Startup valuation is an art not a science

How do you explain the valuation of a Company valued at $1 billion when it is making a yearly loss of INR 500 crores to an Income tax authority?

Currently, there are various factors that determine the valuation of a startup like number of users of the platform/product, revenue forecasted, market size, technology and its future, etc. Traditional valuations are usually based on the forecasted revenue and profit the Company shall make. However, in the current age, various other factors determine the valuation. For instance, Ola acquiring Foodpanda for $200Mn would help Ola strength their food delivery segment. Even though Foodpanda had made losses in the past, this partnership would create a new operational synergy and avenue for Ola and hence the valuation of $200Mn.

The valuation in these kinds of acquisitions/investments is usually arrived based on various operational factors and all these factors cannot be put in a valuation report. The Income tax department has every right to question the basis of this valuation. However, according to me, if the price is agreed between the buyer and the seller, the Income tax department need not question the basis of valuation provided the transaction has been subject to tax accordingly.

Secondly, as per Section 56 of the Income tax act, 1961, any excess consideration received by a Company towards issue of shares, over and above its fair value, is treated as Income and taxed at 30%. This is not applicable in case the investment is received from a non-resident (or) investment received by a venture capital company/venture capital fund.

This regulation was brought w.e.f 1st April 2013 to curb the issue of black money being brought as share capital with a high premium.

Income tax department can question the basis of valuation and appoint an independent valuer to perform the valuation exercise. According to me, this will not produce any results because as stated earlier valuation is an art not a science. Each one might have a different perspective on the valuation including the buyer and the seller. The buyer and seller arrive at a common value through rounds of negotiations. But in the case of an income tax assessment, difference in valuation would lead to long drawn litigations.

Alternatively, the Income tax authorities compare the projections used for arriving at the valuation with the actuals. Usually, an income tax assessment is held after a period of 1 or 2 years and by this time the actual figures can be compared with the projections by the Income tax authorities to verify the accuracy of the valuation arrived at the time of investment. This comparison can be made by an Income tax authority provided factors like economic growth, inflation rate, market scenario, etc need to be given due effect. For instance, business slow down owing to demonetization, GST, etc need to be given due effect in the comparison performed by the Income tax authorities.

In lieu of the above complexities, it is advisable for the startups to prepare the necessary documentations in order to avoid any litigation.

One of the items appearing in the wishlist of all startups and angel investors from the Indian Government is removal of section 56(2)(viib) of Income tax act, 1961 (Also known as Angel tax). Already the Indian Government has taken steps in removing Angel tax for startups registered with Department of Industrial Policy and Promotion (DIPP). However, the startup community expects a further relaxation in this provision or complete removal of the provision as it poses a threat to the angel investors investing in startups purely based on the market potential.

Conclusion:

The Government, on one hand, should ensure the provisions introduced are not misused and on other hand it should promote its startup initiatives. This can be achieved by the Government by closely interacting with the startup communities comprising of startup founders, investors, advisors, etc so that it a WIN-WIN for everyone.

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