The Government has decided to encourage startups through a number of changes they have outlined in an action plan that will help early stage companies do better.

Why Startups?

For one, they are a big source of income and employment, and for another they foster innovation. This is a good idea in my opinion, because startups will be future giants, and we have encouraged “large” companies only for the most part. Startups also have the potential to bring in enormous FDI (they’ve done so in the recent past) and also encourage domestic capital (which knows them best) to grow more such businesses.

Overall, the startup space has been dominated by technology companies in the internet space. Also by some non-tech sectors like grocery and food delivery. The real encouragement should be to startups in multiple spaces – whether it is solar powered tractors, electric engines, shaving blades or better financial products. The point is to foster innovation and challenge incumbents – and thus, create a mechanism where the dying oldies are replaced by faster, better newbies.

And yeah, I’m biased because Capital Mind is a startup, and we’ll take any encouragement we can get.

However, there are serious flaws in this “action plan” which will not reach that lofty goal of actually encouraging startups. In effect, while the intent is good, the system will be lost in government approval quagmire, because: someone random gets to decide what a “startup” is.

The Bad Part: The “Licensed” Definition of a Startup

The Government has decided that a startup is: what it calls a startup, and each one needs an ‘approval’. Yes, you heard that right. Here’s the qualifications:

Private Limited, LLP or Partnership set up less than 5 years earlier.

Annual turnover less than 25 cr. in all of the past 5 years

Needs a “certification from an inter-ministerial board“. (only for tax benefits, it seems)

Oh, and before you try to go to the inter-ministerial board, the startup needs to have any of the following:

a recommendation from an incubator in a post-grad college.

have ‘support’ (whatever that means) or a recommendation from a government funded incubator through an innovation fostering scheme

be funded by an incubation fund, angel network or private equity fund registered with SEBI

have an Indian Patent

And only then the inter-ministerial board will see it, and then choose to approve it.

This is horrible, except perhaps the Patent part. However it can take a while to get a patent, and a new idea might not necessarily be patentable.

Why else? Because you need recommendations from government funded agencies? When was the last time we needed that? Wait, it was called the license raj. This is just sad, because we simply do not trust the government to do this right. Remember the Startup Tax? Well, that was created saying there was abuse by some companies and that genuine startups aren’t affected. We know now that the tax department is hounding genuine startups and not going after the real abuse – because the tax officials know that genuine startups can be easily hounded this way.

While many of these government funded incubators are private, I think this places enormous power in their hands when they get to “recommend” startups to DIPP so that there are tax and other benefits. We have seen in the past that when people get such power, they abuse it. And that was the problem with the license raj, and that’s why we got rid of it.

And the “funded by a SEBI registered fund” is hilarious. If a startup is funded, it doesn’t need further encouragement in the form of tax breaks or lowered regulation? They can pay for staff to handle regulation, and don’t need tax benefits or such.

The further certification by an “inter-minsterial board” is even more horrible. If DIPP is any historical indication, they have a board called the Foreign Investment Promotion Board. The FIPB meets every month to “approve” stuff like can a company get foreign investment etc. They randomly reject proposals giving no reasons whatsoever. They even defer proposals for long periods because…well, because they can. Such a board will now have to approve EVERY SINGLE STARTUP in order for the startup to get tax benefits. (This negates the benefit of lower tax treatment)

Really? We want this big-brother treatment? Is this good?

I believe this is a wrong move and we should have simple “objective” criteria of what a startup is – started in the last five years, with turnover restrictions is good enough. (You have to remove tax incentives, and only clear up labour laws anyhow – but we should be doing that for ALL startups)

Now, For the Benefits

Assuming that this definition of “startup” is somehow tweaked, here’s what the deal is:

Lowered Regulatory Hassles: Startups can self-certify compliance to certain acts, like gratuity (which strangely doesn’t even apply in most startups in the first five years), Contract Labour, EPF/ESI etc. Startups won’t be inspected for the first three years, with the caveat that a credible complaint can still be investigated. While this is nice, it doesn’t actually ease the process of registration – which the companies have to do (self certification of complaince still means you have to comply). And it doesn’t ease the hassles that happen when you register. Still, it’s better than the current situation.

There will be a Startup India Hub. This could help startups in some way, we don’t know how, but at this point, it sounds like a great place to have coffee.

There will be a Mobile app and Portal. For registering a company and self certification etc. I look forward to this because it might make company registration easier!

Startups will get government funded Patent application help. If a startup applies for a patent, the govt will fund the defence of the parent, and give an 80% rebate in fees. The government will appoint “facilitators” whose fees will be paid by the government. Ooh, this sounds like “facilitation” will bea good long-term cash generating business from now on! But yes, patent filing will increase.

Manufacturing Startups will not be discriminated against because of lack of experience or turnover. This is great; most startups that want to serve government organizations cannot do so because the tenders require either 3 years of existence or a certain minimum turnover.

The Bankruptcy Bill ensures startups can be closed in 90 days.

Credit and Investment

The government will invest in startups – Rs. 2,500 crore per year with support from LIC. They won’t directly invest in startups – they’ll put money into registered VC funds, where the fund has already raised an equivalent amount. This is for four years. Some of this is already being done. We haven’t seen an investigation of how well this has done, but it might actually work.

Banks don’t lend to startups for the high risk and lack of collateral. The Government will help by guaranteeing some part of that lending, with a Rs. 500 cr. corpus for each of the next four years.

It’s strange that the debt budget is 1/5th of the equity one, but this might correct over time as da

ta is collected.

No Tax! And Cap Gains Benefits

Startups – as defined by that tenuous process above – will not have to pay income tax for three years. Given the tough definition of what a startup is – and the procedure to get vetted by a inter-ministry board – it is doubtful a startup that is approved will see any profit for three years. If this definition works, the income tax department may be able to claim that if you don’t have to pay tax, you can’t carry forward the losses too (currently allowable for seven years later).

My big apprehension was that if you set a tax-free area, then big companies and money launderers will abuse it to make their own revenues through a zero-tax entity. Given the definition, this is probably too difficult. But in the process, it is also quite difficult for regular startups to use this clause to any decent effect. For funded startups, the word profit is probably shunned, at least in the first three years, so it won’t be a huge attraction for them. I’m not sure who will benefit – unless the shady money launderers have figured out how to get a “certification” and route revenues through “startups” they create. But they already have other exemptions like investing in windmills, or having cold storage units.

Either ways, remember that there is no “tax-free” anything. Minimum Alternate Tax (MAT) is 20% of profits – you have to pay this much regardless of any tax free scheme. There is no mention of MAT exclusion for startups anywhere; therefore we can assume that what this does is: for startups, for the first three years, you pay 20% tax on profits. (if there was a specific exemption for MAT – it should have been mentioned. Let’s see if the government clarifies)

Secondly, the capital gains that you earn from any source (long term) will be exempt from tax if you invest the gains into startup “fund of funds”, recognized by the government. The fact that it’s a fund of funds, and then recognized by the government will complicate the matter as the return of your money is suspect and unlikely for a very very long time. The contours of this clause will come from the budget papers.

I am not for tax exemptions for any such clause. They introduce distortions and promote one set of companies at the expense of another. I don’t think the government can really recognize a really smart startup, so they will favour those that they decide are useful. An agri-startup that provides forward price information for farmers may be deemed unnecessary, but a tech startup doing something hundreds of other people are doing will be considered great because it’s in some favoured sector. The special incentives for the folks that are able to pass these arbitrary gates will act as a disincentive for those that don’t – for instance the tax free nature of export IT profits were considered good, but guess what, they disincentivized domestic focussed IT startups which flourished after 2010 when that silly scheme ended. Or they don’t achieve their objectives: like a friend noted, the tax free nature of profits in units in Pondicherry and Silvassa in the 90s for 10 years, saw FMCG and other cos set up units there, and disband them after 10 years, choosing to exit when the tax benefits went away.

Even the eco-survey findings and finmin notes recently have pushed for the better alternative: remove all specific exemptions and lower the tax rate completely. I’d be much happier if everyone was paying 20%, instead of paying lip service to some industry or the other, at the invisible cost to everyone else.

Both these clauses will only apply from April 1, 2016 – so don’t rush to do anything immediately!

Startup Tax Excluded for Incubators

The government hasn’t eliminated the Startup Tax. Instead, it’s decided that the investment by Incubators will not have a startup tax. (Investment by VC funds, angel funds and foreing investors is already exempt from this tax)

This whole startup tax is stupid. We should eliminate it because – and even portfolio startups of angel funds are being hounded for this tax today! Meanwhile the big fish is probably escaping through the grease-of-palms route. All it has done is create avenues for disproportionate income for certain officials, and is another one of those government erected barriers to startups.

Other Stuff

The government will hold startup fests. I think this is a good idea, the government should be creating avenues like this, but there isn’t a dearth of tech startup events honestly. Hopefully this will help startups in non-tech sectors.

There will be 500 “Tinkering” Labs. Pre-incubation training for founders. Awards. And such, through the Atal Innovation Mission.

The government will fund privately run incubators, through government departments. And they’ll fund research centers and incubators and many current institutions (IITs, NITs). There will also be an Incubator Grand Challenge.

(This is also an incubator action plan!)

Our View

There are many aspects of this plan we don’t like: the narrow definition of a startup that requires recommendations from incubators or an inter-ministerial board approval being the biggest one. The tax benefits aren’t really attractive, and along with the startup definition make things inaccessible for the most part. Plus the 20% MAT means there is no real tax-free anything.

But overall the rest are great ideas: reduce friction to starting up and make government and domestic funds available (would have liked more debt but that can be fixed). The usefulness of incubators may be debatable, and given the tax benefits they may become power centers, but more incubators will help reduce the entry cost for non-tech companies (for most tech companies, an apartment is pretty much all you need).

We look forward to a simpler regulation regime. Also, accessing those government funds will take some understanding, but we hope there is a transparent mechanism to apply for, and understand acceptance and rejection reasoning.

We wish that they would remove the startup tax altogether (or at least kept it only for valuations above Rs. 20 cr. or such). That’s a distress point for raising money from domestic individuals.

Let’s hope we see the real contours of this in the budget. And how the “inter-ministerial board” operates in approving startups that qualify for these schemes. And how the transparency flows through so we can understand and benefit from it.

As a disclosure, Capital Mind is a startup and biased towards such schemes because we hope to benefit from them.