Is angel tax becoming a lost cause due to over-obsession with valuation?

The tax was implemented in 2012 to curb the flow of black money into private enterprise. That mission seems to have given way to the mathematical zeal of the tax man

As the ‘angel tax’ continues to roil the start-up ecosystem with the tax authorities serving demand notices on new ventures, methods used for the valuation of an enterprise seeking to raise funds are coming to the fore in the ongoing controversy.

Lawmakers has passed the angel tax regulations back in 2012 with an intention to curb the flow of black money into private enterprise. The mandate was to check attempts to launder money by using the fund infusion route to convert black money into white. However, industry watchers are of the opinion that current focus is far removed from the mandated objective and focuses rather heavily on the valuation part.

"The main focus today is on valuation, and not on the original intent of this law, which was to find out whether the source of money is clean or not," says Navin K Rungta, co-founder of eLagaan, a company that helps start-ups in various kinds of compliance matters, including fund raising. Having worked with companies like Oyo and Urban Ladder during their early days, Rungta is of the view that start-up valuation will always have a tinge of subjectivity in the absence of defined standards in the Indian context.

Though various accounting standards have been prescribed by the Institute of Chartered Accountants of India (ICAI) for valuation purposes, their applicability to start-ups is very limited. For example, Accounting Standard-2 (AS-2) is applicable to valuation of stocks or inventories. But for a start-up that has just begun operations and is pitching for raising funds, AS-2 provisions become irrelevant. Similarly, AS-3, which relates to cash flow, may not be applicable to a start-up, especially if it in early stage.

Not only accounting standards, even established valuation methods such as discounted cash flow, comparative value or net asset value (NAV) have limited scope in start-up valuation. "There are no prescribed methods of valuation from ICAI or from the regulator regarding valuing a start-up. Regulators expect us to use net asset value (NAV) or discounted cash flow (DCF) methods, but none of these are practically useful for valuing start-ups," says Ashish Fafadia, partner at venture capital firm, Blume Ventures.

So, in the absence of any set norms for valuing a company, existing methods rely on parameters such as market size of a particular product or service, and reputation of founders during the fund raising process.

"Credential of the founders, the value they bring on to the table in terms of experience, knowledge, skillsets and the team working with them are some of the factors considered during valuation," adds Fafadia. Similarly, the target market, market size of the segment in which the start-up functions and the rate of adoption based on the intensity of the problem the company is trying to solve are also taken into account during fund raising activity.

Industry watchers also say that within the same industry, start-ups are valued differently depending on the quantum of money being raised. For instance, a start-up trying to raise money in an angel round against a star founder or pitching to raise funds for his/her second or third start-ups, will be valued differently. Similarly, a founder with relevant experience in the market place along with excellent academic credentials will be able to garner more value for his start-up than others.      

Given the parameters that are taken into account for valuing a start-up, subjectivity will invariably creep in. "It's like a marketplace in which the decision making lies between the buyer and the seller. If an investor sees value in a start-up and is ready to pay a premium, then it should not be questioned," says a founder of Bengaluru-based start-up.

Even industry watchers are of the opinion that questioning the projections of a start-up by the tax department after close to three years of fund raising is impractical. "If a company is raising money today, then the valuation is done considering the current business environment. But the tax notices are being served 3-4 years after the funding round. So, it is very easy to question the projections that had been done four years back," Rungta of eLagaan says.

With the tax department and start-ups continuing to differ in their approaches at arriving at a fair value for a young enterprise, ‘angel tax’ seems to have lost its original intent of curbing black money and may soon enter the club of infamy as another case of abuse of discretionary powers by tax authorities.