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The true cost of investing in Startups for retail investors


India has over 61,400 startups recognized by the Department for Promotion of Industry and Internal Trade (DPIIT), with at least 14,000 recognized during FY22. India has become the third-largest startup ecosystem in the world after the US and China, it said. A record 44 Indian startups achieved unicorn status in 2021, taking the overall tally of startup unicorns in India to 101 in 2022, with most in the services sector. Indian Startups have raised $14.3 Billion in the first four months of 2022. All this investment privilege is available to HNIs, UHNIs, and Financial Institution. However, there are some investment platforms wherein retail investors can invest in startups and participate in their growth story. In this article, we will see the real cost of investing through such platforms.


Investment Instruments offered by such platforms


Startup raises funds through funding rounds wherein Venture Capitalists (VCs), Ultra High Net Worth Individuals (UHNIs) invest money in the company and receive Equity Shares, CCPS, CCD, or NCD. As and when the value of the startup increases the value of these instruments also increases. Various online platforms allow retail investors to invest in the company via such options; however, CSOP (Community Stock Option Plan) is the most common option. The same has been explained below.


What is CSOP?


Community Stock Option Pool is similar to ESOP (Employee Stock Option Plan). ESOP is a pool of shares that is exclusively reserved for current and future employees of the company, similarly, CSOP reserves the shares for the general people of the community. CSOP has similar financial rights as equity shares but no voting rights. Hence, as and when the value of the company increases, the value of CSOP also increases.


CSOP at a later stage gets converted into equity shares. However, there is also an option available with the company to purchase back the CSOP from respective holders at the Fair Market Value. The latter option is generally preferred by the company listed on such platforms.


Charges of such platforms


The charges of each platform vary. However, it is generally 2% of the amount invested at the time of investment and over and above that 2% of sale consideration.


Pros of investing in startups


  • The investor can start their startup investment journey with as low as Rs.5,000/-

  • Startup is a high-risk high-reward game. Hence, if the startup is successful, the investor can make multifold returns (higher than any other investment avenue).

  • Investing in startups can further diversify your portfolio wherein one can invest in upcoming future tech companies.

  • Platforms conduct various sessions between founders of the company and prospective investors wherein any question related to the company can be discussed.

Cons of investing in startups


  • Listed companies are obliged to provide comprehensive financial statements on the exchange through which investors can carry out due diligence. However, these platforms only provide the company’s statutory documents such as Memorandum of Association (MoA), Articles of Association (AoA), and Certificate of Incorporation. Along with such documents, the company provides a pitch deck; however, the financials mentioned in it are not certified by any independent accountant. The investor can only get paid information about financials after it files statements on Ministry of Corporate Affairs (MCA) which creates a lag in information transfer.

  • The platform doesn’t undertake any check for the authenticity of the valuation which can be skewed by the company. In case of any doubt in valuation, an investor can get a company valuated by an independent valuer which can be a costly affair.

  • Such investments are even subject to Indirect Tax as well as Direct Tax (Taxation has been discussed below).

  • There are relatively high platform fees despite there being no concrete information available.

  • Investors have limited options for liquidating the stock against the high liquidity available on listed equities.

  • As these companies are at the initial stage of operations, they either run into losses or recapitalize their profits for future expansion limiting the scope of dividend income.

Taxation of CSOP


Treatment under GST


As CSOP is not equity shares hence the amount invested by the investor shall be considered as Subscription revenue of the income and liable for payment of GST. Hence, any amount invested in the company shall be inclusive of GST.


Treatment under Income Tax


If CSOP is converted into equity shares then such gains will be taxable under head Capital Gains. Such gain derived from these shares is required to be categorized as long-term or short-term based on their period of holding (from the date of conversion to equity shares). Accordingly, if such shares are held for more than 2 years, the same would be categorized as long term, otherwise short term. The long-term capital gains from unlisted shares are taxed at 20% u/s 112 of the IT Act after claiming the benefit of indexation whereas the short-term capital gains are applicable slab rate of the investor.


In case CSOP is being purchased back by the company without converting into equity shares, such gains shall be taxable under head Income from Other Sources (IFOS) at the applicable Slab Rate.


We shall understand by way of example

Suppose Mr. A has invested Rs.10,000 into company X against which it has received CSOP.

As the company has raised money in form of CSOP it shall be considered as subscription revenue and GST on the same shall be paid. Thus, Rs.10,000 shall be considered an amount inclusive of GST at 18%. Hence, the net amount invested will be only Rs.8,274 post platform fees of 2%.


Scenario 1) CSOP is converted into equity shares

Post 1-year company raises funds from VC at a valuation of Rs.10.33 crore and the company decides to convert CSOP into equity shares wherein investors shall be given a 20% discount (as a benefit of an early investor) from the valuation of the new investor. Hence, the CSOP will represent a 0.01% holding in the company.


Now if the value of the company increases by 100% in the next 3 years and the investor decides to sell the shares. The value of shares will be Rs.20,247 post platform fees on sale consideration at 2%.

Particulars

Amount (In INR)

Sale consideration

20,660

Less: Platform Fees

413​

Net Sale Consideration

20,247

Less: Indexed Cost of Acquisition (assuming inflation at 5%)

9,579

LTCG on sale of shares

10,668

Tax on sale of shares

2,134

Net consideration post tax

18,113

Post Tax Return (IRR)

22%

Scenario 2) CSOP is purchased back by the company


Post 1-year company raises funds from VC at a valuation of Rs.10.33 crore wherein existing CSOP holders shall be given a 20% discount. Hence, the CSOP will represent a 0.01% holding in the company.


Now post 3 years valuation of the company increases by 100% and the company purchase back all the CSOP at the latest valuation i.e. investor shall receive Rs.20,247 post platform fees of 2%.

Particulars

Amount (In INR)

Sale consideration

20,660

Less: Platform Fees

413

Net Sale Consideration

20,247

Less: Cost of acquisition

8,274

Gain on CSOPs

11,973

Tax on sale of CSOPs (slab rate assumed at 30%)

3,592

Net consideration post tax

16,655

Post Tax Return (IRR)

19%

Most of the startups opt for Scenario 2 as buying back of shares is costly for the company considering tax on buy back of shares as against buying back CSOPs which doesn’t attract any tax at the company level.


Conclusion


Investing in an early-stage startup is a very risky affair, one should do due diligence before investing as the quantum of information available on the platform is very little.


Moreover, due to the levy of indirect tax and high platform fees, return on investment is getting diminished, as seen above, the company’s valuation increased at the rate of 26% CAGR from the date of investment by VC. However, the retail investor only earned a total 19% return on investment.


The investor should only consider investing that amount through such platforms which it can afford to lose, as there are high transaction costs and very little clarity about the company. Rather than investing directly, one good alternative is to invest in such listed entities which invest in early-stage startups such as Info Edge (India) Limited which had invested in Zomato Limited and PB Fintech Limited (Policy Bazar) at an early stage and benefited from respective IPOs.


Disclaimer: Consult your Financial/Tax Advisor before taking any decision/action. This is not an investment advise.


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