On July 23, Finance Minister Nirmala Sitharaman scrapped the ‘angel tax’ in her budget speech. As most of the post-budget media coverage focused on announcements relating to long-term and short-term capital gains, indexation, and changes in personal income tax rules, this important decision was not given the attention it deserved.
In reality, it can prove a game changer for job creation in India.
Around 2010, there were rumours that some high-networth individuals (HNIs) were into money laundering by investing large sums in early-stage startups at high valuations in a bid to get unaccounted money into the mainstream system and subsequently write off the losses when the start-ups failed. To counter this, in 2012 the then finance minister Pranab Mukherjee, in the UPA government, had introduced the angel tax on funds raised by startups beyond the fair value of the venture.
But, much like the road to hell is paved with good intentions, what followed was ridiculous. While the angel tax may (or may not) have curbed money laundering, it provided income tax (I-T) authorities a tool to harass genuine entrepreneurs.
Early-stage startup valuations are a combination of unbridled optimism, fictional spreadsheets and incredible positivity. All the promise is way, way ahead, and HNIs and family offices invest capital by buying into this rosy future. There’s no legitimate method to value an early-stage startup accurately.
Meanwhile, finance professionals are trained to look at business plans with a critical eye and assess the current value of the enterprise based on the discounted cash flow (DCF) method. And therein lies a tale. Post the introduction of angel tax, I-T authorities sent out notices to entrepreneurs and founders that the valuations at which they raised capital were far higher than the actual valuations according to the (completely inadequate) DCF method.
Entrepreneurs were now entangled in dealing with these notices and, as a corollary, investors were also bombarded with I-T notices seeking data on their source of funds and the logic for paying huge premiums on the startups’ equity. Very quickly, founders started spending more time inside I-T offices than in their own premises; the HNIs, meanwhile, decided to stay away from early-stage investments to avoid future harassment.
India’s youth need jobs. The government’s responsibility is not to provide jobs but build an environment that allows entrepreneurs to flourish, grow their ventures and create employment opportunities. In that sense, this decision to scrap the angel tax is a welcome one. It will hopefully get HNIs and family offices to resume investing lots of capital into early-stage startups, and founders can focus on building their businesses and creating jobs. Take a bow, madam Sitharaman.
(The writer is a serial entrepreneur and best-selling author of the book ‘Failing to Succeed’; posts on X @vaitheek)