Everybody loves a good scam

In some cases, prevention is not better than cure; it may be better to punish bad actors than prevent both good and bad acts

Recently someone came up with an ingenious way of bribing a politician. It was breathtakingly simple. A family member of a powerful politician formed a new company with no assets, no products and offered no service. Yet, it was somehow valued by an “investor” in thousands of crore of rupees. Based on that inflated valuation, he invested hundreds of crore of cash in this company for worthless equity. At some later date, this investor or a related entity was awarded a large public contract by the politician. At some point, the start-up company went bankrupt and investor “lost” his investment in the company with the promoter skimming off the funds. This led to a chain reaction that may well cripple the technology start-ups.

The Income Tax department woke up to a new mode of scamming. What to do? They swing into action and send notices to private companies whose valuations they deemed too high. Companies defined as having investments made at higher than “fair market value” were asked to pay taxes on the difference as income to corporations. They also passed regulations that required investors to file annual income tax returns that show true market value of shares they hold in a private company. Whether this will prevent future frauds is not clear but the more immediate problem was its chilling effect on start-up activity in India. 

These rules tilted the balance against innovators and entrepreneurs, contrary to the stated policy of enhancing entrepreneurship. Across the globe, start-ups are valued for the future revenue potential and not current income. Making CAs or IT officers responsible for determining fair market value turns the focus to immediate revenue rather than future growth potential. It dampens the enthusiasm of entrepreneurs as it reduces the value of their intellectual capital and hard work and gives a greater share of the company to investors. 

When this problem became apparent, several band-aid measures were proposed. First was to accept a legitimate valuation if made by a venture capital (VC) firm. Why would they be more trusted than individuals? Because it is the Securities and Exchange Board of India that recognises such VC firms. So the IT department is off the hook. Problem solved? Not so fast. As it turns out nine out of 10 start-ups that end up receiving VC investments get there after initial seed investments from angel investors. Angel investors are private individuals who invest their own money and are typically not related to the promoters of the start-up. Angel investors tend to take greater risks and without them, start-ups may well starve. Even giants like Google, Facebook, Flipkart and Ola got their start with seed investments from angel investors.

That unpleasant realisation led to a search for yet another exception; specifically a proposal to exempt investments made by members of an Angel Network Group. This is a proposal made by individuals who are involved in forming and promoting angel networks, not totally without self-interest. However, defining what is an angel network is harder than one imagines. Some angel networks have permanent staff and are run with rigid rules of conduct; others have no staff, virtually no rules of conduct and are rather informal in valuing businesses they invest in. So, now the search is on for even more ingenious solutions to escape the straitjacket imposed by IT department on start-up activity.

Would these solutions really work? Consider for instance a high networth individual (with corrupt intent) who could easily induce a legitimised VC firm to make co-investments with him. All he needs do is to promise to make an investment in the venture fund covering their co-investment in the company he is trying to bribe; or he could simply form his own angel network.

This complex web of regulations is more suited to a nanny state obsessed with preventing a child from falling than a nurturing mother encouraging independence and offering a bandage for scraped knees. Here prevention is not better than the cure; it may be better to punish bad actors rather than prevent both good and bad acts. 

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The author is a serial entrepreneur, former partner in a US-based venture capital fund and a member of India and US-based angel investor networks. Views are personal.