Why angel investors prefer Tech start-ups over Non-Tech?

Start-ups (which indirectly fall under MSEs category of taxation) since 2014 have collected around $100 billion and are on the ever-accelerating way to mark its way to $500 billion by 2025, with a projection to create over 35 – 40 lakh jobs. 

It was a beautiful day for Mr. Singh. He had invested in an idea introduced by a bunch of boys who had recently graduated out of an Engineering College. It was something related to irrigation technology with the name “Ivy-Irri Tech”. Mr. Singh had no idea what it was, but his financial advisor and accountant advised him that the investment would garner good profit in a very short period of time. After he found everything to be appropriate, he wrote off a check for Rs 3 crore for 3,000 shares to Ivy-Irri Tech boys. Today, he received the triple of his investment (i.e., Rs 9 crore) as the start-up was brought under the banner of a multinational corporation (MNC).

Mr. Singh was indeed an ‘angel’ who invested in the start-up seeing the growth projection as calculated by the discounted cash flow (DCF) method. He knew and took all the risks on the idea. Like Mr. Singh, there are a number of high-value individuals in our nation who are approached to invest in a small idea, which the ones presenting are able to convince (or show) to be of big worth in a short period of time.

A few days went by and the boys again contacted him over the notice they received from the Income Tax Dept. The notice stated that they had to pay 30% as ‘Angel Tax’ clause of Section 56(2)(vii b) of the Income Tax Act, 1961.

These start-ups operate in a very vulnerable environment and anything can happen any moment. All the money made in the first half of the day may just vanish off by second. The basic principle of start-ups is a low investment to high yield, in less time.

According to Economic Times, “Angel tax is a term used to refer to the income tax payable on capital raised by unlisted companies via the issue of shares where the share price is seen in excess of the fair market value of the shares sold. The excess realisation is treated as income and taxed accordingly.” This is charged when the initial “angel” investor is an Indian, while foreigners are exempted from it as that’d just add more to Foreign Direct Investments (FDI) category. Also, the value of start-ups is counted against the industry suggested method of DCF with the net value present (NVP) method that increases the difference between the projected margins to the excess premium earned.

Hence, nowthe start-up will have to pay the excess of what they received of initial capital (i.e., Rs 3 crore).  In shares & dividend terms – Mr. Singh bought 3000 @ Rs 10000 each. He sold them (the startup sold it to the MNC) at a premium (excess from Market Value – profit) of Rs 30,000 for each share. Hence, for 3000 shares the excess profit is Rs 6 crore. Now 30% of Rs 6 crore is Rs 1.80 crore and that is what the start-up is charged as “Angel Tax”.

This is a major de-motivation to the hardworking, innovative minds that have worked hard to put up the efforts to bring their dream into happening, just like the “Ivy-Irri Tech” chaps and returned the initial investment in a triple in less than some years, but now are a victim of the ‘Angel Tax’.

However, the income tax regimes in our nation, which are duly unregulated at the helm of dysfunctional bureaucracy and call for immediate reforms at a great extent, do not spare even the ‘angels’. This taxation regime has led to the inclination of angel investors into investing in tech start-ups and deviating from the non-tech cohorts. The falling of start-ups into MSEs category, the very narrow definition of start-ups, and the bureaucracy which looks for an opportunity to put to their advantage, are the reasons for non-tech start-ups being not worth investment against hassles.

Of the limited few exemptions in Angel Tax, the angel investors tend to avoid the non-tech sector as there’s a very obstructive measure which restricts the investment into immovable objects. So if the start-up in non-tech sectors, would involve investment in immovable assets (which is the case in most non-tech start-ups) then the investment would not fall into exemption into start-up’s seed funding and thereby incurring additional taxation. The ruling Govt. has presented a very ambitious plan to lead India to a $5 trillion economy for which there needs to be a safe growth rate in the economy at 11.3% (also assuming rupee falls to the dollar, further) for the next five years with no exception contrary to the present which is less than 4%. Further, with Moody’s downgrading India to ‘Baa3’ category, just one rank above “junk” category, the onset of FDIs flowing into Indian start-ups seems reclusive and does not seem to recover anytime soon. So, the Income Tax Act, 1961 needs to reform from its very core to match up the economic challenges of the 21st century for Indian investors to keep the market afloat and its operations flared up. Time is money, and neither of that we do have.