Why do angel investors prefer Tech start-ups over Non-Tech?

Start-ups (which indirectly fall under MSEs category of taxation) since 2014 have collected around $100 billion and are on the ever-accelerating way to mark its way to $500 billion by 2025, with a projection to create over 35 – 40 lakh jobs. 

It was a beautiful day for Mr. Singh. He had invested in an idea introduced by a bunch of boys who had recently graduated out of an Engineering College. It was something related to irrigation technology with the name “Ivy-Irri Tech”. Mr. Singh had no idea what it was, but his financial advisor and accountant advised him that the investment would garner good profit in a very short period of time. After he found everything to be appropriate, he wrote off a check for Rs 3 crore for 3,000 shares to Ivy-Irri Tech boys. Today, he received the triple of his investment (i.e., Rs 9 crore) as the start-up was brought under the banner of a multinational corporation (MNC).

Mr. Singh was indeed an ‘angel’ who invested in the start-up seeing the growth projection as calculated by the discounted cash flow (DCF) method. He knew and took all the risks on the idea. Like Mr. Singh, there are a number of high-value individuals in our nation who are approached to invest in a small idea, which the ones presenting are able to convince (or show) to be of big worth in a short period of time.

A few days went by and the boys again contacted him over the notice they received from the Income Tax Dept. The notice stated that they had to pay 30% as ‘Angel Tax’ clause of Section 56(2)(vii b) of the Income Tax Act, 1961.

These start-ups operate in a very vulnerable environment and anything can happen any moment. All the money made in the first half of the day may just vanish off by second. The basic principle of start-ups is a low investment to high yield, in less time.

According to Economic Times, “Angel tax is a term used to refer to the income tax payable on capital raised by unlisted companies via the issue of shares where the share price is seen in excess of the fair market value of the shares sold. The excess realisation is treated as income and taxed accordingly.” This is charged when the initial “angel” investor is an Indian, while foreigners are exempted from it as that’d just add more to Foreign Direct Investments (FDI) category. Also, the value of start-ups is counted against the industry suggested method of DCF with the net value present (NVP) method that increases the difference between the projected margins to the excess premium earned.

Hence, now the start-up will have to pay the excess of what they received of initial capital (i.e., Rs 3 crore).  In shares & dividend terms – Mr. Singh bought 3000 @ Rs 10000 each. He sold them (the startup sold it to the MNC) at a premium (excess from Market Value – profit) of Rs 30,000 for each share. Hence, for 3000 shares the excess profit is Rs 6 crore. Now 30% of Rs 6 crore is Rs 1.80 crore and that is what the start-up is charged as “Angel Tax”.

This is a major de-motivation to the hardworking, innovative minds that have worked hard to put up the efforts to bring their dream into happening, just like the “Ivy-Irri Tech” chaps and returned the initial investment in a triple in less than some years, but now are a victim of the ‘Angel Tax’.

However, the income tax regimes in our nation, which are duly unregulated at the helm of dysfunctional bureaucracy and call for immediate reforms at a great extent, do not spare even the ‘angels’. This taxation regime has led to the inclination of angel investors into investing in tech start-ups and deviating from the non-tech cohorts. The falling of start-ups into MSEs category, the very narrow definition of start-ups, and the bureaucracy which looks for an opportunity to put to their advantage, are the reasons for non-tech start-ups being not worth investment against hassles.

Of the limited few exemptions in Angel Tax, the angel investors tend to avoid the non-tech sector as there’s a very obstructive measure which restricts the investment into immovable objects. So if the start-up in non-tech sectors, would involve investment in immovable assets (which is the case in most non-tech start-ups) then the investment would not fall into exemption into start-up’s seed funding and thereby incurring additional taxation.

The ruling Govt. has presented a very ambitious plan to lead India to a $5 trillion economy for which there needs to be a safe growth rate in the economy at 11.3% (also assuming rupee falls to the dollar, further) for the next five years with no exception contrary to the present which is less than 4%. Further, with Moody’s downgrading India to ‘Baa3’ category, just one rank above “junk” category, the onset of FDIs flowing into Indian start-ups seems reclusive and does not seem to recover anytime soon. So, the Income Tax Act, 1961 needs to reform from its very core to match up the economic challenges of the 21st century for Indian investors to keep the market afloat and its operations flared up. Time is money, and neither of that we do have. 

                                                                                                                             – Aanandita Singh

The Plight of the MSMEs

The declaration of the COVID-19 as a global pandemic gave rise to a state of confusion amongst nations. With people foraging for an answer during these uncertain times, Google reported that “since the first week of February, search interest in coronavirus increased by +260% globally.” The pandemic was successful in not only putting a dent in the health-related sectors but also in the economic sphere. McKinsey and Company revealed that the onset of this pandemic made huge ripples around the globe. The effects of these ripples were further built up with the discovery of the situation of several jobs around the globe.  A recent data of the International Labour Organization (ILO) with regards to the impact of COVID-19 pandemic on labour market revealed the ruinous effects it had on workers in the informal economy and on hundreds of millions of enterprises worldwide. The closure of factories and business mostly in MSME sectors was seen.

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MSME

The declaration of COVID-19 as a pandemic in March saw and continues to see a steep surge in unemployment. The sharp drop in work as a result of the outbreak meant that around 1.6 billion workers in the informal economy (approximately 50% of the global workforce) face the danger of levelling of their livelihoods warned the International Labour Organization. “ILO Monitor third edition: COVID-19 and the world of work,” brought to light that the drop in working hours especially in the current quarter of 2020 is expected to be notably worse than anticipated.  “Compared to pre-crisis levels (Q4 2019), 10.5 per cent deterioration is now expected, equivalent to 305 million full-time jobs (assuming a 48-hour working week). The previous estimate was for a 6.7 per cent drop, equivalent to 195 million full-time workers. This is due to the prolongation and extension of lockdown measures,” stated a document issued by the International Labour Organization regarding the crisis.

The disturbance in the economic sphere has led to a damage of billions of informal economy workers (representing the most vulnerable in the labour market), out of which a worldwide total of 2 billion and a global workforce of 3.3 billion suffered massive impairment to their livelihood. The ILO revealed that the initial months of the crisis is estimated to have resulted in a drop of 60% in the income of informal workers globally. Statistics divulged that a drop of 81% in Africa and the Americas, 21.6% in Asia and the Pacific, and 70% in Europe and Central Asia was witnessed. The challenge regarding employment has been especially critical for small businesses. Firms with fewer than 100 employees have been seen to be more vulnerable when compared to 40% of the large private-sector employers.

Moody’s Investor Service claimed the downgrading of Indian economy by estimating 0% growth in FY21. The study laid bare that the fiscal measures introduced by the Government were unlikely to offset lower consumption and slow-moving economic activity. Berstein entertained -7% growth, whereas both Goldman Sachs and Normura forecasted a 5% contraction in the Indian economy. The report further stated that although the direct fiscal impact of the policy reforms 1-2% of GDP, it would provide limited impetus to the furtherance of the economy. A strain in the fiscal deficit would contribute to an increase in future debt in debt-to-GDP term reported Moody’s. Moreover, the Investor Service opined that Indian Government’s extension of ‘working capital loans’ to micro, small, and medium enterprises (MSMEs) will not suffice and shield from the economic shock they are facing now as they were already facing financial strain well before the crisis.

The MSME sector which is among the worst-hit, globally, accounts for 33.4% of India’s output along with a whopping 45% of Indian export. These enterprises, since the day of the announcement of the pandemic, have been facing the possibility of extinction. The MSMEs that rely upon daily transaction to stay afloat have been facing serious problems as a result of thee nationwide lockdown. A survey conducted by All India Manufacturers’ Organisation (AIMO) that covered 5000 MSMEs showed how 71% of the small businesses were unable to pay salaries since March. Moreover, the findings of the survey revealed that more than 40% of the businesses would shut shop sooner or later.  The CII CEOs snap poll disclosed that almost 54% of company heads predicted job losses irrespective of the sector they are in whereas 45% foresee 15-30% layoffs. For instance, one of the most famous auto-manufacturing company, Maruti Suzuki informed that the production in April was ‘zero’. The predicament has been visible across different manufacturing industries, including textiles, chemicals, etc. TransUnion Cibil discussed that there was a risk of 2.3 lakh crores worth loan might become non-performing. Moreover, with the increase in the demand for cash flow, there will emerge issues that are expected to prevail even with relaxations introduced by the government.

To give a shove to the MSMEs and inject life-blood to this sector:

  1. GOI declared a cut in a policy of repo rate by 75 basis points to 4.4%.
  2. More than 3 lakh crore rupees was injected into the system.
  3. Moreover, it allowed a 3-month moratorium on the payment of instalment with regards to existing loans.
  4. Reserve Bank of India (RBI) opened another window of 50,000 rupees for refinancing. Based on this, post receiving this money, banks will be mandated to invest within one month. RBI also reduced liquidity coverage ratio to 80% whilst providing a special financial scheme to All India Financial Institutions (AIFIs) at repo rate.
  5. Emergency credit lines have been created by several banks.
  6. A low-interest rate of 5% has been declared.
  7. Various business continuity measures have been adopted by the RBI.

Nitin Gadkari, Minister for Road Transport & Highways, Minister of Shipping and the Minister of Micro, Small and Medium Enterprises, explained that Government of India has been working tirelessly on policies concerning the MSMEs with focus on entrepreneurship development. The sector that accounts for nearly 30% of the economy of Indian nation needs a robust economic plan so that it can get its engine running once again after COVID-19 ceases to exist. The post-pandemic economic scenario would be one that would introduce capital scarcity to the globe. Nations all around need to conclusively come up with a plan that would be mainly concerned with reviving the MSME sector. A comprehensive system that would get back the MSMEs on track is the need of the hour.

                                                                                                                         

By: Sagarika Mukhopadhyay

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