Angel tax effect: Equity stakes yielding ground to other funding avenues

Convertible debentures & preference shares have emerged as options of choice for new ventures because, apart from deferring valuations, they allow founders to retain a hold over their companies

As angel tax demands and the fear of ceding control to investors roil the start-up ecosystem in India, financial instruments such as Compulsorily Convertible Preference Shares (CCPS) and Compulsorily Convertible Debentures (CCDs) are increasingly becoming the options of choice for fund raising.

These financial instruments not only help start-ups to avoid the incidence of tax by deferring valuation, but also allow the founders to retain greater control over their companies.

"Fund raising through CCPS and CCDs has always been there but after the imposition of angel tax, these instruments have seen wider acceptance, as they help in deferring valuation to a later date," says Navin K Rungta, co-founder of eLagaan, a company that helps start-ups in various kinds of compliance matters.

CCPS is a financial instrument in which preference shares issued to investors are converted to equity shares at the time of maturity. CCD, on the other hand, is a hybrid instrument that typically starts off as debt with regular servicing of interest to the holders, till its conversion to equity shares.

In the recent past, most new age start-ups operating in areas like e-commerce, ride-sharing and hotel aggregation have raised money by issuing such instruments. Hotel aggregator Oyo, for example, raised $100 million in December last year from Singaporean ride-hailing company Grab through the issuance of 2,884 convertible preference shares. In September of 2018 too, the Ritesh Agarwal-founded company had raised $1 billion from Japanese conglomerate SoftBank through issuance of similar instruments. Likewise, e-commerce giant Flipkart had used these routes to raise funds in multiple rounds before Walmart picked up controlling stake with an investment of $16 billion last May.

According to industry experts, both CCD and CCPS have emerged as preferred structuring options, as fund raising process through these instruments is a lot more flexible from the valuation perspective. These instruments also provide cushion to investors against any downside in the valuation of the companies they are investing in.

Let's assume a company has raised Rs 1 crore at an entity level valuation of Rs 10 crore through issuance of CCPS to investor, which will be converted equity shares after three years at a 20 per cent discount. After a few years, the same company raises money at an increased valuation of Rs 20 crore. So, the existing investors will convert their shares at Rs 16 crore valuation (Rs 20 crore less 20 per cent of Rs 20 crore).

From the angel tax perspective, fund raising through CCPS is helpful in several ways. Firstly, while a start-up will find it difficult to justify the initial valuation of Rs 10 crore (when it is just starting out operations) to tax authorities, it is easy to explain Rs 16 crore of valuation after three years because of tangible cash flow and other financial transactions through bills receivable, bills payable, creditors and debtors list among others. In a way, these deferral in valuation by three years (as in the example) helps the start-up to avoid getting angel tax demand notices.

"We have seen that a start-up, after raising money in the angel round, normally get funds from institutional investors subsequently. As valuations of institutional investors (like a VC or PE fund) are acceptable to tax authorities, incidence of angel tax is minimised by raising funds through CCPS," added Rungta of eLagaan.

Similarly, CCPS is also a useful instrument for founders as it enables them to exercise greater control over their companies.

"Through issuance of compulsorily convertible instruments, promoters can retain majority control of equity share capital, while the investors' interests remain protected through contractual provisions," said Archana Tewary, Partner and part of J Sagar Associates' start up practice. "There is a great deal of flexibility in structuring transactions while balancing commercial interests," she added.

According to industry experts, outright dilution of stake by founders through issuance of equity shares can put them in a tight spot, as an investor with majority shareholding may dictate terms through the board.

From the investors’ perspective, CCPS is also beneficial as anti-dilution clauses in these instruments help them in protecting their interest. Suppose, an investor has infused Rs 1 crore in a firm at Rs 10 crore valuation through issuance of CCPS. After a few years, the company's valuation goes down to Rs 6 crore. Then, specific clauses in the CCPS will make sure that the investor is issued higher number of shares in the company taking into account the drop in valuation. This way, any drop in the company valuation will protect the investor's interest by giving higher number of shares.

Similarly, CCDs are also quite useful for start-ups in the fund raising process as they do not have to increase their paid up capital in case of such issuances. Also, they won’t have to pay the stamp duty until the CCDs are converted into shares.

"Given that valuation is a subjective issue wherein a lot of assumptions are taken into account, CCPS and CCDs are the preferred ways of raising money due to their flexibility," said Jayant Jha, cofounder and CEO at Yaantra, an online mobile phone repairing and refurbishing start-up. The company had raised Rs 1.2 crore in an angel round way back in 2014 through issuance of CCPS.