Angels in India

Budget might have far-reaching effects on start-ups

The proposed budgetary changes in the treatment of angel investors are, on the whole, positive for this segment of the investment industry. But more could and should have been done in order to promote and encourage early-stage entrepreneurship. By proposing that pooled angel investments be regulated as Category 1 Alternative Investment Funds (AIFs), the Budget brings them under the purview of the market regulator. Category 1 AIFs can have a maximum of 1,000 members, and each member must contribute a minimum of Rs 1 crore. They receive advantages in tax treatment in comparison to individual angels, and to Category 2 and 3 AIFs. Category 1 funds may offset profits against losses on failed investments; and returns are also "pass-through" - that is, the pool itself doesn't pay taxes on money repatriated to members. Members may have considerably reduced tax liabilities, especially if resident in low-tax regimes like Mauritius or Singapore, which have double-taxation treaties with India. A third break is that Category 1 funds aren't liable under Section 56 of the Income Tax Act, wherein angel investments are liable to be taxed as income in the hands of the start-up receiving the capital, unless the assessing IT officers consider the assigned equity valuations "reasonable". All start-up valuations are notional and hinge on optimistic projections. So, Section 56 and the discretionary authority given to the IT department effectively put up a roadblock that dissuades angel investments.

The proposal for easier listing of small and medium enterprises on SME exchanges without undergoing the tedious processes and higher compliance thresholds of initial public offers will also make exiting investment easier for angels. This definitely makes early-stage investing more attractive. Another potentially interesting outcome may arise if the changes simplify investment flows into sectors with restrictive foreign direct investment (FDI) limits. A multi-brand retailer, such as Flipkart, must now set up a complex structure to access overseas capital. Under the new provisions, it may be possible for an angel based outside India to invest beyond stipulated FDI limits in a restricted sector, through the medium of an angel pool. However, this back door may eventually be plugged in the fine print. The concept of pools in any case reverses normal practice. Most angels are individuals doing their own due diligence. They often invest much less than Rs 1 crore (the minimum pool threshold). By denying the same tax breaks to individuals, or Category 2 and Category 3 AIFs, the Budget is asking angels to operate collectively and make bigger-ticket investments. It remains to be seen if this is too cumbersome and unrealistic. The Budget could have offered more liberal provisions that created a more even playing field for individuals and Category 2 and Category 3 funds. That would have given smaller start-ups better access to capital at the very initial stages.

The legal and tax differences in the definition and regulation of venture capital vis-à-vis angel investments are, in many senses, artificial. Both focus on early-stage entrepreneurship and accept high risks in the hopes of higher returns. "Angels", a description borrowed from the theatre, typically provide small amounts of initial capital to start-ups, while venture capitalists enter later in the cycle. By raising minimum investment thresholds and offering preferential treatment to pools, the Budget may induce angels to behave more like venture capitalists. This doesn't improve access to capital for the very small start-up.