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Startups

Startup Tax: Tax Dept Tells You How To Value Your Startup

We know now that the new amendment in the budget will attempt to tax angel investors that want to buy into a company at a “premium” valuation, a concept rife in the startup world.

The “Startup Tax” article has generated some excellent responses. Among them is Rajesh’s reply which I’d like to highlight in a separate post: Rajesh says:

You can always prove the FMV and we will hopefully know it in the fineprints. There is however an existing notification (NOTIFICATION NO 23/2010, Dated: April 8, 2010) for valuing unquoted shares and securities. You may find the details of this notification here – http://www.caclubindia.com/forum/notification-for-determination-of-fmv-u-s56-78062.asp.

If you check the last clause(c) for valuing unquoted shares and securities, the FMV of unquoted shares and securities, other than equity shares in a company which are not listed in any recognized stock exchange, can also be estimated to be the price it would fetch if sold in the open market on the valuation date and the assessee may obtain a report from a merchant banker or an accountant in respect of such valuation..

Thus, all that you as a startup might have to do is get the valuation done by an accountant or merchant banker and give a report to the tax man.

And it is reasonable for the tax man to require the startup to get a valuation report from a qualified person.

If I was the valuer, I might do this. Estimate the earnings (E) for the following years, determine the PE of listed companies in the same industry as the startup and apply such PE (avg. or the lower PE) to arrive at the FMV or market price (P) of an equity share in the startup.

I think this is good feedback, about a way to work around the valuation rule.

My reply:

Rajesh, at the seed level, you can’t estimate any earnings accurately. You can only take a wild guess. In fact, most seed level valuations happen with no income in sight for the next one or two years. There is no P/E if there is no earnings (profits). Merchant bankers have found it very difficult to value such companies anyhow, but let’s

Secondly, that’s not what the clause says, I just read it carefully:
…the fair market value of unquoted shares and securities other than equity shares in a company which are not listed in any recognized stock exchange can also be estimated to be the price it would fetch if sold in the open market on the valuation date and the assessee may obtain a report from a merchant banker or an accountant in respect of such valuation..

What I have marked in bold above means that this clause does not apply to unlisted equity shares. You could apply it to unlisted preference shares, stock options (which are securities), RSUs, or other such shares.

The equity share valuation is above in the link you specified.

the fair market value of unquoted equity shares shall be the value, on the valuation date, of such unquoted equity shares as determined in the following manner namely:-

The fair market value of unquoted equity shares = (A-L) * (PV)
(PE)

Where, A= Book value of the assets in Balance Sheet as reduced by any amount paid as advance tax under the Income-tax Act and any amount shown in the balance sheet including the debit balance of the profit and loss account or the profit and loss appropriation account which does not represent the value of any asset.

L= Book value of liabilities shown in the Balance Sheet but not including the following amounts:-

(i) the paid-up capital in respect of equity shares;

(ii) the amount set apart for payment of dividends on preference shares and equity shares where such dividends have not been declared before the date of transfer at a general body meeting of the company;

(iii) reserves, by whatever name called, other than those set apart towards depreciation;

(iv) credit balance of the profit and loss account;

(v) any amount representing provision for taxation, other than amount paid as advance tax under the Income-tax Act, to the extent of the excess over the tax payable with reference to the book profits in accordance with the law applicable thereto;

(vi) any amount representing provisions made for meeting liabilities, other than ascertained liabilities;

(vii) any amount representing contingent liabilities other than arrears of dividends payable in respect of cumulative preference shares.

PE = Total amount of paid up equity share capital as shown in Balance Sheet.

PV = the paid up value of such equity shares.

This kind of valuation metric is horrendously inadequate for a seed or angel level funding (there won’t be any profit, or reserve, or much paid up capital!)

If you say then that the company shouldn’t be valued so much, then I will tell you that is bunkum. The whole of Silicon Valley has been built on this principle, that you let founders go build companies and give them money, and leave them enough equity to make their effort worthwhile.

Finally, the point is this: It’s stupid to do this law for multiple reasons. First, there are WAY too many startups with investments from friends, family or angels. In comparison with the “black money” funded startups, these regular startups are probably 1000:1 (even going by the number of cases that have been raised for scrutiny) So all this does is cause hardship to more people for the sake of catching a few. Gassing room for mosquito.

Next, The folks that have black money can easily route their money abroad and have a foreign entity invest back into the Indian company – in that case, this stupid valuation metric etc. is NOT EVEN REQUIRED! (it only applies if your investor is an Indian resident).

Plus, the section 68 change [I will elaborate] already requires a company to have a record of where the investor got his money from – that is onerous but more understandable as a law. So effectively, this Section 56 clause (the one that needs valuation) does not prevent ANY money laundering, except by stupid people who can be caught using Section 68 anyhow.

All it does is create enormous power in the hands of an IT Assessing officer to harass legitimate startups. Such discretionary powers are the root of corruption, and we must avoid creating such ambiguous laws completely. What would be best is to remove this law completely, by understanding that valuation is not something IT officers will ever understand, and therefore there is no incidence of tax when a company is invested into. This is the law all over the world, and it exists for a very good reason: common sense.

[Correct me if I’m wrong please…]