Category: Cover Feature : Startups

Generally, the
valuation approaches or methodologies are based on the evaluation of assets,
revenue, profitability, etc. of the business. However, in case of startups,
they neither have an asset base nor revenue. For example, the valuation of
Airbnb is over twice as much as that of Hyatt – although Airbnb is effectively
the world’s largest hotel chain without owning a single hotel room! Hence, the
exercise of valuing a startup poses various challenges to the valuer.

 

In effect, valuing a startup is an exercise of calculating the best
estimate of the sum of its parts, i.e., all its resources, intellectual
capital, technology, brand value and financial assets that the startup brings
to the table. In this article we will cover the basics of startup valuation
progressing over stages of financing, need of valuing start-ups and methods of
valuation, followed by a case study in the Indian market.

 

So what does a
startup mean?

 

WHAT IS A STARTUP?

A startup is a
business enterprise incorporated to solve a problem by delivering a new product
or service under conditions of extreme uncertainty. It is a company typically
in the early stages of its development.

 

These
entrepreneurial ventures are typically started by one to three founders who
focus on capitalising upon a perceived market demand by developing a viable
product, service or platform. The founders’ effort is to turn their idea into a
repeatable and scalable business.

 

In the Indian
scenario, the Department for Industrial Policy and Promotion (DIPP) issued a
notification in February, 2019 defining a startup as an entity which is in
existence up to a period of ten years from the date of incorporation /
registration with a turnover for any of the financial years since incorporation
/ registration not exceeding Rs. 100 crores and working towards innovation,
development or improvement of products or processes or services or, if it is a
scalable business model, with a high potential of employment generation or
wealth creation – provided that an entity formed by splitting up or
reconstruction of an existing business shall not be considered a startup.

STAGES OF FUNDING

At the initial
stage, startups are self-funded by members of the founding team who also try to
secure funding through an investor or obtain a loan to help fund their venture.
There are various stages when a startup raises funds and its valuation differs
in each stage or round of funding.

 

1.  Angel/Seed Funding – This is typically
the very first stage where the funding is required for market research and
developing the product. At this stage the founder personally invests or raises
funds from acquaintances, or it comes from someone not known to the founder
called an ‘Angel Investor’. Seed capital is often given in exchange for a
percentage of the equity of the business, usually 20% or less;

2.  Series A Funding – It is when startups
have a strong idea about their business and product and may have even launched
it commercially. Series A Funding is typically used to establish a product in
the market and take the business to the next level, or to make up the shortfall
of the startup not yet being profitable;

3.  Series B Funding – The startup has
established itself but needs to expand, either with organic growth, with new
markets or acquisitions;

4.  Debt Funding – When a startup is fully
established it can raise money through a loan or debt that it will pay back,
such as venture debt, or lines of credit from a bank. A venture debt fund
typically lends when the startup is backed by known investor funds;

5.  Mezzanine Financing – It is also known
as bridge financing because it finances the growth of companies prior to an
IPO. This is usually short-term debt with the proceeds of the IPO or buyout
paying it back;

6.  Leveraged Buyout (LBO) – This form of
funding is made up of convertible debt or preferred shares which are more
costly and provide investors certain rights over the holder of common equity.
It is a strategy where someone acquires an existing company with a significant
amount of borrowed funds. Usually, the assets of the business being purchased
are used as leverage and collateral for the loan used to purchase it;

7.  Initial Public Offering (IPO)
– An IPO is when the shares of a company are sold on a public stock exchange
where anyone can invest in the business. IPO opening stock prices are usually
set with the help of investment bankers.

 

A point to note is
that a startup valuation is required at each stage of funding.

 

CONSIDERATIONS FOR
STARTUP VALUATION

Startup valuation
means believing in the story and the founders’ strength to turn it into
reality. It could be the sum of all resources, technology, brand value and
financial assets that the startup has developed.

 

Startups usually
have little or no revenue or profit and are still in a stage of instability.

 

For startup
businesses one should consider the top-down approach by looking at the total
market available to the product / service and derive the cash flow to the firm
/ company therefrom. The following factors need to be considered and evaluated:

 

 

VALUATION APPROACHES
AND METHODS

Startups don’t have a long track record of generating cash flow and
valuations in such cases are highly subjective. While making an investment
decision, investors assess the valuation of such startups blending various
methods together.

 

The following are
the various valuation methodologies generally used to value startups.

 

VALUATION METHODS VIS-A-VIS PRINCIPLES

1   Berkus	Valuation based on the assessment of five key success factors
2   Risk Factor Summation	Valuation based on a base value adjusted for 12 standard risk factors
3   Scorecard	Valuation based on a weighted average value adjusted for a similar company
4   Comparable Transactions	Valuation based on a rule of three with a KPI from a similar company
5   Book Value	Valuation based on the tangible assets of the company
6   Liquidation Value	Valuation based on the scrap value of the tangible assets particularly to be used in a liquidation scenario
7   Discounted Cash Flow	Valuation based on the sum of all future cash flows generated
8   First Chicago	Valuation based on the weighted average of three valuation scenarios
9   Venture Capital	Valuation based on the ROI expected by the investor
10 Price of Recent Investment	Valuation based on the price of the recent investment round in the company

 

Berkus Method

The Berkus method, developed by Dave Berkus, is used to value pre-revenue
startups and is mostly applied to technology companies. This method is based on
the assumption that the company has the potential to reach $20 million or more
in revenues by the 5th year of operation.

 

The Berkus method applies a scale to the following five components of a
startup, rating each from zero up to $0.5 million:

(a) Sound idea (attract of core business to buyer)

(b) Quality of management (good management in
place)

(c) Strategic alliance (go-to-market)

(d) Product prototype

(e) Product rollout and sales plan

 

Using this method, the highest valuation could be a maximum of up to $2.5
million and, in case of a pre-revenue startup, it could only score up to $2
million.

 

Risk Factor Summation Method

This is a slightly
more evolved version of the Berkus Method. It is widely used by Angel Investors
for pre-revenue startups when determining seed investing and subsequent
financing rounds. The method is based on the average industry pre-money
valuation and adjusted for the following 12 risk factors associated with the
startup and its industry:

 

I.      Management risk

II.     Stage of the business

III.    Legislation / political
risk

IV.    Manufacturing risk (or
supply chain risk)

V.    Sales and marketing risk

VI.    Funding / capital
raising risk

VII.   Competition risk

VIII.  Technology risk

IX.    Litigation risk

X.    International risk

XI.    Reputation risk

XII.   Exit value risk

 

Each risk factor is
assessed and scored on a scale of 5 to a range of +$500K to -$500K (+$500K,
+$250K, 0, -$250K and -$500K). The net out-ratings / scores are adjusted to the
average industry pre-money valuation to arrive at the startup’s pre-money
valuation.

 

Scorecard Method

The Scorecard
Method, developed by Bill Payne, is similar to the Risk Factor Summation and
Berkus Methods and is usually used to value pre-revenue startups. This method
uses a combination of industry data and weighted percentages based on detailed
analysis of the following quantitative and qualitative factors:

 

(1) Management team
(0-30%)

(2) Size of
opportunity (0-25%)

(3) Product /
technology or service (0-15%)

(4) Competitive
environment (0-10%)

(5) Marketing /
sales channels / partnerships (0-10%)

(6) Need for
additional investment (0-5%)

(7) Other factors
(0-5%)

The sum of the
above factors is multiplied to the industry average pre-money valuation to
arrive at the startup’s pre-money valuation.

 

Comparable Transactions Method

This method is used in case of both pre-revenue and post-revenue startup
valuation. It involves determining similar merger or investment transactions in
the recent past and in the same industry as that of the subject company
business. The relevant comparable transactions valuation is analysed based on
the relevant key metrics of the industry and a range of multiples is derived
which is used in the determination of the valuation of the subject company.

 

Book Value Method

The Book Value
Method is an asset-based valuation approach and refers to the net worth of the
company. Here, the book value is calculated by deducting the value of
intangible assets and liabilities from the value of the total tangible assets.
The value of total tangible assets in this case is the cost at which the asset
is recorded in the balance adjusted for accumulated depreciation and impairment
costs.

 

Liquidation Value Method

In this method the
assessor determines the Fair Value of an asset when the company gets liquidated
or if the asset is no longer usable. The method considers only tangible assets
like plant and machinery, fixtures, inventory, etc., and intangibles are not
considered irrespective of the value they may hold. The net liquidation value
is calculated by deducting the value of liabilities from the total liquidation
value of all the tangible assets.

 

Discounted Cash Flow Method

The Discounted Cash
Flow method determines the attractiveness of the investment in the startup
based on the present value of the cash flows and that the startup is expected
to generate in future. The investor assesses the value derived from this method
and the cost of the investment. In case of pre-revenue startups, the cash flows
are normalised based on the stage of the life cycle of its business and once
the business starts growing at a steady pace, it is believed that the business
will generate cash flows for an indefinite period.

 

First Chicago Method

This method is used
to value post-revenue startups. It is based on probabilities with the following
three scenarios of financial forecast of the startup:

1.  Worst case

2.  Normal case

3.  Best case

 

Each valuation is made with the Discounted Cash Flow Method and assigned
a percentage reflecting the probability of each scenario occurring.

 

Venture Capital Method

The Venture Capital Method, described by Prof. Bill Sahlman in 1987 at
Harvard Business School, is based on the expected future returns of the
investor.

 

In this method the investor assumes that after a span of ‘n’ years the
startup could be sold for ‘x’ amount. Based on the expected return on
investment and the sale value, the investor determines the price he / she is
willing to pay today for investing in the startup, after adjusting for dilution
and future rounds between now and the company sale.

 

Price of Recent Investment Method

The recent
investment in the business is often taken as the base value if there are no
substantial changes since the last investment.

 

The Price of a Recent Investment valuation technique is likely to be
appropriate but only for a limited period after the date of the relevant
transaction. Given the relatively high frequency with which funding rounds are
often undertaken for seed and startup situations, or in respect of businesses
engaged in technological or scientific innovation and discovery, this method
will often be appropriate for valuing investments in such circumstances.
Generally, Fair Value would be indicated by the post-money valuation. The
length of the period for which it would remain appropriate to use this
valuation technique will depend on the specific circumstances of the investment
and is subject to the judgement of the valuer.

 

ASSESSMENT OF KEY
PERFORMANCE INDICATORS AND METRICS

The application of
the above methods is based on the assessment of risk parameters and other
factors discussed earlier specific to the startup under valuation. The common
set of target milestones would be established at the time of making the
assessment; these will vary across types of investments, specific companies and
industries, but are likely to include:

Financial
Measures:

– revenue growth;

– profitability
expectations;

– cash burn rate;

– covenant
compliance.

 

Technical
measures:

– phases of
development;

– testing cycles;

– patent approvals;

– regulatory
approvals.

 

Marketing and
sales measures:

– customer surveys;

– testing phases;

– market
introduction;

– market share.

 

In addition, the
key market drivers of the company, as well as the overall economic environment,
are relevant to the assessment.

 

FACTORING SCENARIOS

Therefore, using
the scenario-based DCF method (DCF with First Chicago Method) that considers
one or more future scenarios and assigning the probability of success to each
scenario gives a reliable indication of Fair Value. Further, there is also a
probability-weighted expected return model (PWERM) whereby probabilities can be
assigned to the expected up rounds, flat rounds or down rounds to arrive at a
value.

 

The option pricing
method (OPM), a forward-looking method that considers the current equity value
and then allocates that value to the various classes of equity considering a
continuous distribution of outcomes rather than focusing on distinct future
scenarios or a hybrid of a scenario-based method and OPM, can be considered.

 

For seed, startup
or early-stage companies in the absence of significant revenues, profits or
positive cash flows, other methods such as earning multiple are generally inappropriate.
The most appropriate approach to assess Fair Value may be a valuation technique
that is based on market data.

 

It is appropriate
to use an enhanced assessment based on industry analysis, sector analysis,
scenario analysis and / or milestone analysis. In such circumstances
industry-specific benchmarks / milestones approach, which are customarily and
routinely used in the specific industries of the company to be valued, can be
used in estimating Fair Value where appropriate.

 

The DCF method may
be used as cross-check; the disadvantages inherent in DCF, arising from the
high levels of subjective judgement, may render the method inappropriate
without corroborating support.

 

CASE STUDY

Let us discuss how
one can apply the valuation approaches discussed above in a newly-started
company which operates an online fund-raising platform, which connects
fund-seekers with lenders. It is intended to be an end-to-end connected and
fully integrated system providing a one-stop solution for individual and SME
borrowers, lenders and service providers such as finance professionals and
investment bankers.

 

The company has got the necessary approvals as required by the
regulatory bodies in India. The company would further require approvals for
using bureau data, KYC data and other government data. The company has also
entered into agreements with multiple banks and NBFCs in India. However, the
revenue generation is yet to be initiated.

 

Valuation Issues:

The company is in the initial stage of business life cycle. There are
various competitor platforms available in the market selling a boutique of
similar products and allied services.

 

Revenue generation is dependent on regulatory approvals and success fee
commission from tie-ups with financial institutions.

 

The business model
shared by the company projects a revenue growth at a CAGR of 200% in the first
five years.

 

Valuation Approach & Methodology:

We start with understanding the business model, the market it addresses
and the total size of the market, percentage share of the same the business is
trying to achieve, identifying the key valuation drivers, i.e., growth rate of
subscriber base and variation in success fee.

 

We then analyse the
comparable transactions at various stages of funding similar to the target entity
(i.e., Series A and Series B).

 

The Series A
transactions were dated a year or two back to the valuation date and at a
comparatively higher valuation range due to the different market scenario at
the time of funding. Hence, a discount was applied to such valuation range
arrived. The discounted EV / revenue multiple for Series B transactions (being
the recent ones) was considered for validation check.

 

We then consider
the discounted cash flow method considering three scenarios assuming lower
growth rates and lower success fee ratios.

 

We need to consider
a higher discount rate based on the expected returns of the investors and high
risks associated with the achievement business model.

 

Valuation Conclusion:

On the basis of the above analysis, we have
arrived at a valuation range using CTM and validated based on multiple
scenarios and sensitivity analysis on projections and discounting rate as per
DCF.

BACKGROUND

What do you
generally mean by a startup? The Collins English Dictionary defines it in this
way: “A startup company is a small business that has recently been started by
someone.” But the Oxford English Dictionary calls it “a company that is just
beginning to operate”. The Merriam-Webster Dictionary, on the other hand,
describes it as “a fledgling business enterprise”. Therefore, any new business
in its infancy is a startup.

 

In India, the information
technology (IT) industry has been a significant driver of growth, employment
and exports. Using technology effectively, startups can ramp up scale and grow
significantly within a short period of time. The government, through the
Ministry of Commerce, has therefore been seeking to encourage startups through
initiatives such as Start-up India.

 

Initially, and with
effect from February, 2016 under the Start-up India initiative an entity was
considered a startup:

 

a. Up to five years
from the date of its incorporation / registration;

b.  If its turnover for any of the financial years
has not exceeded Rs. 25 crores; and

c.  It is working towards
innovation, development, deployment or commercialisation of new products,
processes or services driven by technology or intellectual property.

 

However, an entity
formed by splitting up or reconstruction of an existing business is not to be
considered a ‘startup’.

 

On 23^rd May,
2017, the definition was amended by:

 

i.   Increasing the period from five to seven years
and, in case of startups in the biotechnology sector, from five to ten years;
and

 

ii.   Amending the nature of
activity to “working towards innovation, development or improvement of products
or processes or services, or if it is a scalable business model with a high
potential of employment-generation or wealth-creation”.

The definition was further amended on 19^th February, 2019
under Start-up India; now, an entity is considered a start-up:

 

a.  Up to a period of ten years from the date of
incorporation / registration, if it is incorporated as a private limited
company (as defined in the Companies Act, 2013), or registered as a partnership
firm (registered u/s. 59 of the Partnership Act, 1932), or a limited liability
partnership (under the Limited Liability Partnership Act, 2008) in India;

b.  The turnover of the entity for any of the
financial years since incorporation / registration has not exceeded
Rs. 100 crores; and

c.  The entity is working towards innovation,
development or improvement of products or processes or services, or if it is a
scalable business model with a high potential of employment-generation or
wealth-creation.

 

One of the
categories of incentives offered to startups is of certain income tax benefits.
There are, however, other tax provisions which have been a source of harassment
to startups. What are these tax benefits and tax provisions and how well have
they achieved their purpose?

 

TAX BENEFITS

1.  Lower rate of tax –
section 115BA

One of the benefits
which was supposedly meant for startups has been section 115BA, which provides
for a lower rate of tax of 25% for eligible domestic companies with effect from
assessment year (AY) 2017-18. These eligible domestic companies are those that:

 

a.  are set up or registered on or after 1^st
March, 2016;

b.  engaged only in the business of manufacture or
production of any article or thing, and research in relation to, and
distribution of such manufactured / produced articles / things; and

c.  the total income is computed without certain
incentive provisions, including additional depreciation, and deduction u/s.
80-IAC.

 

Given the fact that today most mid-sized and small companies (those
whose turnover in 2016-17 did not exceed Rs. 250 crores) are liable to pay tax
at only 25%, the tax rate of 25% u/s. 115BA is no longer an incentive rate.
Further, the restrictions for claiming a benefit under that section meant that
it was restricted only to manufacturing companies and most startups, which
provide services, were not able to avail of the benefit of this provision at
all.

 

In any case, today
most startups would qualify for the normal lower corporate tax rate of 25% of
their profits (provided, of course, if they have any taxable profits).

 

2.  Deduction of 100%
profits – section 80-IAC

This incentive
provision, meant specifically for startups, was introduced with effect from AY
2017-18. The objective of this provision, as explained in the Explanatory
Memorandum to the Finance Bill, 2016, was to provide an impetus to startups and
facilitate their growth in the initial phase of their business.

 

Under this section, an eligible startup can claim deduction for 100% of
profits and gains of eligible business for three consecutive assessment years
out of the first seven (increased from the first five, with effect from AY
2018-19) assessment years beginning from the year of its incorporation.

 

An eligible startup
is one which meets the following requirements:

 

(a) It is a company or a Limited Liability
Partnership (LLP);

(b) It carries on eligible business;

(c) It is incorporated on or after 1^st April,
2016 but before 1^st April, 2021;

(d) The total turnover of its business does not
exceed Rs. 25 crores in the relevant previous year;

(e) It holds a certificate of eligible business
from the Inter-Ministerial Board of Certification as notified in the Official
Gazette by the Central Government;

(f)  It is not formed by the splitting up or
reconstruction of a business already in existence; and

(g) It is not formed by transfer of
used plant or machinery to a new business. Used plant and machinery can,
however, constitute up to 20% of the total value of the plant and machinery
used in the business without it being regarded as a violation of this
condition. Further, plant and machinery used outside India is not regarded as used
plant and machinery if it is imported into India, was not previously used in
India before installation by the eligible startup, and no depreciation has been
allowed / was allowable in India on such plant and machinery for any period
prior to the date of installation by the eligible startup.

Till AY 2017-18, the definition of “eligible business” was comparatively
narrow and restrictive – “a business which involves innovation, development,
deployment or commercialisation of new products, processes or services driven
by technology or intellectual property”. From AY 2018-19, the amended
definition is “a business carried out by an eligible startup engaged in
innovation, development or improvement of products or processes or services or
a scalable business model with a high potential of employment-generation or
wealth-creation”. This wide definition has the potential of encompassing a
large number of businesses and not just those engaged in the IT sector or
providing services using technology as a disruptor.

 

Till the third week
of November, 2018, out of a total 14,036 (19,287 as of 20^th June,
2019) startups registered with the Department for Promotion of Industry &
Internal Trade (DPIIT), Ministry of Commerce, Government of India under the
Startup India programme, 91 (94 till 20^th June, 2019) startups had
received approval for the tax exemption. The procedure for applying for
approval is quite simple – Form 1 (which is a fairly simple form) has to be
filed along with the Memorandum of Association / LLP Agreement, board
resolution, copies of accounts and income-tax returns for the last three years.
The Board can call for further documents or information, and make enquiries,
before granting or refusing registration.

 

A partnership firm,
although it may be registered as a startup with DPIIT, is not eligible for the
benefit of deduction u/s. 80-IAC, even though an LLP, which is also taxed as a
partnership firm, qualifies for the benefit of such deduction.

 

Since this is a
deduction of profits and under Chapter VI-A such deduction may not really be of
much use to most startups which require five or more years to attain
profitability, and then, once they attain profitability, would first be setting
off their brought-forward losses before being eligible to claim exemption under
Chapter VI-A. Further, such deduction is not allowable for MAT / AMT purposes
and hence a startup would end up paying MAT / AMT at 18.5% of its profits while
claiming deduction u/s. 80-IAC in its normal computation of taxable income.
Ideally, to be really effective and meaningful, the benefit should have been
provided for any three out of the first ten years beginning from the year of
commencement of business and not from the year of incorporation, and such
deduction should have been excluded from book profits or adjusted total income.

The turnover limit of Rs. 25 crores is also too low for most startups to
be profitable and be eligible to claim the deduction – it should have been kept
at the same level as in the definition of “startup” in Startup India of Rs. 100
crores.

 

3.  Taxation of share
premium u/s. 56(2)(viib)

Section 56(2)(viib)
was introduced with effect from AY 2013-14. It seeks to tax amounts received by
a company in which the public are not substantially interested (a closely-held
company) from a resident as consideration for issue of shares at a premium, to
the extent that the consideration exceeds the fair market value of the shares.

 

If one looks at the intention behind the introduction of section
56(2)(viib), the Explanatory Memorandum to the Finance Bill 2012 lists this
amendment under “Measures to Prevent Generation and Circulation of Unaccounted
Money”.

 

The fair market
value of the shares is the higher of:

 

a.  the value determined as per Rule 11U read with
Rule 11UA, or

b.  the value as substantiated by the company to
the satisfaction of the Assessing Officer, based on the value, on the date of
issue of the shares, of its assets, including intangible assets, being
goodwill, know-how, patents, copyrights, trademarks, licences, franchises or
any other business or commercial rights of similar nature.

 

Rule 11UA(2)
permits the company to adopt either the book value (break-up value) method, or
the Discounted Free Cash Flow Method for determining the fair market value of
unquoted equity shares of the company.

 

An exemption is provided for consideration received by a venture capital
undertaking from a venture capital fund (VCF). There is also a provision for
notification of a class or classes of persons (investors) by the Central
Government for exemption. Two notifications have been issued under this clause
– Notification No. 45/2016 dated 18^th February, 2016 and
Notification No. 24/2018 dated 24^th May, 2018. Notification No.
45/2016 granted exemption for subscription by a resident person to a startup
company, which fulfilled the conditions of a startup as per the DIPP
Notification dated 17^th February, 2016. Notification No. 24/2018
granted exemption to consideration received for issue of shares from an
investor in accordance with the approval granted by the Inter-Ministerial Board
of Certification as per DIPP Notification dated 11^th April, 2018.

Again, so far as
investments by non-resident investors are concerned, the provisions of section
56(2)(viib) do not get attracted, since they apply only to investments by
resident investors.

 

Grant of approval for exemption

The procedure for
grant of approval is contained in DIPP Notification No. 364 of 11^th
April, 2018 as modified by Notification No. 34 of 16^th January,
2019, and further modified by DPIIT Notification No. 127 dated 19^th
February, 2019.

 

Initially, the
conditions for approval were as follows:

 

i.   the aggregate amount of paid-up share capital
and share premium of the startup after the proposed issue of shares does not
exceed Rs. 10 crores;

ii.   the investor / proposed investor, who
proposed to subscribe to the issue of shares of the startup has,

(a) the average
returned income of Rs. 25 lakhs or more for the preceding three financial
years; or

(b) the net worth
of Rs. 2 crores or more as on the last date of the preceding financial year;
and

iii.  the startup has obtained a
report from a merchant banker specifying the fair market value of shares in
accordance with Rule 11UA of the Income-tax Rules, 1962.

 

The amendments
brought about by DIPP Notification No. 34 of 16^th January, 2019 were
that:

 

a.  The average returned income of Rs. 25 lakhs
over the preceding three years was replaced by a returned income of Rs. 50
lakhs or more during the financial year preceding the year of investment; and

b.  The requirement of a report from a merchant
banker under Rule 11UA was done away with.

 

Significant
amendments were carried out to the conditions vide DPIIT Notification No. 127
dated 19^th February, 2019 as under:

 

(1) The upper limit
for the aggregate amount of paid-up share capital and share premium of the
startup after the proposed issue of shares was increased from Rs. 10 crores to Rs. 25 crores. Further, in counting this amount
of Rs. 25 crores, amounts received from non-residents, venture capital
funds and frequently traded listed companies (whose net worth on the last date
of the financial year preceding the year in which shares are issued exceeds Rs.
100 crores or turnover for the financial year preceding the year in which
shares are issued exceeds Rs. 250 crores) are to be excluded;

(2) Further,
amounts received for subscription from such listed companies are to be exempt
from section 56(2)(viib);

(3) The requirements of investor returned
minimum income and minimum net worth were deleted; and

(4) An additional condition was inserted to the effect that the company
should not have invested in the following assets, and shall not invest in such
assets for a period of seven years from the end of the financial year in which
the approved share issue at a premium takes place:

 

a.  building or land appurtenant thereto, being a
residential house, other than that used by the startup for the purposes of
renting or held by it as stock-in-trade, in the ordinary course of business;

b.  land or building, or both, not being a
residential house, other than that occupied by the startup for its business or
used by it for purposes of renting or held by it as stock-in-trade, in the
ordinary course of business;

c.  loans and advances, other than loans or
advances extended in the ordinary course of business by the startup where the
lending of money is substantial part of its business;

d.  capital contribution made to any other entity;

e.  shares and securities;

f.   a motor vehicle, aircraft, yacht or any other
mode of transport, the actual cost of which exceeds Rs. 10 lakhs, other than
that held by the startup for the purpose of plying, hiring, leasing or as
stock-in-trade, in the ordinary course of business;

g.  jewellery other than that held by the startup
as stock-in-trade in the ordinary course of business;

h.  asset, whether in the nature of capital asset
or otherwise, specified in sub-clauses (iv) to (ix) of clause (d) of
Explanation to 56(2)(vii), viz., archaeological collections, drawings,
paintings, sculptures, works of art and bullion.

 

The Inter-Ministerial Board of Certification (IMBC), which is the
authority to grant the approval, has taken certain positive decisions in this
regard. At its meeting on 16^th May, 2019 the following decisions
were taken, inter alia:

 

i.   It was observed that a large number of
applications were being rejected for availability of similar products /
services. The applications should not be rejected merely on the basis of
similar products / services as it could mean higher demand and competition.

ii.   Startups from remote / rural areas and women
entrepreneurs should be encouraged to apply.

iii.  IMBC may ask for video presentation of a
defined duration with specific areas to be covered by a startup for applying
for the tax exemption.

iv.  IMBC may also hold video conference with the
startup, if required.

 

The objective of
IMBC, therefore, clearly seems to be to encourage genuine startups to apply for
and to grant the exemption from section 56(2)(viib). One understands from press
reports that so far 672 startups have been given approval u/s. 56(2)(viib).

 

Difficulties faced by startups

So far as most
startups which are innovating are concerned, their business is based on a
novel, untested concept. Their future business projections are based on hope
that their business concept or model will succeed. Investors place faith in the
startup founders’ ability and invest in the company based on such rosy
projections, knowing full well that the business model or concept is untested
and untried and that there is a high risk that the business may not succeed.
The investor investment at high valuations is based on the small chance that
the start-up may succeed and do so well that the consequent appreciation in
value of investment may more than compensate for the loss suffered on
investment in other startups. That is why investors spread their risks by
investing across various start-ups.

 

It is quite common
for a startup investor to invest in a company at the seed stage at a premium,
when the business is yet to commence, and all that is in existence is the idea
and a business concept in the mind of the startup founder. Similarly, most such
investments are made at premium valuations when the startups are still
incurring huge losses, with no profits in sight for the next few years. The
investment and its valuation is therefore more of an expression of confidence
by the investor in the founder and his business plan and not based on the
accuracy of the future numbers.

 

The problem faced by startups was that from AY 2013-14 till almost AY
2016-17, the provisions of section 56(2)(viib) applied without the benefit of
any exemption notification being available to them. Even from February, 2016,
many startups could not meet the DIPP criteria to qualify as a startup and
hence could not avail the benefit of exemption u/s. 56(2)(viib). The April,
2018 Notification and procedure did apply to more issues by startups, but was
still comparatively restrictive. It is only with effect from 2019 that startups
really started getting the benefit of exemption. Therefore, startups faced
serious problems of large demands in assessments for earlier years, due to
additions made in respect of premiums received on share subscriptions.

 

Since a vast majority of startups do not succeed in their business, when
the assessments for the year of investment came up for scrutiny, the numbers
actually achieved by the startups came nowhere close to the numbers that they
had presented to investors at the time of investment. The valuation based on
the actual numbers was thus a fraction of the valuation at which the investment
was made a few years ago. As a result, AOs sought to use the benefit of
hindsight to reject the pre-investment valuation provided by the company based
on projected financials and substitute it with a far lower post-investment
valuation based on actual financials. Since the investments were made at a far
higher premium, the provisions of section 56(2)(viib) were invoked to tax the
startups on such alleged “excess premium”.

 

At times, where
resident investors had invested along with venture capital funds or
non-resident investors at the same valuations, it led to an absurd situation.
While the investments by the VCFs or the non-resident investors were spared
from the provisions of section 56(2)(viib), the provisions were invoked for the
similar investments by resident investors. Indeed a very peculiar situation,
given that the valuation of the resident investment was validated by the
valuation of the VCF or non-resident investment!

 

Further, the stated
purpose of section 56(2)(viib) was almost completely ignored by the AOs. Even
cases where the investments were being made out of known sources of income of
the resident they were being taxed as income of the issuer company, even though
this could in no way be regarded as generation or circulation of unaccounted
money. Therefore, such action was contrary to the purpose of the provision.

 

Pending issues

The DPIIT Notification No. 127 of 19^th February, 2019 states
that the notification for exemption would apply irrespective of the dates on
which shares are issued by the startup from the date of its incorporation,
except for the shares issued in respect of which an addition u/s. 56(2)(viib) has
been made in an assessment order before the date of issue of the notification
(i.e., 19^th February, 2019). Therefore, if a startup has made any
issue of shares for which assessment is pending or has not been completed prior
to 19^th February, 2019, it is advisable for it to obtain such
approval from the DPIIT, with consequent approval from the IMBC. In fact, even
startups whose case has not been selected for scrutiny in the year of such
issue of shares may find it beneficial to obtain such approval, to protect
themselves from any possible reassessment proceedings.

 

The most common
issue that many startups face is the fate of pending assessments and appeals,
where large demands have already been raised. There is no express provision in
such cases and the matters would have to be decided independently in appeal in
such cases. It would have been far better if a resolution process had been laid
down in such cases, which the appellate authority could have followed. For
instance, any startup fulfilling the conditions of exemption could have been
granted relief after verification of compliance with the conditions.

 

The other issue
faced by startups is the restriction on acquiring certain specified types of
assets, before and for seven financial years after the end of the year of share
issue, which could result in loss of the exemption. There is no minimum value
for such assets. Take a few situations: A startup buys a painting for its
office, costing Rs. 2,000; a startup gives a loan of Rs. 10,000 to its
employee; a startup buys a delivery vehicle for Rs. 11 lakhs; a startup invests
Rs. 1 lakh in a subsidiary. Any of these could result in a possible loss of
exemption! Perhaps, such interpretations were not intended. The objective of
the condition of investment in assets is to ensure that under the guise of
raising capital for the business, a startup does not become an investment
vehicle, and not to prohibit such normal business transactions.

 

A startup is merely
required to file a declaration that it has not invested in such assets and
shall not invest in such assets for seven years, in Form 2 with the DPIIT,
which will forward it to the IMBC. The IMBC will then grant the exemption. The
withdrawal of exemption will also be by the IMBC. In order to avoid unnecessary
loss of exemption for certain common business transactions, it is essential
that clarifications are issued by the DPIIT, clarifying that certain normal
transactions would not attract withdrawal of exemption. So also, a minimum
limit of, say, Rs. 5 lakhs, should be prescribed, below which limit,
acquisition of the specified types of assets would not invite withdrawal of
exemption.

 

Further, no procedure has been laid down for cancellation of the
exemption notification. However, before any cancellation of exemption is
resorted to, the basic principles of natural justice would have to be followed
by IMBC. This would require that the startup would have to be given a show
cause notice for that purpose, in response to which it would have a right to be
heard.

 

4.  Set-off of Losses
under Section 79

Under section 79,
where there is a change in beneficial ownership of 51% of voting power of a
closely-held company from the end of the year in which a loss was incurred to
the end of the year in which the set-off of the loss is claimed, the benefit of
set-off and carry forward of loss is not available. The objective behind this
provision is to prevent transfer of loss-making companies for sale of losses,
where the benefit of the set-off of losses can be availed of by the acquirers.

 

In startups, such
change in beneficial ownership of voting rights is quite common on account of
dilution by the founders in each round of funding, and not by transfer of
shares. A concession has therefore been provided to startups in section 79(2)
with effect from Assessment Year 2018-19. A startup which is eligible for
deduction u/s 80-IAC can continue to obtain the benefit of carry forward and
set off of losses of the first seven years from the date of incorporation,
provided all the shareholders holding shares of the company in the year in
which the loss was incurred continue to be shareholders of the company as at
the end of the previous year in which the set-off of the loss is being claimed.

 

From the language of the section, it appears that in case of a startup
even if one shareholder transfers his nominal shareholding before set-off of
the loss, the benefit of carry forward of the first seven year losses will be
lost, as opposed to a less stringent 49% permissible transfer in case of other
closely-held companies. Also, there is a lack of clarity as to losses incurred
by startups after the first seven years – whether the
provisions of section 79(1) would apply or whether there would be no
restrictions at all.

 

CONCLUSION

Startups which have
raised funds at high valuations in recent years have faced a torrid time in the
past few years. Fortunately, the government has responded to their request for
relief and laid down a procedure which, by and large, excludes such startups
from the rigours of section 56(2)(viib). One only wishes that other businesses
were also spared from the unnecessary litigation that section 56(2)(viib) has
generated.

 

The government has spared startups from a nuisance provision. But has it
really provided enough tax incentives? The provision u/s. 80-IAC for tax
deduction of profits is not really a significant incentive. Today, compliance
involves a significant cost for most businesses, having become fairly onerous.
What startups would perhaps better appreciate is a tax regime with lesser
compliance hassles – exemption from tax deduction requirements as well as
having tax deducted at source from their incomes, exemption from scrutiny
assessment u/s. 143(3), etc. This would allow startups to focus on their
business, instead of having a part of their energies diverted towards
compliance, and definitely result in an improvement of productivity of the
startups.

 

The above provisions are based on their
legal status as on 23^rd June, 2019.

Funding startups
is glamorous, but the big question is how much returns can they generate as an
investment asset class?

 

Start-ups are
young, emerging companies working on breakthrough innovations that would fill
the need gap or eradicate existing complexities in the ecosystem. These
companies are in a constant endeavour for new development and researching new
markets. They have agility embedded in their inventive thinking. Angel investors
fund a startup for several reasons but the first and foremost reason is that
they believe in that idea, project or passion. They want to make the
entrepreneur startup successful with the help of the disposable capital
available at their end.

 

Investing in
startups is more an art and less of a science – it isn’t meant for everyone; it
is subjective. There is no method to this madness, nor a defined college degree
to help you learn venture investing. Every deal, experience and strategy shared
in the public domain is anecdotal. Angel investors provide capital for small
entrepreneurs but are not in the money-lending or financing business. The
finance they provide is for that first round of seed capital to make the idea /
vision into a reality. Entrepreneurs can also find angel investors in their
family and / or friends who will support them with capital on terms favouring
them. Angels risk their money in people, teams and ideas which are fragile in
nature. Hence this is termed risk capital investment.

 

Angels are
individuals who have a good, successful background; their names evoke trust in
the minds of customers or future investors. They back the startup by
associating their name with it, which provides the entrepreneurs the required
creditworthiness in the market.

 

Why I love startups
as an asset class for investment is because I can offer my time besides my
capital. In other investments like public equities or real estate I can’t
influence an outcome. Venture investing is a people business, so if you
like meeting, working and helping people, then your chances of success are very
high. With early stage startups as their lead investor, I work closely with the
founders to create a positive outcome. Before beginning a discourse on the
merits and demerits of investing in startups, let’s first understand investing
in startups from the bottom up.

 

What is investing?
It is the process of putting money into various physical or abstracted assets
with the expectation of making a profit. One can expect to make a profit on the
money invested by seeing an increase in the value of the asset – whether real
or perceived – and selling off the asset at the increased value. When you
invest in a company – public or private – you invest in the asset that is the
company itself; you get a part of the ownership of the company. As the value of
the company increases, so does the profit you can make by selling off your
stake. A key difference between investing in public companies and private ones
like startups is that in public companies selling off your stake is far easier
and near instantaneous. The same cannot be said about private investments –
hence investments in startups is one of the most illiquid asset classes. It can
give you huge profits, but those profits will be only on paper for the most
part because realising an exit takes a lot of time. It is an illiquid
investment.

 

A basic,
fundamental point that every early-stage investor should know is that startups
follow the law of power – a small percentage of the startups you invest in will
give you the majority of your profits. Take (for example) Andreseen Horowitz’s
portfolio. They’re one of the top VC firms – and about 60% of their returns
come from about 6% of their deals. What does this tell us? It means that to
truly make a profit from startup investments, you should be able to access
those 6% of deals. The rest of your investments may or may not materialise
significant returns for you – but that 6% of your portfolio is where the real
return is. If you invest in few startups it’s like buying a lottery; it’s the
portfolio approach which helps the early-stage investor create mega returns.

 

Given this
background, let us come to the question at hand, “Are startups a good
investment?” Startups are high-risk high-return investments which follow the
power law. It is not about the number of hits you have, but the magnitude of
those hits. That’s where we find the answer to our question. The wealth
creation opportunity that startup investments provide is nearly unparalleled.
But it is also extremely risky and conditional. So when are startups good
investments?

 

It is a good idea to invest in startups when one has the appetite and the
capacity for the high risk involved. The investor with the mission to give
first, to help founders and build business will win this game. One must be
capable of creating a significantly sized portfolio of investments in the hope
that some of the investments are part of the 6% and give one huge returns. One
can create a startup portfolio by investing about 5-10% of one’s total
investment capacity in such an illiquid asset class. It is worth noting that
the money invested here must be thought of as a sunk cost – until and unless an
exit is realised. The investors must be able to stay patient with their capital
– the best companies can give returns after ten years.

 

The toughest part of investing in startups is gaining access to the top
tier of deals that can give you the huge hits. When one has access to those 6%
of deals, it is a great idea to invest in startups. One cannot ascertain at the
beginning whether a particular investment will provide the returns one hopes
for – but one can invest in startups that can give the unparalleled returns
that one hopes for if they work out. To gain access to the top startups, one has
to put in time and effort to become a part of the startup ecosystem, become a
part of various investor networks and collaborate with other lead investors and
VC firms.

 

Startup investments can provide disproportionate wealth-creation
opportunities. Before investing in startups, every investor should ask himself
– Am I ready to take on the capital risk? Do I have the required time and
effort to build a portfolio? And, last but not the least, do I have the
patience to wait for the disproportionate return?

 

Investing in early stage companies is
about capturing the value between the startup phase and the public company
phase.

From Inception,
Capital Raises to Strategic Acquisition

In this second interview of the July special issue, BCAJ Editor
Raman Jokhakar talks to Matthew Emerman, CFO of JioSaavn. The company recently
underwent a merger valued at $1 billion and was widely reported. Matt joined
Saavn since its inception in 2007 and has seen it from inside as its CFO and
Global Head of Corporate Development. This interview walks the reader through
an amazing journey of 12 years from early start up days and culminating in a
merger with one of the largest companies in India.

 

In a free
flowing interview, Matt talks about initial idea of Saavn and how it filled a
market void at that time, challenges of early stage funding, addressable market
and selecting Jio as its partner in the next leg of its journey. Matt has been
a member of the founding management team and has seen the challenges that a technology
driven startup goes through.

 

 

Q. Can you tell us a bit about Saavn the
company and its journey from its founding in 2007, to acquiring rights to about
50 million music tracks and 100 million active users – and to the recent deal
with Jio Music?

 

A. When we started in the US it was a B2B
distribution company. We were taking Indian movies, bringing them across the
cable services in North America and the UK. We realised that there was a void
in the market for Indian music when a lot of it was not digital.
Historically, it has always been mostly pirated music. So we started licensing
content exclusively from the likes of T-Series and Saregama and distributing
these to different services like iTunes and B2C platforms. When the users
started downloading say from iTunes, Indian music was difficult for consumers
to discover or search for the specific songs they were looking for. Services at
that time were not designed for Indian music. Many a times users looking for
content didn’t really know what they were searching for – they would know the
movie name, they would know the actor’s name but they would not know which song
they were looking for. So a lot of the metadata that was there was not designed
for digital.

 

So we worked really closely
with Apple and Google at that time and we decided internally that the future
was to move the business to a more direct to consumer focused model. At that
point of time we worked really closely with Google who was creating a new
Operating System that we know today as Android. And we realised that for us to
really move into the future, direct-to-consumer was the best path. 

We started our
direct-to-consumer business called SAAVN (South Asian Audio Visual Network).
This new business model approach led to us raise our first institutional
funding in June 2011 from Tiger Global. That funding really put us on the map.
From 2011 to 2017 we raised well over a hundred million dollars of
institutional funding. Over that period of time we raised capital from world
renowned institutional investors such as Bertelsmann, Liberty Media, Wellington
Management, Steadview Capital.  We also
attracted investment from some of the top global artistes and managers,
including Guy Oseary, U2 and many other top global musicians. We have been
really lucky in our journey in terms of having incredible people who believed
in us.

 

We were in a very difficult
space – in terms of having global investors that really understood India and
especially the content and entertainment eco-system. It was hard for investors
to understand the growth opportunity which was there. Building a service for
the Indian market also has a lot of challenge from a regional perspective, from
a language perspective, device capabilities and historically connectivity was
always an issue.

 

We saw the shift, this
inflection point in September, 2016 when Reliance Industries launched Jio. For
the first time, cellular streaming eclipsed Wi-Fi. This is really a systemic
change in the entire digital eco-system across the country. And we saw that
everything changed after this – our user base and our engagement increased with
introduction of 4G throughout the country.

 

In terms of how we thought
about our partnerships we have had long conversations with almost all the top
tech companies and others. India has a lot of headwinds but when you think of
the tailwinds, Jio was really doing something amazing of having 0 to 300
million subscribers till today in a short time frame. They are adding 10
million subscribers each month.  We had
20 million users at the time of the transaction that has multiplied many times
over and now we are the largest music streaming platform in the country.

 

There were various factors
which were at play. Innovation in the way they think about building businesses,
the way they truly appreciate this market and all the dynamics that are there.
Then there are regional dynamics and challenges, you have people coming online
for the first time, how do you really understand the consumer, how do you
target the consumer by saying that now you are not going to go for the pirated
experience but are going to go online, going digital and going online with
digital payments. It’s a completely new experience. When we thought of what was
that next level for Saavn, it was this $1 billion transaction.

 

Q. Way back in 2007, how did the founders come
up with this idea of Saavn? Were they trying to solve a certain problem and was
it that something like this never existed at that point in time?

 

A. Almost everything in life is about timing. Lot
of it was an opportunity where there was a void. Cable companies in the US were
losing a lot of subscribers to satellite. And we thought we want to have a
South Asian video on demand channel. There was a void in the market and
consumers were very hungry for this content. So how do we bring movies to North
America, US and UK so that cable companies have a competitive offer? People
were paying $60 – $70 per month for the services to experience the content they
were used to when they were back in India. So that is where the genesis of the
opportunity existed and slowly realising that there is a void from a music
perspective.

 

Q. You seem to have started by taking Indian
content to the other side – and now you have brought the entire thing back
here! Do you still have that set-up back there in the US?

 

A. Yes we are really a global company. We have
offices in New York, California and that is really important from a talent
perspective but also from a global tech perspective.  We have an incredible engineering team based
in Mountain View, CA. That’s a very interesting perspective that we bring to
the market.

 

What separates us from
anyone else is the data that we have. Since the launch of our streaming
services way back in 2010-11, we have terrific data of the consumers. This
(data) is in terms of their listening behaviour, patterns of listening when it
comes to music specifically, when it comes to Indian music from a regional
perspective and how that is curated is what makes our algorithms, our
technology, our backend really unique. Everything is customised and built
inhouse, nothing is outsourced. We have incredible engineering, product and
design teams split across India and the US.

 

Company
communication is so important for us, because we are working all round the
clock. And we have been really lucky from a point of view of having an
incredible culture. How we as an organisation ensured that everyone was an
actual owner of the business and incentivise the team members to be a part of
something. That’s part of the journey and it’s really important for people.
It’s happening more and more where companies are offering equity incentive
plans to their teams. There is such incredible talent that is here in India.
And what we are seeing for the first time here. Historically,  from a tech perspective, there has been brain drain. Some of the brightest
minds have historically moved abroad to work at tech companies like Microsoft,
Google, Apple, etc.

 

From a
recruiting perspective, we are getting incredible talent from the IITs. We have
a first day recruiting programme with all the IITs and it’s been phenomenal. We
are also seeing a shift in executives who have got incredible experience in the
US, want to come back because of what is happening in the eco-system here.

 

Q.What was the trigger for the alliance with
Jio?

 

 A. Like I said everything is timing. If you look
at the music space in the market you have Apple music, Spotify, Amazon, YouTube
music is here. There are local players like Gaana and Wynk. So there is a lot
of noise and a lot of perception vs. reality. There are people that make these
press announcements. And then there is a certain standard kind of matrix that
is there – industry standard like monthly active users, and streams. Some of
these press announcements give a feeling about perception vs. reality whether
you are a private company or a public company, the difference about what is
happening on the ground is different.

 

So we looked at the notion
of saying that we have brought the business to a certain level of user base and
scale. To really get to the platform where you have 200-300- 500 million users,
it was really important for us to find a strategic partner who has the vision,
who has patience from a capital perspective and a longer timeline than
institutional investors. And that from timing perspective made a lot of sense
for us. And like I said before we know and respect all the major companies
globally that are there in the music playing technology space. But there was no
better partner for us.  From the founding
team that is leading this initiative and from Reliance perspective, when you
think about the digital services business, it was important for them to find an
incredible group of entrepreneurs, a team and culture that would really fit
within the eco-system.

Q. What were some of the elements that you
looked for which helped you determine that this strategy and this partner would
really work and that this is someone you want to have an alliance with?

 

 A. I think a lot of it is looking at just the way
they built Jio and looking at what they built in terms of the digital services
business. If you use some of the services apps that are there, they have such
an incredible team, and they have done an amazing job of building what they
have built. You walk on their campus in RCP in Navi Mumbai you feel like you
are in any large tech company’s campus in California. It’s really incredible
when you talk about any large tech companies worldwide. So when you think about
that stage that they are in, it made a lot of sense. From a strategic
perspective we have an incredible team of brilliant minds collectively working
together on how do we achieve this kind of targets that we have in our
business.

 

It’s also the notion of the
actual current addressable market in India. You have 1.3 billion people here
and how do you not have 700-800 million users? You have Tencent Music which has
over 700 million users worldwide. These numbers are staggering. I think there
is the reality of what is the actual addressable market that is here. For
example you think about the users in the amount of subscribers that Jio has
today, and so it was something that we really took a lot of time to think about
what was the aspiration that we have as a business.

 

We also thought from the
perspective of giving access to content. Not just from music perspective but we
have over 50 million tracks, and from having worked very closely with all the
music labels these 10 years. We were the pioneers of other forms of audio
content – in terms of podcasting, and other shows, and original music.  We were the first ones to start doing
original music and giving the community and independent artistes’ a platform.
Historically, music consumption in India has been film based. And there are so
many incredibly talented bands and musicians that that never had a place for
the music to be heard. So we were able to give a platform to independent
artists. There has been an explosion of independent music scene here over the
last few years.

 

Q.You spoke about the valuation of over a
billion dollars and also spoke about how it worked out in terms of number of
customers and so on. Do you want to tell us a little bit more about arriving at
the value for a transaction like this one?

A. In this case it is a combination of value of
an existing business and of JioMusic and then looking at it from a value per
user basis. Generally for this type of business, and if you look at other tech
companies there is per user value that is attributed to that. There is
traditionally DCF and all that but that doesn’t generally work for technology
companies. Multiples are very different for technology companies when you
compare them to traditional companies.

 

All investors have their
target ownership, what’s been invested to date in the business on both sides,
value that is there on both sides and then the intangibles, the brand names
that are there, the consumer confidence in the businesses, all of these are
very important. All of these come together and then at the end of the day it’s
like in any other deal – negotiations.

 

We had some incredible
advisers and the deal was closed in record time of under 2 months. It required
incredible coordination amongst our legal counsels and tax advisers from both
sides.

 

It’s so
important having people you can trust in the market. We have an international
corporate structure and so we have to think how to structure this kind of a
transaction especially when it involved a public company in India. So there was
a lot of consideration that was there. Having trusted advisers by your side and
I would actually call them trusted partners. Because of the time zones that
were involved we had to be very flexible, late IST calls and early morning EST
calls. We worked Saturdays and pretty much on all Sundays. Seven days a week
throughout the transaction for six weeks or so and that takes incredible
relationship to close a deal of this magnitude in this period of time.

 

It was
a great learning experience. And what’s so important is to really have your
advisers and team members by your side from day one and that they have context
to your business.

 

Q. Would you like to share something about
what you learnt which makes a deal like this work on both sides? Especially
since it all happened within two months? Attributes that each side displayed
which you think made a deal like this work?

 

A. Incredible communication – of being able to
work so closely with people. We were partners even before the deal was closed.
It’s also very telling in terms of what the future is going to be like. If you
can close something of this size in such a short span of time imagine what you
can build together.

 

And again every deal has
its moments of complexity, there is no question about it. I think communication
across the board on both sides was important when we had aggressive timelines.
In hindsight it is really communication. As a CFO you can’t miss anything and
have to ensure full communication with teams at all times.  The passion everyone showed, seven days a
week. That’s when you talk about people feeling like an owner of the company,
part of something, you can’t teach that.
I think that’s something really incredible.

 

Q.Coming to the wider canvas of the
music-streaming world and all its bits and pieces, how do you see it going
forward? You have a vision and your perspective of the market – and you are
perhaps creating some of it. How do you see this whole thing evolve from what
we see today?

 

A. I think what you will see especially from the
India perspective is consolidation. I think one thing that you are seeing with
companies like Netflix is that consumers are really willing to pay for good
content. And I think that’s what is so unique.

 

Then there
are challenges from infrastructure point of view.  Like you go to see a big festival in India,
you know three days before it was an empty field. So that is something that is
really changing. Especially, things like Jio Garden or Jio World Center which
is completely world-class state of the art facility that will be opening
shortly. I think there is going to be a new consumer experience that is going
to happen. This is really important and people are really hungryfor it.

 

Q. On the technology landscape, do you feel
that some of this is going to get disrupted? What will improve further, or is
something else going to come up in the future in place of what we have today?

 

 A. I think what is happening more and more is
curation. From the data that we have of a user that comes to the app – we know
what kind of music he would like to listen to. Based on certain patterns – are
they in the gym in the morning and what they listen there, do they listen to
devotional content in the morning and what do they listen to when they are
driving to work for forty five minutes. So you kind of track the pattern and
from an AI perspective and Algorithm technology perspective you are delivering
a service where a consumer goes WOW – this understands me. It’s intuitive

 

And when you look at a
million peoples’ apps every user experience is customised and is unique to that
person, their behaviour and what they are listening to.

 

This is what is happening
now. And again music is so emotional and so in the core. When you think about
incredible moments in your life there are songs for them. You might watch a
movie for a few times but you will listen to the same song hundreds of times if
not thousands of times. So music has a different way of connecting us
individually with ourselves but also connect us to our friends. Look at
playlists sharing.

 

Q.Can you share some takeaways from the last
12 years? Did you ever think when you started out with Saavn that this day
would come, that you would go through what you have gone through so far?

 

A. I think it’s been an incredible journey. I
love spending time with entrepreneurs. But it’s that kind of resilience. It
takes special individuals to go through hundreds of VC pitches. And it not just
an individual but teams to go through that. It’s not easy to do it. Like
raising institutional funding, building a business, these are challenging
things. Having resilience, having really good advisers by you, it’s so
important.

 

We also found that
leadership development training and personal and professional development is
critical for the growth of teams.  I
think people really take it for granted that more you are able to invest in
people the more you are able to get out of them.

 

But besides
that what keeps the founding teams and the people together is resilience. The
notion of being positive, having a sense of humour and having the conviction
that this will work out. The people you surround yourself with, who gave you a lot of inspiration
and advise. It’s ok to not have all the answers. I think you are really in
trouble when you think you know everything because that’s when you are going to
be taught certain lessons which you thought you are never going to experience.
So it’s really important to be really humble. And kind of being able to
appreciate what you are able to do every day! And when you are able to do that
you find things that start to come your way. Those times that were the
hardest building the business were the most humbling and those were some of the
greatest things and greatest experiences that we know.

In this interview, we talk to Gaurav Anand, co-founder of Namaste Credit, about his start-up journey. The interview walks one through the journey of a founder. Gaurav discusses how he decided to switch from a job with the largest rating agency in NYC to starting off into uncharted territory. What drives an entrepreneur and what are the challenges and how he perceives them. Gaurav also shares his views on why finding a real problem and solving that problem is the bedrock of entrepreneurship and how an enterprise needs constant passion and relentless execution.

Gaurav runs Namaste Credit, an online marketplace founded in 2014 that dynamically matches SME businesses looking for financing with lenders. It leverages on technology to obtain optimal loan products from lenders and NBFCs across India. In this interview BCAJ Editor Raman Jokhakar speaks to the young founder of a FINTECH startup to tell his tale.

Can you tell us about your background, your life journey till you reached that moment of choice, deciding that you want to start something on your own?

I am originally from Delhi, did my MBA from N.M. College, Mumbai. Along with my post-graduation, I did CFA and Financial Risk Management (FRM) as well. My first job was with Credit Suisse. I spent about four years in London as part of a training team. Then I moved to New York to work with the world’s largest rating agency Moody’s, leading the North America practice of risk analytics, advising financial institutions, including Wall Street banks. That’s where I met my co-founder Lucas Bianchi. We thought of moving from a cushy job – from monthly pay cheques to a startup life. Essentially, it was based on two key pivots – a passion and a drive to make a meaningful impact on others’ lives; and second, the supreme confidence that we can execute our ideas and our vision. These beliefs gave us the urge to take the plunge. We wanted to touch the larger eco-system, in fact, improve the eco-system – in this case the SME lending space – and impact a wider audience.

You felt that these features were not present in the system?

People are always looking for the bigger and wider spaces available in the world, where we can go and disrupt them, and also the right time to disrupt them. We chose and started in India because India has the largest SME base, and from the technology point of view, India has a large market potential. We believed this was the right time for this space to get disrupted. We saw the huge market potential and the right timing for us to start.

What were the learnings from your earlier work profiles / experiences that helped you to get the confidence to execute?

These are large institutions / corporates where you learn how to work within the rules / framework and how to be super-efficient at it. People who are very successful at large corporates are very good at working within the rules. You do not have significant room to push the envelope so you have to be super-efficient to play within the rules and yet execute very well. Whereas in the startups world, there are no rules, no regulatory body for startups, you write your own rules and play by your own rules. However, having worked in a more restrained environment, that allows you to narrow down, put your thoughts and execution plans in action and work on them. This gives you that added discipline in a startup, otherwise it is easy to get carried away with no ring-fencing.

Considering your experience, exposure and knowing where India was, you could spot the opportunity. Can you take us through the process – spotting a problem, believing that you can solve it and choosing the right time to do it?

In 2013-2015, we saw disruption happening in the developed world. Fintech had started to play a significant role in the US and European markets. There was maturity in the financial market from the Fintech point of view. If you break the developed world into smaller portions and rule out the purchasing power parity, these are small islands of opportunity for you.

Although a company like PayPal has been in the market for two decades, the new-age companies, especially in the SME lending space, were starting to take some giant strides. So, from the timing perspective, we could either be a part of a crowded market or jump into a bigger market with 50 million SMEs with hardly any technology adoption and disruption and create our own niche or brand. We chose the longer path because of lack of digital infrastructure then. The first two years were a struggle because of lack of digital infrastructure where these initiatives could be scaled up. We chose to bite the bullet and knew we could make it through our execution.

Being a founder of a startup, having an idea in place and the decision to leave the US… as a founder, what kind of challenges you had visualised – what if all this didn’t work out?

It was a big personal decision. I had the vision for this startup and my family supported me to make it work. But the real driving factor was the passion and the urge to make a much bigger impact than what I could think of making as part of the corporate world. Although we were working with the largest financial institutions in the world, we were still away from the ground reality. It was a personal decision and also a decision of the family. Had we remained in the corporate world, the impact would have been quite shielded or guarded. It would have a limited multiplier effect in a broader eco-system. Therefore, we thought that we had to develop our skills and get to the bottom of the problem to emerge with an impactful solution.

Bearing in mind the uncertainty in Indian regulations (say a sudden new tax) and where there is no answerability for such flip-flop changes, did you think of the risks while returning to India with the startup idea in mind?

The first challenge was to get a grip of the sheer size, complexity and diversity of India and assimilate certain facts. It was like dealing with 28 countries because in India each state behaves like a country. To have a pan-India presence, we have to deal with a lot of moving parts; like the Central and State Governments are at different tangents, they take whimsical decisions on the fly. Even with respect to day-to-day operations or lifestyle, we have a lot of complexity, unlike the developed world where most things are automated or pre-set. India doesn’t work as per that clock.

This was the first and the biggest challenge – setting up new and better ideas in India is difficult because everybody questions you due to lack of successful predecessors. Seriously, you have to convince yourself first, then your client and then your other stakeholders that this idea can really work in India.

The next challenge for a new venture is to have and find like-minded people, both from the aptitude and from the passion points of view. It is very important to have the right team. We have been very conscious of building the right partners in our business model, the right teams and the right functional heads. Today, we have a 300-member team and we have various leaders in each function. Like-minded and similarly driven people – from skill set, to vision and the execution point of view.

The third biggest challenge was that being in India tends to give you a false sense of security, that I have a fallback option, my family is here – they can afford it if I have to relinquish my startup and live an ordinary lifestyle. Therefore, to stay away from leaning on our support system, we set up our headquarters in Bangalore and not in Delhi – we set up in a new state and started from ground-up in a new city.

Finally, you need to have that constant drive, to literally question your instinct – day in and day out – ‘am I doing the right thing, am I on the right path?’ But then when you don’t have successful predecessors to guide you, you become your own guide and you become your own positive agent.

How would you classify the different stages of your journey, these three years since having started?

I can divide these years into broadly three stages:

1. Proving the concept, which also encapsulates the team formation (what kind of founding team); are the building-blocks strong enough or not; when you continue to get questioned on proof of concept do you prove that it works?
2. In India there is a slight advantage in proving the concept, in that you can taste some initial success. It gives you confidence that the concept is working with limited stakeholders. This is where you taste initial success;
3. The third stage, where we are right now, is how to scale it up in such a wide and diverse country; scale up consistently and at a pan-India level. How can we work it consistently and where are the levers?

Most of the foreign investment is coming to India chasing the same middle class that comprises of the top 20 to 30%. There is hope that they will become more upper class (30 to 40%) and the remaining 80% will eventually become that 20 to 30% middle class. Everybody is betting on the fact that India as a country has scale, is still growing at 7 to 7.5% average for the last four to five years, it has democracy and the rule of law. The hope is that purchasing power will eventually catch up with the advent of technology and with more globalisation.

In our business model, we also struggled with the same. We were targeted on SME lending. This has its own challenges, so the proof of concept was first to find out whether my solution is cutting across all industry and all segments of SMEs that we are dealing with. Secondly, after tasting some initial success, how can I make my solution more pervasive and more omnipresent? This is what we continue to prove. I think we have clearly emerged as one of the largest online SME lending market places. We are the only company in Fintech which licenses its technology to some of the leading financial institutions who are also suppliers of credit on our platform. Those,
I would say, are the three stages.

What kind of professional support did you receive from chartered accountants or any other professionals? Was it useful and would you like to say something about it?

In the Fintech space, the chartered accountant community has a massive role to play. In fact, in our business model, CAs played a significant role. We have a network of 7,000 influencers who work with us digitally, out of whom 2,000 plus are CA partners.

Our CA helped us incorporate our company in India and also register the patent and a company in Mauritius. He was extremely helpful as we had limited insight about the rules of the game and what regulations would apply. In my view, professional help of CAs is a must for initial infrastructure blocks and regulatory adherence. I believe the CA community has the wherewithal and carries a responsibility to play a much more active role in guiding startups, in nurturing them and also participating in their growth. The advice of a CA does influence when it comes to taking credit decisions in SMEs. It has been a great help from our CA partners network and a big thanks to the whole community.

Some startups are bootstrapped and some go for other funding options. How did funding work in your startup business?

Right from day one we approached the business with the thought that we should not be solely dependent on external funding to make our idea work. We always wanted to use external or equity funding in the business as the growth engine, but not as a proof of concept. In India, people don’t fund you on the basis of the idea; even we had to go through the path where we had to show proof of the concept’s success in the initial stage. We actually ended up scaling at profitable economics which was a great validation that this model in SME lending is a profitable venture.

You need capital to scale it up since you have to deploy a lot of capital expenditure in the business and you are trying and testing out new things, that’s where you actually end up spending most of your equity investment. However, if the fundamentals are strong enough – then if tomorrow there is no funding, your business can run on its own. Our motto was that our business model should be self-sustaining even if tomorrow there is no funding… we should run on our own lends. Funding was for growth.

And it was easy to find the right chemistry with the venture partners and all that?

I think it is not easy because in India still a lot of venture capital people do not have a real-life entrepreneur experience to understand the challenge of running a business. Most of the VCs in India are still boardroom-grown or boardroom-groomed without real-life experience of how to create scale and execute; so when we finalised with NEXUS, although we had three or four more options on the table, the reason we went ahead with them was that they had a global reach; so as and when we want to grow globally, their portfolio has a lot of global companies, which means a better eco-system and a network to leverage and penetrate. Besides, some of the partners had real-life entrepreneur experience so they could connect with the challenges, the execution, the scale and the day-to-day humdrum of the entrepreneur. We can have a much more tactical and strategic discussion and execution-oriented discussion with them rather than just having a talk on, say, this is the GMV or “this is the top ten we have to achieve by… and I don’t care how”.

But to your question – yes, it’s difficult to get the right frequency, to get the right chemistry; we have seen a lot of young entrepreneurs who are just out of college getting to the nitty-gritty of choosing the right venture / investor partners and ending up diluting the whole entrepreneurial instinct. We were lucky because we had prior experience in the corporate world, we could figure out who were the good partners; and then the conviction that we wanted like-minded people as part of the deal.

Having been part of the Fintech space in western countries, how do you see the Fintech landscape in India currently (within which you are operating) and how will it shape up in future?

In my view, Fintech is a global phenomenon which has actually matured into a global juggernaut. It is here to stay; it continues to change and create an impact in the overall financial eco-system globally.

The journey of Fintech in India for the last eight to ten years – Fintech initially starts by solving basic problems like e-commerce or payments solutions that are low value but significantly impactful solutions. This is how it happens in the western world, too. Fintech improves the core infrastructure, digitises it, automates it. The journey typically starts from B2C and then moves towards B2B since that is slightly more complex and more nuanced. Thereafter, you move up the value chain.

At Namaste Credit we are essentially solving the SMEs’ credit-lending problems. It is one of the most complex and heterogeneous spaces given the diversity of SMEs. It is a less disruptive market. We see a two-year trajectory – how Fintech is nurturing and getting into a more complex space and chipping in on edge as of now before becoming a dominant player.

We believe that the next stage is an amalgamation of AI with Fintech. We are very proud to say that we have filed three patents – two of these are an amalgamation of Fintech which is our core engine, and topping it up with artificial intelligence and machine learning. The space we operate in is more up the value chain and more complex, where we are adding the power of artificial intelligence to process the data which is a critical component in SME lending to create more predictive analytics back to the financiers, so that they can lend faster and lend more. From the SMEs’ point of view, it’s accessing the platform that uses artificial intelligence for matching which gives them the highest conversion rate for loan application and funding.

Can you tell us a bit about how the process works on your platform if someone logged into your portal?

For the B2C side, we have the origination engine for SMEs and our network of influencers. They can digitally upload the documents on the platform. Based on this, our credit under-writing engine performs the credit assessments. Afterwards, it goes into the matching algorithm, which has the policy framework of 60 large financial institutions (probable lenders). The matching algorithm closely matches and shows where this SME is most likely to get the loan from and what is the right loan product, given its requirement and credit assessment. By a combination of these two factors – credit assessment and matching – it results in an over 70% conversion rate of applications through our platforms.

The second engine we have built is an automation engine which is built on AI and machine learning, given on license to banks. The issue we are solving is, how can banks take better and faster decisions in credit and SME underwriting? In this we analyse 100 times more data points than the traditional underwriting function at banks. Since we use automation, we are able to process in 90% less time. This is the power of technology and should allow banks to disseminate credit to the SME segment which is due.

Can you explain how do machines work on uploaded documents?

We have trained our OCR to read the scanned documents from different banks. On the analytics engine it fits in the slot so that we can get a highly-qualified credit assessment. Then it gets matched with banks’ policy, which gives a super-optimal outcome. We are solving a discovery problem – that for an SME what is the right product, which is the right bank; and from the banks’ point of view, which is the right SME they should lend to? By bringing technology and by adding layers of advanced data on the core engine, we are able to make it much more intelligent. We rely less on user input data and more on credible and verified information like bank statements, financial statements, GST returns, etc., on the basis of which banks can take a credit call.

Do you feel that there is some missing link in the SME lending space? Is there a missing ‘good to have’ enabler for lending to meet its logical end?

I think in India we have somehow not been able to bridge or build a deep credit market. Whatever little credit market we have has literally been accessed by corporates. For SMEs there is still no secondary market. Due to this, banks are very selective in SME lending because they know that regulation is not hard enough for them to go after the SMEs, so they (the banks) would rather have a proven and conservative credit policy before they lend.

Imagine a scenario where you have the data being readily shared amongst the banks. Secondly, you also have a much more vibrant and deeper secondary market where you can actually float your own assets much more freely than what happens today where you have to securitise almost your entire portfolio with some other party. Securitisation is a much more illiquid form of secondary market. Imagine you have a very deep secondary market, a very clear and transparent data flow amongst the banks (not just the CIBIL score – which accounts for a tenth of the component), you still have a 90% component which is not shared amongst the banks. It allows each of the lenders to (a) risk-price the SME better, and (b) be able to freely trade or lend to the SME based on the risk-based pricing that each lender comes up with. Today, everything is an island. No data-sharing or exchange or performance data-sharing. Due to this the deserving SME gets marginalised.

For someone who is thinking of starting on their own, what are some of the lessons that you would like to share?

For any entrepreneur, it’s very important that they pick up a problem to solve that has a meaningful impact. We do come across lots of ideas but are all the ideas solving the real problems of people? That’s the first and foremost decision you need to arrive at before turning an idea into a business. Once you cross this hump, you need to put all your might and ingenious approach to make sure that your idea succeeds.

India is still a tough market to operate in, it has its own legacy issues and it has a high cost of running business. Although we hear a lot about venture capital funding in India, no one is giving funding on the basis of ideas. This is in contrast with the developed world where you can raise decent money for a solid idea. In India, despite having a good idea you need to really prove execution and you need to show some scale for anybody to trust you with funding.