Friction=Waste=Startup Failure

In India currently, the government provides more incentives for investors to invest in shares in Reliance Industries than in a fledgling startup. While successive Governments have made big pronouncements about the value of entrepreneurship and boosting startups with grand schemes like the Fund announced by Narendra Modi in 2014 and the Start up, Stand up program in 2015, relatively little has been done to enable the startup ecosystem on a basic, practical level. Rather than government-backed solutions that focus on investing in startups and the like, what the ecosystem really needs the government to do is to ease the administrative and bureaucratic hurdles that currently plague entrepreneurs. To a large extent, as with a lot of things in India, the entrepreneurial ecosystem that has developed has done so in spite of the State, rather than because of the State. The State would be well to take further steps to reduce hindrances to growth for startups rather than proactively try to mandate things. Startups would be best served if the government reduced its involvement and did away with elements that obstruct startup growth.

Here is my short-list of some laws that currently plague entrepreneurship in India that could be addressed by (relatively simple and thus implementable) policy adjustments:

• Equity Investment into Startups – The requirement to justify fair value to the taxman: Based on a law passed in 2014, if a private company raises money from an individual investor at a price higher than par value, the Company has to prove to the Tax Assessing Officer that the transaction is at a fair price. This is a ridiculous rule that basically that requires and puts the onus on the entrepreneur to justify the seed/angel/VC round capital raise price to the tax authority. I believe the government’s thought process in enacting this rule was to stem the flow of black money into dummy private companies but clearly this seems like a case of throwing the baby out with the bath water. Based on this rule, every Company needs to satisfactorily defend its share price to the assessing officer, and if it doesn’t the amount of capital raised would be automatically considered taxable income in the hands of the Company. So, if you raise 1 crore from angel investors and the AO doesn’t agree with your valuation, the 1 crore would be considered taxable income for the startup and taxed as income with a 30% tax rate.

• Equity Investment into Startups – Long Term Capital Gain rate applies after 3 years rather than 1 year if an investor invests in public equities: For several years now, investments into private company shares had less favorable capital gain treatment compared to public company shares. Investors investing in publicly listed companies enjoyed a 0% tax rate on long-term capital gains, whereas investors in private companies were taxed at 20% on long-term capital gains. But now, based on the changes effected by the Finance Act 2014, private company shares are at an even greater disadvantage relative to public shares. The definition of long-term capital gain has been changed from the earlier level of 12 months to new level of 36 months. An investor has to hold the private company shares for 36 months for it to be classified as long-term whereas his holding in public company shares qualify as long-term after a 12 month holding period. If the intent is to provide impetus to investment in startups and small private companies, this is a counter-intuitive policy. We should be looking at ways of providing incentives for people to invest in small private companies rather than disincentivize them from buying startup shares and nudging them to buy shares in Reliance Industries and Tata Steel instead.

• Loans to startups – basically not allowed: Based on changes made to the Finance Act 2014, no individuals other than directors can extend a loan to a Company. Earlier, directors and their families were permitted to extend loans. Still earlier, even members (shareholders) were allowed to extend loans to a company. This is a significant constraint for a new company. Loans from friends and families may often be the only way for you as an entrepreneur to get a business off the ground. If that avenue is no longer open, your options are much more limited. You are allowed to take a loan from a bank, but the chances of a bank extending a loan to a startup are miniscule.

• Payments to foreigners – painful right now: as a country with capital controls, we have a series of laws that put restrictions on foreign exchange transactions. This also includes laws that define processes around payments to foreigners, whether in Rupees or in foreign currency. While a lot of people are not aware of these laws, they define a process whereby you must make disclosures and get documentation from a chartered accountant prior to making the payment. As an example, if a Company has to make a payment to Facebook for Business which is a foreign company, the Company must first fill a Form on the Tax Department (Form 15CA) website, and then get a Chartered Accountant certificate (Form 15CB) confirming the tax rate applicable. This must be done prior to buying the service. These kinds of rules are an annoyance for big firms but are much more harmful for startups. Unlike big companies, small companies do not have the bandwidth or the knowhow to deal with this kind of issue. They probably don’t have a team of chartered accountants and company secretaries to guide them through FEMA regulations. The reality is they will either ignore the rules and thus risk prosecution, or they will try to educate themselves and abide by the rules which will cost time and money. Speed is the essence of a startup, and impediments to speed such as this, are very detrimental to startup success.

While I am sure most countries have laws that could hinder the speed with which startups can access capital and operate, I think that the problem in India is that these structural constraints incentivize capital to flow to areas other than startups, limit the financing options available to startups and generally reduce the speed and bandwidth within a startup. Getting a startup off the ground is incredibly hard as it is. More hurdles that serve to reduce the probability of startup success, only make things harder. While currently the easy money environment across the globe coupled with the hype surrounding Indian startups has provided a window of opportunity for many startups to set up and get funded, my fear is that the difficult operating environment will result in sub-standard performance and investment returns and could sour the picture when people start expecting a return on their capital. In an environment where there is an abundance of private investment capital looking for returns, the government would be better served focusing on creating an atmosphere conducive to startup/business success rather than trying to directly invest or bolster early-stage venture funds.

Hopefully, the Indian government will look to remove some of these structural impediments to startup growth, along with announcing the splashy big-ticket entrepreneurial initiatives that they have been. A combination of these efforts could truly create a robust startup ecosystem and allow entrepreneurs to achieve their full potential.

Aman Chowdhury

September 2015