The changing startup ecosystem in India

New angel tax and implications for foreign investors

This blog aims to look at the startup ecosystem in India from a holistic approach and from the lens of foreign investors looking at investing in the country. It answers questions such as – Why is India an attractive market for startups? What are the possible economic reforms in the country that could impact the startup ecosystem in terms of interest rates and taxes? And, how can investors (Indians and foreigners) get access to deal flow in India?

The Indian startup ecosystem

India is one of the fastest-growing economies. It has seen various spurts in funding activity – from 2008 to 2009, 2014 to 2015, and a digitisation-led spike caused by the pandemic and low dollar interest rates from 2020 to 2021 [1]. Although there has been a significant fall in the quantum of funding in India since 2022 (The ‘funding winter’), there has still been a continuity in the funding of early-stage startups. VC funds in India have generously increased their average ticket sizes in early-stage startups, as can be seen in Figure 1 below:

Figure 1

In 2022, the most funded sector in India was enterprise-tech, with 22.43% of the total number of deals and $444mn in the sector alone. This was followed by Fintech.

The charts below show the sectors by amount invested in 2022 and the number of deals in the sector in 2022.

Figure 2

While the rate of seed funding growth in India decreased in 2022, it had still peaked in terms of the number of deals completed in any given year since 2014, when there were only 103 deals, compared to 758 in 2022.

So what is it that has led to this significant growth in seed funding? The main answer is simple – technology! The popularization of sectors such as ConsumerTech, FemTech, FinTech, AgriTech, CleanTech, TransportTech, TravelTech, and others, along with the marriage of these sectors, has created some unique companies that have proliferated!

Another factor that has led to the rise of early-stage funding is the failure of some significant IPOs, in terms of exorbitant valuations. Seed stage entrepreneurs saw these failures in the IPOs and the overvaluations, and as a result, their hubris became subdued. Their Icarus wings melted and they came back to what seemed to be reasonable valuations. Hence, the expectations at seed stage became dampened, where previously the valuations had started skyrocketing for no reason. Paradoxically, smart investors found these more modest and credible startup opportunities more lucrative.

According to Inc42, 2023 will be the year of DroneTech and EV in India. The government is also highly subsidizing the consumption of electric vehicles in the country.

According to Nasscom-Zinnov [2], India is to have 200 unicorns by 2025. The Indian startup ecosystem alone will account for 37,000 tech startups and around 180-200 unicorns with a cumulative valuation of USD 600-700 billion.

However, what is interesting, is that in FY22-23, only 6 of the 51 non-listed unicorns in India that have filed results this year have been profitable, down from 9 in the year before [3].

The most profitable sectors included SaaS and baby care, while the sectors with the most significant negative hits to profits were FinTech and EdTech in general. However, they still accounted for the largest chunk of the deals closed.

Figures 3, 4 and 5 below show some statistics and names of the companies that increased in profitability, some that slipped, and some whose losses just worsened. The data is pulled from moneycontrol.com and is in the Indian unit of crores. 1 crore is 10 million Indian rupees.

Figure 3

Figure 4

Figure 5

Figure 6

On 9th March, the Reserve Bank of India (RBI) hiked the REPO rate by 25 bps to 6.5% [4]. This policy change was a move towards a contractionary monetary policy by the central bank, prompted by the country’s hyperinflation in food and oil prices. As a result, raising funds for startups became harder than in the existing funding winter. Higher bank rates would mean more money being deposited in the banks and a higher lending rate. The effects, however, could also be seen even in the startup ecosystem.

This year’s biggest shock was the note in the union budget announced on 1st February 2023. According to this note, foreign direct investment (FDI), will also be subject to angel tax in India, making it harder for Indian startups to raise funds from abroad. It impedes the economy’s growth and affects the country’s balance of payments since we will receive lower investments from abroad. [5]

Angel Tax

Startups have been selling shares at a premium. Around 2016, the Department for Promotion of Industry and Internal Trade (DPIIT), stepped in and made it a requirement for every startup to get a DPIIT registration to be recognised as a startup. Before they could raise funds at high valuations, the startups needed to present an independent merchant banker’s valuation to the department rather than to their company’s chartered accountant. The tax on the premium for these startups in excess of the fair market value is called angel tax and is taxed in the hands of the investors at a flat rate of 20%.

This year, the finance minister, Nirmala Sitharaman, in the union budget, has mentioned that the premium on shares issued by startups to foreign investors will also be taxed as angel tax. This change created significant ambiguity and raised concerns regarding how foreign investors will invest in the country. It’s worth noting that it does not apply to VC funds abroad, as the FDI implications would be extreme. Also, there would be an issue of multiple valuation methods using FEMA.

Due to this change, startups might only price future funding rounds at a higher valuation if there has been a significant change in the valuation [6], which would have a substantial impact on the MOIC of the investors. In turn, even domestic investors would become much more choosy when funding startups!

How to gain access to Indian deal flow?

Taxes aside, it is straightforward for foreign investors to invest in India. Deal flow is readily available. One promising means of investing are through VC funds both abroad and in India, which invest in various startups in the country at multiple stages and across sectors. This is also the safest route for investment in higher ticket sizes since the VC fund managers would take board seats in the investee companies and ensure the due diligence is done correctly before the money is invested. Another method of getting access to deal flow is by joining angel networks/funds or becoming a part of syndicates. Some notable ones include Lead Angels (which has a network and an angel fund) and AngelList (Now known as Wellfound) India, which is itself an angel fund but has various syndicates represented on it. The Securities and Exchange Board of India (SEBI) has mandated that anyone can invest in an angel fund by committing a sum of INR 2.5m over a period of 5 years.

A new platform for investors abroad to invest in startups in emerging economies is Crowd Invest [7]. This platform acts as a crowdfunding platform for Indian and other emerging economy startups to get funded by foreign HNIs.

Conclusion

The Indian startup ecosystem has shown significant growth in terms of the number of deals and value in recent years. There has been a growth in the number of unicorns, and India is likely to cross 200 unicorns by 2025. Although there is a big push for the startup ecosystem in India, certain regulatory hurdles do exist which might act as a hurdle for foreign investors to invest in India. However, there are several ways to work around this and to continue to have access to Indian deal flow, with a moderate level of risk for a private equity investment.

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