The government is aware that the next budget is very crucial from the POV of the country’s economic empowerment – especially when the world is grappling with geo-political tension and inflation. In this regard, one must applaud the government for its proactive initiatives for the startup ecosystem – the driving force of the Indian economy since 2014. However, the pre-requisite for our Hon’ble Finance Minister to determine if she should indeed act on the wish list is to determine whether the industry is deserving enough.
The state of the start-up ecosystem and why the FM needs to pay attention
Until five years ago, experts and commentators had falsely argued for over two decades that India would continue to be reliant on IT services and did not have the DNA for building products and platforms. The other myth that India can never succeed in manufacturing is being put to test in the days to come. More recently, unemployment (commonly understood to mean lack of government jobs) is going to be the bane of our economy. Luckily for India, Indian Entrepreneurs, in general, and startups in particular are critical in debunking these myths and proving that it is India’s decade.
India has over 83,000 startups and currently ranks 3rd in the global startup ecosystem. It has over 100 unicorns on the last count. Indian upstart-ups attracted about $112 bn of investment in the 8 years alone and have directly created millions of jobs in the country. The collective valuation of these startups is upwards of 400b USD. The sector has achieved scale and is a crucial link between growth, innovation, employment, and even exports.
This year the global macroeconomic environment has changed and the higher cost of capital and lower appetite for risk is most likely going to make the journey of startups much tougher. Valuation will correct significantly, and rightly so, several weaker startups will shut down but the underlying technology supercycle coupled with the new-found zeal of entrepreneurship has a long runway ahead and therefore the further expansion of the startup ecosystem is a given if one takes a 10-year view of things.
“Tapping and incentivizing entrepreneurs and investors to participate and drive the growth in these new-age industries is critical”
In addition, with the Make-in-India and Atmanirbhar Bharat programs, India is trying to seed and grow several new industries such as electronics, semiconductors, manufacturing, and renewables. Tapping and incentivizing entrepreneurs and investors to participate and drive the growth in these new-age industries is critical for the success of these programs. Finally, India will continue to have a savings-to-investment deficit for at least the next decade. Attracting global capital flows to participate in our emerging industries and provide an exit to our startups via IPOs and M&A is critical in maintaining the robustness of the startup ecosystem.
There is enough context and case for the potential impact on the economy that the finance minister and her team should consider the wish list from this sector. The finance minister is probably used to endless wish lists of incentives, tax breaks, subsidies, etc. I am going to focus my wish list mostly on capacity building with a few pointers to tax and regulations.
The wish list, therefore, is divided into two parts: 1. Capacity and Capability Building 2. Improving Regulatory and Fiscal Framework
1. Capacity Building
Seeding Entrepreneurship in Emerging Industries: There is a need for the government to set up Fund of Funds for Industry oriented early-stage capital – just like PLI, early-stage funding of funding in some sectors such as space, Agritech, hardware, Industry 4.0, and Energy to promote entrepreneurship and drive new investments in these sectors. The ROI for this is visible globally. Singapore’s Pharma/Biotech R&D and Israel’s defence sector are great good examples of this approach. Similarly, providing seed capital for R&D and IP filing to encourage R&D in our higher institutions and enable commercialization of the IP will help increase its R&D spending as well as increase the number of patents filed (we are currently 1/10th of filings in India and 1/60th that of China). Such an attempt also encourages VC funds to partner with these institutes to drive innovation and R&D.
Continuing on the adage of “data in the new oil” and AI will take over most repetitive work, the government should seed industry-focused Sandboxes in key industries health, Agri-tech, financial services, smart cities, industries and make them available to startups to build their products on. Ensure startup procurement programs in PSUs and incentivize Large Indian corporates to do the same.
Expanding Domestic LP base and widening the Capital Pools: Building LP capacity and capability within the country, and building a larger pool of domestic capital for this sector, is critical for the long terms sustainability of the sector and the ability to capture returns for domestic savers. In this regard, allowing Pension Funds to invest in private equity and venture capital, reduces friction for insurance companies to invest in Venture Capital, particularly for allowing their portfolio companies to internationalize. Similarly aligning the LTCG tax for the resident investor (currently 20%) with that of NRI investors (10%) will incentivize domestic investors to increase their allocation to this asset class.
India restricts investment in AIF to a minimum Ra 1 cr per program. This is designed to protect retail investors. In most jurisdictions including Singapore and US and HK, the protection is enabled by allowing only accredited investors to invest in this asset class (defined usually by income and asset size). This is a better framework and allows investors to invest smaller amounts of capital as long as they are sophisticated enough (accredited).
While we have a robust angel investor base and over 300 incubation networks, we need to deepen and widen pools of capital. Internal regulations in the fund-of-fund program seem to disincentivize the scale for funds. This results in the shortage of domestic players in the later-stage VC space for several years. Allowing Pension funds to participate and increasing the allocation of insurance companies will also result in improving the landscape for domestic later-stage funds.
The government should also consider regulations around crowdfunding and angel funding platforms. There is a need to bring them to international best-in-class levels to enable more transparency as well as permit more avenues for startups to raise money. The government’s own efforts to bring international fund houses to set up in Gift City will also help. This should be accelerated.
2) Building Paths to Exit
The first set of tech IPO has been disappointing, largely because of aggressive valuation and steep market correction. This should not put an end to tech IPOs. It is not prudent to throw the baby with bath water. Tightening regulations for IPO will help in ensuring more alignment of interest between exiting investors, founders and IPO investors.
The government should also provide incentivize investors to participate in MSME listings will help improve the liquidity of the listing of smaller startups. Similarly encouraging domestic institutional investors to participate in this market will also improve liquidity and therefore attractiveness to list on the exchange. The government should rationalize the path to dual listings and encourage domestic exchanges to partner with other exchanges eg Singapore, Tokyo, Canadian exchanges, and Australia to help attract a wider set of investors to invest in mature Indian startups.
Finally, the path to close companies should be shortened since it is inevitable that startups will fail.
Building Talent Pool: Talent is the major raw material along with capital to tap the emerging opportunities. Cost, Availability, and quality of talent have become a constraint for many startups. This problem is likely to get worse in the coming decade. The government has a key role to play in the setup of training institutes or building skill development infrastructure and partnerships in new areas such as manufacturing, agri-tech, drones, IOT, etc. This may take the form of skilling subsidies linked to employment or in setting up infrastructure and providing funds at par with the core sector to encourage the private sector to participate in these programs and increase the capacity and capabilities of the labor market in India.
This also goes a long way in ensuring the competitiveness of emerging sectors and in alleviating the employment challenges in the country.
Improving Fiscal Regimes
Several areas of tax and regulatory rationalization will help improve the competitiveness of the domestic VC and startup industry, attract more investors to invest, and provide a more certain regulatory environment. Some of them include the following:
- Introducing new structures such as Variable Capital Companies in Singapore to provide greater flexibility for fund management companies to set up vehicles at a lower cost. The trust structure which was originally designed to manage wealth has been retrofitted to use as a fund vehicle and does not always meet the requirements of a new-age fund management company
- Enable a regime for innovation in financing to allow for more financial instruments quasi debt and equity to fund social enterprise and startups in sectors that typically don’t attract
- Modify and align regulations to remove the lacunae on GST on carried units and management fees
- Removing practical challenges of having to file advance tax for exits done late in March, which ends up attracting penal interest from investors
The startup ecosystem and the Private capital space in India is an important pillars for India’s growth aspirations in the coming decade. Strengthening the ecosystem and building capacity is an important policy direction for the government. The industry has the potential to become one of the largest and most attractive ecosystems in the world.
(The author is a managing partner at IvyCap Ventures)