Clipping angel wings isn’t cutting, but…

Carve-outs for foreign investors facing angel tax will elicit a mixed response from startups. True, exempting sovereign investors, allowing a broader spectrum of valuation methods, and the introduction of a valuation band will lessen the impact of the tax. But these are, at best, partial relief. The class of exempt foreign investors is conservative by nature, and their exposure to innately risky startups is limited. More ways to value startups do not address the issue of fair valuation being the only tax-efficient means to raise capital. The 10% safe harbour valuation may not be wide enough to cover fluctuations in macroeconomic variables. Valuation by merchant bankers could reduce the flexibility startup founders and venture capitalists have become accustomed to. Relief, while welcome, is meagre.

The government’s attempt to make startup valuations realistic through taxation coincides with an investment downturn. It risks diverting capital and entrepreneurship to friendlier jurisdictions. The cohort of India‘s unicorns was unduly tilted in favour of incorporation abroad even before the imposition of angel tax on foreign investors. The original purpose of the tax was to curb pooling of unaccounted capital in the startup ecosystem. This was, subsequently, revised to include investor protection. Both these objectives will be met. But a tax is not the best way to go about it.

Particularly when the bets are on ideas. Investors with an appetite for risky innovation have their own yardsticks for valuing infant businesses. These need not conform to the officially acceptable definition of fair value. The government may be within its rights to know where the money is coming from. But it is introducing market imperfections by trying to set prices of companies. This increases constraints under which locally incorporated startups operate. Such interventions can also slow innovation in India, a market that offers enormous scope for deploying technologies like artificial intelligence (AI) based on the richness of data it is expected to generate.