Tag Archives: externalisation

Externalization: Flipping the holding company outside of India

We have seen a steady increase in the number of companies, especially tech and tech-enabled companies set up their entities outside of India. More often than not, the reasons are better valuations, ability to raise larger investments, large customer base etc. We are also seeing a few companies (so, cannot call it a trend) internalizing and flipping their holding company into India. Strangely, for the same reasons.

Here’s an exclusive interview with Mr. Shailesh Ghorpade, Managing Partner and CIO at Exfinity Venture Partners. Exfinity provides innovation capital and with established connects and ecosystem across India and US, Exfinity focuses on pioneering start-ups that are ready to scale across the global stage. It was nearly an hour-long candid discussion on all things startups, scaling-up, cross border, hiring, issues typically faced by founders while expanding etc. The lucid thinking during the conversation was delightful to witness.

picture Shailesh-Exfinity.jpg

Good morning and thanks Shailesh for taking the time to talk to us on your experiences of working with early-stage founders and their journey of expanding beyond India.

Sharda: You have seen BTB businesses very closely and I have heard you say before that many these entities should be outside of India. Why and what are those factors that a founder should think through before structuring themselves up outside India.

Shailesh: In India, we have given more attention to BTC where the markets, consumers, sellers are in India. However, you would have noticed that in many cases, these companies are not domiciled in India. There are many investors who like the “India story” but there is some anxiety on India domiciled companies. The comfort would be to have a stable tax regime, stable regulatory regime, certainty of repatriating the proceeds during an exit are some of those.

There is a perception that it is difficult to do business in India because of the unpredictable regulatory structure and since business models are evolving faster than regulations, investors are cagey of onerous regulations being promulgated and we do have a reputation for being an over-regulated economy whether we like it or not. That is one part of it. Take the other part of the BTB businesses themselves.

Enterprise businesses don’t get as much attention as they should, though they are working on cutting-edge IP, solving a real problem, capital efficient. There are Indian large corporates who need these products. Unlike a BTC, it is not “a winner takes it all approach”. BTC will need high capital infusion, if it is the distribution game that we see India being attractive for.

However, BTB business find it hard to sell and make money in the Indian market. Indian enterprises don’t value IP or software product as much as they should and they drum-down the prices drastically. It is not about how easy or difficult to sell, but it is about ROI and price points at which the products can be sold elsewhere, especially USA.

Sharda: If it is just about customers, then the startup could have subsidiaries set up in those jurisdictions. But investors do mandate companies to set their holding companies outside of India. You did speak about “not-so-easy-do-do-business-in-India”

Shailesh: There is a greater possibility of getting a Series B, with say more than USD10 million and above, in the USA. Let me explain.

In early stage, the investor is looking at product build, its scalability more than customer revenue. This is where Exfinity and other investors in India invest the early cheque. But these companies have to scale. The larger, deeper organizations which “pay” for these products are based in the USA. So do the Series B investors who can cut a larger cheque. These Series B investors would want to invest in companies domiciled in their country since they understand the compliances, entity structures better. They also have the comfort of the other regulatory issues that I mentioned including certainty of getting the proceeds at exit.

The exit options for BTB companies is primarily trade-sale / M &A for the products. These acquirers are also based in the USA. It is so imperative that the young companies be domiciled in USA.

Sharda: Legal is certainly an issue that the founders would face. Flipping the entity or structuring them outside of India is so nuanced. The easiest part is the entity set up in the USA but the regulatory compliances from the India side is complex and nuanced (In fact, we wrote about it). Apart from the legal aspects, what are the other top 2 issues that you would highlight?

Shailesh: Hiring and Sales. They are inter-related. Let me explain. We have top notch talent in India. Indian entrepreneurs many a time are defining technology. BTB sales is about selling the technology. However, a local sales person, who knows the terrain is highly helpful. Infact, I would recommend a local sales person who can do the same “speak”, perhaps local ethnicity could play a role too in closing the sale. You might be interested to know, that sometimes the conversations veer towards India, while the discussion should be towards the product and sales itself. Hiring local sales person helps in that case.

Indian subsidiary would continue to have the product development, customer support etc.

Sharda: If there is one point you would like to tell the Indian regulators what would that be?

Shailesh: “Keep things simple”

The Government is trying its bit with Startup Fund, reducing the cost of filing IP and the like. But issues such as Angel tax, numerous compliances under Companies Act and so many other legislations are bogging the startup down. I would ask, if the legislations can help the regulator as well as the startups by keeping things simple, therefore the companies can be compliant.


Externalisation: Many Indian Startups are Choosing to have their Holding Entity Outside India

Indian companies have been facing issues in doing business, without any ease. Compliances have become complex and are becoming harder to meet all the compliances though there is full intent in complying with the various laws. While foreign direct investment has been eased, obtaining the registration number for such investment by Reserve Bank of India (RBI) takes quite some time, even though all these filings are now online. Without these registration number, the secondary sale of shares is difficult. Investment by early-stage resident Indian angels is subject to issues of valuation by merchant banker, with prior approval for the proposed investment by the Inter-Ministerial Board of Certification or valuation is proven to the satisfaction of tax officer. Else, there is a possibility that the investment can be taxed as income.

Offshore entities

Many startups have global businesses. Startups that get selected for global accelerator programs are asked to have a holding company, primarily in the USA.

Restrictions on Exit Price (Put Option), under the Foreign Direct Investment Policy, the Indian entities cannot determine or assure the exit price to its non-resident investors. This restriction would impact where the investors require optionality clauses, which allows investors to sell their shares at a predetermined price after a predetermined period.

The new disruptive, technology companies find it easier to find exits such as Initial Public Offer, become attractive targets for acquisition/ merger. It is also believed that there is an inherent premium to valuation in being a non-Indian company.

Running a global business from India is most Indian entrepreneurs dream. However, the above and many other factors are making the Indian promoters to move their holding entity ie., the value-creating entity outside of India.

These and many other factors are the triggers for the promoters to move their holding entity outside of India (“externalize”). The Indian legislations are not easy to comply even during externalization.

Incorporation of an Offshore Entity

Firstly, the Founders are required to incorporate an offshore entity as per the governing law in the host country. The Founders shall also consider the restrictions/compliances under Liberalised Remittance Scheme (LRS) as notified by RBI.

LRS facilitates Indian resident individuals to remit funds abroad for permitted current or capital account transactions or combination of both without prior approval of RBI. While the RBI has relaxed the individuals from seeking approval, it is pertinent to note that the outward remittance towards the share capital of overseas entity is allowed only in case if such entity is an operating entity and not have any step-down subsidiary. Further, LRS does not permit remittance towards incorporation of an entity.

Incorporation of Indian Subsidiary

Should the promoters wish to have a wholly owned subsidiary in India, (assuming there is no LRS), the subsidiary will primarily operate as a cost center, wherein the intellectual property is with the holding company. The employees of the subsidiary are eligible for ESOP of the holding company. The services agreement between the holding and subsidiary company should adhere to the transfer pricing regulations. Every care has to be taken to ensure that there is no round-tripping of funds. 

If an Investment is Raised

If the promoters had raised investment in the Indian entity earlier, then externalizing to ensure that the economic interest of the investors are protected has to be undertaken with care. There are processes such as transfer of shares, swap of shares that can be considered, while ensuring that the valuation of the Indian entity is an important matter to evaluate from tax perspective.

Some of the matters to consider is customer revenue, intellectual property, ESOP granted to employees etc.

The ODI Regulation as prescribed by the RBI is applicable in case of acquisition/transfer of shares of an offshore entity from Person Resident in India to Person Resident outside India[1] or vice versa.

Intellectual Property (IP) Licencing Agreement

If the Indian subsidiary enters into any customer agreements, then it is essential that the Indian subsidiary is appointed as a distributor or reseller or is a licensee of the IP in order to have the rights to sell the products to customers.

Applicability of Place of Effective Management (POEM) under Income Tax Act 1962

For the purpose of identifying the tax incidence, POEM plays a key role. POEM considers amongst other aspects, determination of active business outside India; identifying key persons where management and commercial decisions are taken and determination of place where those decisions are taken; location of the meeting of the Board; location of the head-office of the company and the like. However, POEM is applicable to those companies whose total turnover during the year is more than INR. 50 Crore.

We are witnessing many Indian startups move out of India and it is time that Indian regulators pay attention to actually ease doing business in India.

Author: Ashwin Bhat, Junior Partner

[1] Definition of Person Resident in India and Person Resident outside India is as captured under section 2(v) and 2(w) of the Foreign Exchange Management Act, 1999