US-based startup accelerator Y Combinator’s (YC) decision to ‘flip’ Indian startups into American entities for the purpose of funding is facing backlash from early-stage investors and founders alike. Startups set up in India but selected for Y Combinator’s 2019 and 2020 batches are mandated to shift their headquarters to the US, which essentially ‘flips’ their Indian identity and make them wholly-owned subsidiaries of the US-based accelerator, Inc42 has learnt from founders and early-stage investors who have invested in YC-selected startups.
Several early-stage investors with whom Inc42 had spoken, raised concerns over the shifting of startup headquarters from India to the US, which would increase administrative and legal costs. This could have been avoided had Y Combinator directly invested in the Indian entities.
Rajesh Sawhney, the founder of GSF Accelerator, took to Twitter, saying that the flipping of headquarters “creates so much of extra work for founders and early Indian investors who backed the company (before it went to YC)”.
“They like the Indian market and talent, but not Indian laws… The Indian government should take the talk (have a conversation) with them,” Sawhney added in his Tweet. He, however, did not respond to Inc42 when requested for comment on the current scenario.
Why does YC need to force Indian companies to flip to US structure?
This flipping creates so much of extra work for founders & early Indian investors who backed the company.
They like the Indian market & talent, but not Indian laws.
Indian Govt should take a talk with them.
— Rajesh Sawhney (@rajeshsawhney) December 3, 2020
Sanjeev Bikhchandani, executive vice chairman of the digital behemoth Info Edge that owns Naukri, Jeevansaathi, Shiksha and 99acres (the holding company is currently listed on the New York Stock Exchange), said on Twitter that Y Combinator’s demand of flipping India-incorporated startups to the US is an “institutionalised transfer of wealth”. He also likened the flipping of headquarters to the exploitation of Indian intellectual property (IP), where YC gets to gain from the IPs developed by Indian founders.
“So you have a bunch of foreign investors who tell our best young startups that they will invest in their companies provided they shift their company domicile overseas. The reason being that they do not want to be subject to Indian laws, taxes and government rules except to the minimum extent required (because) they say they do not trust the Indian government and the legal system. So the ownership of the startup, the intellectual property (IP) and data all shift overseas. However, other operations continue as before; they build their products in India as before using Indian manpower; they sell to customers in India as before,” Bikhchandani told Inc42 in an emailed response.
While some of these concerns seem to paint a grim picture of an alleged brain drain of Indian entrepreneurship, the reality is that India’s incorporation and taxation laws have not been exactly friendly to startup investors and founders, especially to those in the early-stage ecosystem.
There are plenty of examples. When the coronavirus pandemic hit India in March this year, the “angel tax, which is levied on non-listed companies (such as startups), made a comeback, even after the Indian government had abolished the controversial tax on paper.
Besides, the ESOP tax, which puts the burden of double taxation on startup employees holding equity shares, was supposed to be abolished after Finance Minister Nirmala Sitharaman addressed the issue in this year’s Budget presentation. But the burden of double taxation continues to plague Indian startup founders and employees, as only a few government-recognised startups can claim tax reliefs.
Although Indian taxation laws may seem unfavourable to investors and founders, many early-stage backers are far from happy about Y Combinator’s recent mandate to Indian founders on headquarters shifting. According to Kushal Bhagia, chief executive of early-stage fund Firstcheque.vc, early backers of those startups will face huge legal challenges when the companies in question get restructured.
So, what will be the most pressing issues?
The ‘Flip’ Process Explained
First of all, the Indian entity in question would have to be reclassified as a wholly-owned subsidiary of the foreign entity, and it would have huge administrative and legal implications for existing investors or shareholders of that startup.
“After creating the US company, the founders and current investors (who have put their money into the Indian entity) would have to be ‘gifted’ some shares of this new U.S. entity for a nominal amount. Next, the US entity (of the startup) will have to open an Indian subsidiary that will carry out all essential operations like hiring employees or building products. Interestingly, the U.S. company will own the IP (intellectual property) and the brand, and will have a service agreement with the Indian subsidiary through which it will pay for the cost of operations with the money raised outside India,” explained Bhagia.
Another early-stage investor from a prominent venture capital fund told Inc42 how it panned out when his portfolio company was selected for Y Combinator backing. His lawyers suggested shutting down the Indian entity into which he held shares and shifting those to a new Indian entity. This had to be done to cut down on legal and regulatory costs arising for early investors as the existing Indian entity was already earning revenue from its operations, and had a predefined shareholding structure in place.
“Replicating the existing capitalisation table in the main parent company in the US after the flipping requires a lot of paperwork. At times, when the Indian entity already has some revenue operations in India, there are certain challenges if you suddenly classify it as a subsidiary,” adds the investor quoted above, asking not to be named.
According to Bhagia of Firstcheque.vc, the previous (Indian) company where Indian investors held shares will have to be shut down due to the flipping of headquarters from India to the US.
“All India-registered alternative investment funds (AIFs), which have invested in that startup, will have to apply to the Securities and Exchange Board of India (SEBI) for approval before they can invest even a token amount in the US company. And the whole thing will take months,” he added.
Bhagia, however, pointed out that many Indian founders choose to incorporate their companies in the US or Singapore due to several advantages, including the ease of fundraising from foreign investors and the ease of doing business with foreign clients.
“Companies selling (products and services) to enterprises abroad have an advantage if they are registered in the US as enterprise customers prefer working with U.S. firms,” he added.
Rahul Mathur, the founder of the insure-tech startup BimaPe, told Inc42 he had voluntarily registered his startup’s parent entity in Delaware, US, especially after his first round of fundraising was pledged by a foreign investor. It made things easier for him to allocate the funds into his startup. Before the external fundraise, Mathur had registered his startup in Mumbai, which is now a wholly-owned subsidiary of the Delaware entity.
“We do transfer pricing for whatever payments we need to make (salaries, vendors’ payments and so on). We have an Indian lawyer for the Indian company and a foreign lawyer for the Delaware corporation. However, we expect the subsidiary firm in India to get an insurance brokerage licence in the future,” said Mathur.
Transfer pricing refers to the price (tax) which is paid when capital goods or services need to be transferred from one unit of an organisation to another unit located outside the geography of the parent company. These taxes have to be paid every time there is a movement of capital or payments have to be made to vendors outside the parent entity.
Some investors, however, point out that transfer pricing does not ensure that the IPs created by the Indian founders will be utilised in India technically.
“Whether you raise money in the US or Singapore, your employees (expenses) are going to be registered in India, which essentially means the Indian entity is going to be your offshore development company. It is almost as if your IP now belongs to a US company, and India just becomes an offshore development centre. But ideally, the Indian entity should be holding the IP, as well as the revenue, from product and service sales,” said the VC quoted earlier in the article.
Bikhchandani of Info Edge also told Inc42 flipping headquarters of an Indian startup to a foreign nation is the “act of externalising a company” where the startup has to transfer ownership of all its shares to an overseas company that has only been set up to move shares around. If such flipping takes place on a massive scale, the country might end up with a situation where the startups, the investors, the IP and the data are all domiciled overseas with little accountability to Indian regulators, he added.
“If 500 of our best startups have shifted overseas and 2% of those become as successful as Naukri and half of that (2%) become as successful as Infosys, we are talking about a future loss of more than INR 17 Lakh Cr in market cap at current prices. These companies will operate in India and access the market. However, they will not be Indian companies. A domicile shift and transfer of IP and data to an overseas company is a permanent loss. As a company grows, so does this loss. Remember that HCL and Infosys were startups in the early ’80s. Imagine what would have happened if they had flipped overseas when they were young. This is a matter of strategic significance for India,” says Bikhchandani.