How policy muddle is leaving start-up founders worried

The Commerce Ministry’s Department of Industrial Policy and Promotion (DIPP), which deals with start-ups, came out with a notification last week that was meant to dispel a lot of doubts in the minds of start-up founders and angel investors. On the contrary, say entrepreneurs, it has only complicated matters further and made the whole process more bureaucratic.

Concern over ‘Angel Tax’

As it is, start-up founders were worried over the “Angel Tax” that the Income-Tax Department was going after, asking start-ups that raised money from individual investors – or angel investors, in industry parlance – to pay income-tax on the investment on the grounds that the valuation for raising funds was not correct. About 50 founders came together and highlighted their concerns to the powers that be. The entrepreneurs say they raised the investment on a story or a forward projection sales number and mostly with no assets.

According to Section 56(2)(viib) of the Income-Tax Act, when a closely held company issues shares at a price that is more than the fair market value, the money received in excess of the fair market value will be treated as income from other sources and the company levied tax for that amount.

Quite often, say entrepreneurs, they raise money from angel investors only with an idea and projections of what they hope to achieve. The investors too put in money knowing fully well the risks that their investment face and that nearly nine times out of ten, the idea may fail and that their investment will have to be written off.

When IT assessing officers were asking the start-ups to pay income on the money that was in excess of their fair market value, the group of entrepreneurs started a campaign, including through online channels. The CBDT then clarified that no coercive action would be taken against the start-ups to recover the outstanding amount from the start-ups.

According to entrepreneurs, there were instances of threats from IT officers to freeze the bank accounts of the start-ups. The Angel Tax itself is a legacy of the UPA government in 2012; the rationale being to prevent money laundering by investors who put in money before taking it out at a high premium.

However, the group of entrepreneurs says that the NDA government’s StartUp India programme itself is in danger of getting derailed if these issues are not dealt with it at once. Those involved in the entrepreneur ecosystem, including angel investors and angel network representatives, say that there has been a lot of discussions with Finance Ministry officials and their response has been positive.

DIPP’s clarification

To clarify on various issues and simplify matters, the DIPP came out with a notification on April 11, including defining what was a start-up. The DIPP said a company will be considered a start-up up to seven years from the date of incorporation/registration and for ventures in the biotechnology sector, they will be considered start-ups for 10 years from the date of inception.

The DIPP further said the company will be a start-up if its turnover for any of the financial years has not exceeded ₹25 crore; that the entity is working towards innovation, development or improvement of products or processes or services, or if it is a scalable business model with a high potential of employment generation or wealth creation.

The DIPP notification also said that an investor should have an average returned income of ₹25 lakh or more for the preceding three financial years or have a net worth of ₹2 crore or more as on the last date of the preceding financial year. It also said that an eight-member board consisting of representatives from the DIPP, ministries of Corporate Affairs and Electronics and Information Technology, departments of biotechnology and science and technology, CBDT, RBI and SEBI will approve the investment.

Entrepreneurs are concerned over the red-tape involved if they are to get clearance from the eight-member board for their investments. Till now, they only had to convince their investor about their idea and their business model. For start-ups, say entrepreneurs, speed is of essence in raising money. Now, if they have to convince someone other than an investor, they fear that the whole process may get delayed because of which the venture will collapse.

The entrepreneurs say angel investors know and understand the nature of start-ups. Many of the investors are even prepared to take a more relaxed view on the valuation of the business, for the idea to get validated and the start-up to achieve product-market fit, before they can reap the benefits of their investments.

Angel investments

According to some entrepreneurs, fear over Angel Tax resulted in a sharp fall in angel investments last year. There were only 800 angel deals in the country last year compared with about 71,000 in the US, they say. Of course, they admit, the US is a different ecosystem altogether, but if the Centre’s objective is to foster entrepreneurship, generate employment and achieve wealth creation, then the steps being taken are not conducive for achieving those objectives. Also, the process of the inter-ministerial board (IMB) approval for either the definition of a start-up or for the investment itself will be time-consuming. The board meets once a month and so far has approved around 90 applications as start-ups as defined by the DIPP, of the nearly 3,000 that have been submitted.

According to both entrepreneurs and angel investors, the compliance burden on the start-up founders has gone up tremendously. Most often, they point out, the founder wears several hats. He or she is the CEO, marketing officer, product head, finance person and what not. The founders do not have the money at the stage of their first fund raise to employ a team of professionals to look after various functions. And, the compliance requirements will be one more onerous responsibility they will have to shoulder.

However, they point out that they are on the same page as the government if it wants to curb money laundering or go behind the source of funds. They are prepared to submit all relevant details to the authorities concerned to prove the bona fide of the investors.

The way out, according to both investors and entrepreneurs, is for the government to have a system to certify angel investors, as is done in the US. Venture capital and private equity investors have to get SEBI approval as alternate investment funds for them to invest in companies. Something similar could be thought of in the case of angel investors, say the investors. There is a move within the Indian Private Equity and Venture Capital Association to have a separate vertical for angel investors.

The entrepreneurs have a simple message to the government – don’t burden us with red-tape and compliance issues, simplify rules, and don’t treat all of us as breaking rules.

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