Simplifying Startup Investment - Understand Valuation Norms & Requirements

Introduction

Primary / fresh investment in a startup requires the startup and investor to comply with valuation norms under various regulations like company law, income tax and FEMA from different professionals such as CA, merchant banker and registered valuer. This can get very confusing and therefore to help simplify it, we have provided a concise summary of the necessary valuation report requirements based on the instrument being used and the relevant regulations. Let us dive in to learn Simplifying Startup Investment.

Type of Instrument

Under Companies Act, 2013

Under Income Tax Act, 1961

Under FEMA regulations

Equity Shares

Registered valuer Report

Valuation Report

From Merchant Banker (MB) – calculated using DCF method
From chartered accountant (CA) – calculated using BV method (Rule 11UA)

Valuation report from CA or MB or cost accountant – as per internationally accepted pricing methodology

Preference Shares /CCPS/ CCDs/CNs

Valuation report

from MB -calculated using DCF or BV or any other method.

Notes:

We have assumed that the instruments will be allotted under private placement.
The above table is based on provisions of section 62(1)(c) of companies Act, 2013, Section 56(2)(x), and Section 56(2) (viib) of the income tax Act, 1961 read with relevant rules and Rule 21 of the foreign exchange management (non-debt instruments) rules, 2019.

Conclusion:

It can be intimidating to navigate the complex world of startup funding appraisal. Both founders and investors may set out on this road with more clarity and confidence if they are aware of the important legislation, use the accompanying table as a reference, and consult an expert. It is important to maintain open communication, openness, and meticulous evaluation of all pertinent aspects in order to arrive at a just and long-lasting value that is advantageous to all stakeholders.

Three key regulations govern startup valuations:

Companies Act, 2013: Ensures fair allotment of shares by mandating valuation reports under specific circumstances.
Income Tax Act, 1961: Determines tax implications based on the fair market value of issued instruments.
FEMA regulations: Regulate foreign investment and ensure accurate valuation for capital inflow/outflow.

Navigating the Table:

The provided table offers a concise overview of report requirements based on the instrument used for investment:

Equity Shares:

Under Companies Act: A registered valuer’s report is mandatory, typically using the Discounted Cash Flow (DCF) method provided by a Merchant Banker (MB).
Under Income Tax Act: A valuation report is required, but the method is flexible. Choose either a MB’s DCF report or a Chartered Accountant’s (CA) report using the Book Value (BV) method under Rule 11UA.
Under FEMA: No specific mandate, but consider using internationally accepted pricing methodologies for transparency.

Preference Shares/CCPS/CCDs/CNs:

Under Companies Act: A valuation report is mandatory, with flexibility in choosing the method. Options include DCF, BV, or other methods provided by an MB.
Under Income Tax Act: A valuation report is required, again with flexibility in methodology. Consider reports from CAs, MBs, or cost accountants, ensuring adherence to internationally accepted practices.
Under FEMA: No specific mandate, but consider internationally accepted methodologies for compliance.

While the table provides a structured approach, remember that valuation is an art, not an exact science. Consider these additional factors:

Startup stage and potential: Early-stage ventures might rely more on qualitative factors like growth potential, while established startups might have more concrete financial data for DCF models.
Investor expectations and negotiation: Both founders and investors should have clear expectations and engage in open communication to reach a mutually agreeable valuation.
Transparency and documentation: Maintain detailed records of the valuation process, including chosen methodologies and assumptions, for future reference and compliance purposes.