Espinal's summary. If it is as complicated as this and if the angel investor will always try to keep valuation down to keep his risk low, any amount that an innovator gets should not, and must not, be taxed on the pretext of it being above fair market value.