Domestic capital looking to invest in the start-up sector still faces many hurdles, including from tax policy
By TV Mohandas Pai & Yash Baid
Start-ups are leveraging technology-led change to transform societies the world over. These start-ups are entrepreneurial innovation engines that change the context for society alongside creating disproportional value. Roughly 250 years ago, the world changed forever with the advent of the Industrial Revolution. We saw the rise of Europe and the decline of Asia. India and China were the richest economies from the dawn of civilization until then. From years 1800 to 1900, Europe leveraged the rise of the machine to dominate the global economy, creating a global supply-chain, connecting consumers and producers all around the world.
About 20 years ago, the internet rose as an alternative to this supply-chain. And now, the internet has brought people together like no other phenomena in history. Today, of the 7.8 billion people on the planet, 6 billion people have a mobile connection, more than 5 billion have an internet connection, and 4.5 billion use social media to stay connected. The internet allows you to communicate with each other, do business, get educated, be entertained, access health, and access every other conceivable product or service through global suppliers.
The growth of the internet has given rise to giant technology conglomerates, some of which are today valued around $2 trillion each. These US-based companies are leading the pack of the top-10 valuable companies in the world. In fact, nine of these are digital companies, a phenomenon never seen before. To put this in perspective, Apple, at a $2 trillion market cap, is worth almost two-thirds of India’s GDP.
India too is catching up and is now the third-largest start-up ecosystem on the planet. The depth of this ecosystem is significant, with 55,000 start-ups having already created $350 billion of value and employing over 1.5 million people. Indian start-ups raised over $70 billion over 2014-2020—$11.5 billion in 2020 and $10.5 billion in the first half of 2021 alone, a period marked by the Covid-19 pandemic.
The year 2020 first set the pace, seeing the most number of new unicorns in a year, with 11 start-ups reaching the milestone—only to be topped by 2021 (ytd), where we were witness to 6 unicorns crowned in one week, and 18 being created in just the first half, with an expectation of 25 unicorns by year-end.
Of the $110 billion in capital raised by Indian start-ups since 2008, $70 billion was raised in the just last five years— a remarkable acceleration of capital deployment that has gone largely unnoticed by most of the mainstream Indian industry. It has led to the creation of 59 venture-funded tech companies, valued at over a billion dollars each in just a decade.
By the year 2025, India will host 100,000 start-ups and 150 unicorns, cumulatively supporting 35 lakh jobs, and creating $1 trillion of value and possibly seeing another $150-200 billion being invested cumulatively. The first listing of a start-up just now augurs well for the Indian public markets, becoming the agent of change. The pace of growth in this sector is creating immense value for the nation and those that invest in it.
The outburst of innovation across the past decade is built upon the successes that India has had in the software services industry between the 1990-2010. This year, India will export more than $170 billion of software globally, with over 60% of global technology outsourcing coming to India. To put this figure in perspective, these exports are much larger than the oil exports made by the world’s largest oil exporter, Saudi Arabia. Today, India is the largest global exporter of software services, with five of the 10 most valuable software services companies being Indian and three of the top-five, with 2m of the total 2.8m employees in the top-10 companies, being Indian.
India is using its deep supply of technological talent to provide high technology services to the world. In the next two years, all these software companies expect to grow in double-digits, and by 2025, we could be exporting $250 billion of software services.
These companies have created a market-value of more than $400 billion today, and there is the hope that, with the start-up IPOs happening in the public markets today, the market value of both the IT service companies and the start-ups combined could reach more than $1 trillion in India’s public markets by 2025. This is in addition to the huge value of unlisted start-ups.
India is transforming rapidly, ably supported by prime minister Narendra Modi’s vision of creating a Digital India. The government worked hard to connect all Indians through a common digital identity (Aadhaar) and provided bank-account access for all. Today, India has 1.2 billion unique Aadhaar accounts, 1 billion bank accounts, 1.2 billion mobile phones, and 900 million mobile connections.
This has truly created an interconnected India. The UPI infrastructure facilitates over 2.8 billion transactions a month. The government has transferred more than Rs 17 lakh crore over the last seven years, directly to citizens’ bank accounts via DBT. During the nation-wide lockdown, this digital infrastructure came to the fore as the government was able to transfer sums of money, along with rations to crores of citizens, together giving Indians the wherewithal to survive the pandemic.
The pandemic also gave momentum for the widespread adoption of technology in India. A large number of people migrated to digital services and got accustomed to purchasing and transacting on e-commerce. They availed or reserved services through apps, got healthcare information at the click of a button, and also got consultation from their doctors.
There is a whole new generation of children who have gotten accustomed to getting almost all aspects of their education and extra-curricular activities online. People found their individual entertainment needs—be it movies, gaming, music streaming, or picking up new hobbies—all being met through apps, even in their native languages. This was a seamless transition for more than 50% of India’s population, with enough of a critical mass being generated to provide the momentum to accelerate coverage over the next few years.
But, as a start-up nation, India is still number three in the world. India’s technological advancement is still inhibited by a paucity of local capital. The US invests more than $135 billion annually on venture capital and start-ups, while China invests more than $65 billion, with over 60% being local capital. In stark contrast, India invests only $10 billion a year, with 90% being overseas capital. Of course, there is now enough momentum to warrant an estimated influx of $150-200 billion of capital by 2025.
With the recent events creating capital distrust in China, the world’s attention is sharpening on the lucrative tech opportunities in India and the value that could be created. But India requires decisive policy measures, in addition to the Digital India initiative. Today, out of the 59 unicorns, nearly 30 are domiciled outside India, driven outside by outdated forex regulations, non-implementation of relevant federal regulations, tax terrorism, and lack of local capital incentives.
DeepTech and healthcare start-ups still do not get adequate early capital to grow in this country and are forced to domicile outside. Tax terrorism continues to reign supreme. Even though the finance minister has said that the angel tax will be a thing of the past, many start-ups are still stuck in litigation. Antiquated forex regulations from the FERA-era, like those on round-tripping, convoluted documentation for purchase of an Indian company, unnecessary valuation certificates, approvals required to remit foreign exchange, etc, are driving many companies to headquarter in other countries where they can easily access capital.
There has been improvement, but it is not enough. We need stronger regulations for both global and domestic investments in start-ups. Global investors want to make sure they can invest freely in India and get their returns when they sell as well, as is the norm in the stock market, which sees massive influx of FDIs. We need to create a repository of investor-KYC, ensuring traceability and seamless governance, while incentivising global institutional investors by allowing them to freely remit their gains.
Further, we need to make sure that more domestic institutional capital comes into start-ups as there is a real danger of India becoming a digital colony by 2025. A great majority of our unicorns, their tech IP, and even their holding companies are owned by foreign capital. There is nothing wrong with foreign capital, but while India welcomes foreign capital, it should not disincentivise domestic capital.
Today, the capital gains tax on unlisted companies is 20% plus 37% surcharge above Rs 5 crore, whereas foreign investors can invest in unlisted companies inviting a capital gains tax of only 11%. This massive discrimination against Indian investors has reduced the flow of capital into a vital sector for India. After liberalisation, the software industry is majorly Indian-owned and managed, and so are the telecom and pharma industries, and infrastructure. But the most innovative and forward-looking of all, the start-up industry, is in danger of not having adequate Indian capital.
In countries leading the race for technological growth, like the US and China, large and consistent investments into PE/VCs and start-ups come in from insurance companies, pension funds, and other such long-term sources of capital. Similar organisations in India must be incentivised to support India’s innovation ecosystem more holistically. Investors like LIC cannot excuse themselves from doing so, citing their lack of knowledge towards such investments, when their contemporary bodies from outside India, like the Canadian Pension Fund, Ontario Pension Funds, and others, have invested over $10 billion in India’s innovation ecosystem already.
India’s regulations for trusts, pension funds, and insurance companies have recently been changed to allow their investments in fund of funds, hence allowing such companies to invest by diversifying risk and spreading the flow of capital over a large number of start-ups. The only redeeming factor about Indian capital has been the Rs 10,000 crore fund of funds for start-ups set up by the NDA government about six years ago, which has revolutionised the AIF industry. Today, India has more than Rs 4 lakh crore committed to the AIF industry and over 650 funds. A new generation of fund managers have come up, but they too are finding it difficult to access domestic capital.
India today is being driven ahead in leaps and bounds by young entrepreneurs who use technology and innovation to grow their businesses, and there is strong backing in them from the largest and most distinguished sources of capital globally. The recent listing of a start-up, with a warm market reception has become a harbinger for many more listings to come. The tech opportunity is being finally made available to the Indian masses and the momentum is only going to pick up with more such opportunities expected. What the nation needs at this hour is helpful policies in foreign exchange and taxation that supports more domestic institutional capital. Technology has the power to both improve the quality of life for India’s citizens and to facilitate improved governance for the nation. This is a once in a lifetime opportunity for India and we must capitalise on it to make India a great start-up nation.
Respectively, chairman, and principal, 3one4 Capital Views are personal