Tag Archives: Income Tax

Advisors in Start-ups and Early Stage Companies

India is witnessing a high growth in the number of start-ups in the country and is also amongst the top start-up ecosystems in the world. The government has provided a few benefits to startups as well, through the Startup India Action Plan.

However, only a few of these start-ups actually succeed. It is a treacherous path with a lot of unknowns. An advisor or an advisory board in a start-up might help the early stage companies to atleast know some of those unknowns. Financial investors certainly add value, sometimes domain expertise even. The comfort of speaking with an advisor where they bring in the expert views, advice and sheer experience onto the table is very valuable. As the saying goes, ‘Experience is the best teacher’.

Who are these Advisors and what role do they play?

An advisor is a person who brings in his unique skill sets and expert opinion on the business of the company, operational or otherwise. They are the people ‘who have been there and done that’. They can play a major role, especially if the founders and the team are new to the industry and do not have much experience. There are celebrity advisors even, who by being called as an advisor adds value to the startup.

Advisors can play different roles, for example, advisors who bring in their expertise in a particular domain or area; help with their networks and can introduce potential clients, employees or investors; or scaling up teams; expansion to new geo. It is not just having the advisors but also heeding to their advice. Therefore, advisors need to be chosen very wisely, so that their advice can be relied and executed upon.

How to choose the right Advisor?

Hiring an advisor who does not add much value or provides incorrect advice to the company may turn out to be counter-productive or disastrous. The advisors bringing in complementary skills or “deeper” skills which the founding team has a gap would be great. Identify the areas where the founders lack expertise or sufficient industry knowledge, where they face difficulties or have faced difficulties in the past or any area where they would require expert advice. Once there is clarity on where and why advisors are required, do some research and talk to people who can introduce you to some advisors. Discussing the same with the existing investors (if any) might also be a good idea as they might be able to connect the founders with the relevant people. And since the investors have invested in the company, they would ensure that the advisor will be someone who can add value to the company.

Ensure that they are people with the relevant expertise and knowledge, proven track record, good communication skills, networking skills, etc. Advisors should be individuals who would invest their time for the growth of the company and who can provide support to the founders where there is lack of expertise or knowledge.

Engaging with the advisor

An advisor may be compensated in cash, equity etc. Many a time, the advisor is interested in just giving back to the eco-system. One should evaluate if the advisor has time to provide support to the startup, whether the advisor is associated with other companies which the startup may have conflict / competition.  Maintaining a good rapport, having regular discussions and candid conversations, updating the advisor on a regular basis about the business and other relevant aspects of the business can go a long way. The most important factor is to ensure that there is trust between the parties.

Some startups look for a small investment by the advisors into the company, as a test to ensure that the advisor believes in the idea, startup, founders etc.

Compensation for Advisors

Let us now evaluate some of the ways to compensate advisors for the value-add they bring to the company.

Start-ups, more often than not, compensate advisors by giving a percentage of equity in the company since they may not have the finances to give cash compensation (unless well-funded). New shares can be issued to the advisors or shares can be transferred from the founders. Such issuance or transfer should ideally happen at the face value of the shares since it is a compensation for the services rendered by the advisors and the advisors would not want to pay the full price of the shares. As the same is being issued/transferred at face value instead of the fair market value, tax implications need to be evaluated since any issuance/transfer of shares below the fair market value will fall under the ambit of the Income Tax Act, 1961. Also, the percentage holding of the founders needs to be taken into account so that their shareholding percentage does not get diluted to a large extent considering that there will be future investments, where the shareholding will get diluted further. Another aspect to be considered is that, an issuance of shares will dilute the shareholding of all shareholders (including investors if any) whereas the transfer of shares from founders will dilute only the founders’ shareholding.

Another way of compensating the advisors is by issuing shares to them by way of consideration other than cash under section 62 (1) (c) of the Companies Act, 2013 (“Act”) read with rule 13 of Companies (Shares Capital and Debenture) Rules, 2014. The private placement process under section 42 of the Act will have to be followed for this purpose. The advisors have to raise invoice for the services rendered which will be commensurate with the fair market value of the advisory shares. Company will be responsible for TDS which will be a cash out on the Company. Further, the entire amount shall be taxed in the hands of the Investor as income from other sources, at the applicable tax slab.

Yet another option could be granting phantom stock options (“PSOs”) to the advisors. These are options which are settled by way of cash settlement. It a performance-based incentive plan through which the advisors will be entitled to receive cash payments after a specific period of time or upon reaching a specific target. A separate agreement can be entered into for capturing the details. This is directly linked to the value of the company’s share price. For example, the advisors could have promise of ‘x’ number of shares at ‘y’ price at grant. At exercise, the appreciation in the value of the share price, is handed out as cash incentive. Tax will be applicable at the time of payout. However, unlike employee stock options, which is recognized under the Act, PSOs by private limited companies does not fall under the ambit of the Act and therefore, will be in the nature of contractual right. Please see our previous post on  Phantom Stock Options to know more about this.

It has to be noted that advisors are not eligible for employee stock options (ESOPs) as ESOPs can be given only to employees and directors subject to the restrictions under the Act and relevant Rules.

Advisory shares to Non-Residents:

It becomes a little more complex when the advisor is a non-resident since the shares issued/transferred to a non-resident needs to be in compliance with the pricing guidelines as provided in Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017 (“FDI Regulations“). As per the pricing guidelines, capital instruments which are issued or transferred to a non-resident has to be priced as per any internationally accepted pricing methodology for valuation on an arm’s length basis duly certified by a chartered accountant or a SEBI registered merchant banker, in case of an unlisted company. Considering these rules, granting of advisory shares to a non-resident can be a very tricky situation. PSOs may be a better option in this case.

Formal Agreement with Advisors

The engagement with the advisors should be fruitful for the company and help in its growth. It is advisable to enter into a formal agreement with the advisors which captures all important terms regarding the engagement which will be beneficial for both the company and the advisors. This will help in keeping track of the contribution of the advisors and also if in future, any differences arise between the company/founders and the advisors, it will always help to have a formal agreement. The exact role of the advisor and deliverables, vesting schedule, time commitments, compensation, non-compete, confidentiality, exit related provisions, etc. should be captured in such agreements. Specific milestones may also be included in these agreements. Once the milestones are satisfactorily completed, compensation as agreed can be given.

Once the advisors become shareholders in the company, depending on the shareholders’ agreement (if any), the advisor might need to enter into a deed of adherence, so that the rights of the shares are captured.

Author: Paul Albert

 

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Fund raising and valuation: Company can choose the methodology

The recent ruling by the income tax appellate tribunal (“Appellate Tribunal”) of Jaipur dated 12 July 2018 in the case of Rameshwaram Strong Glass Private Limited v ITO has come as a significant relief for tax payers. In this matter, the Appellate Tribunal has held that the income tax laws in India gives an option to the assessee under rule 11UA of the Income Tax Rules, 1962 (“Rules”) to adopt either the break-up value method or the Discounted Free Cash Flow (“DCF”) method for valuation purposes.

Brief facts of the case: Rameshwaram Strong Glass Private Limited (the “Company”) incorporated on 31 January 2011, is a closely held company manufacturing toughened glass. There was no business conducted by the Company from assessment years 2011-2012 to 2013-2014 except for purchase of land. During the assessment year 2013-2014, the Company issued shares at a premium as per the valuation report prepared by a chartered accountant as per the DCF valuation method. The assessing officer (“AO”) claimed that the break-up value method was to be adopted by the Company instead of the DCF method for the purposes of valuation. As per the AO, since the DCF method was adopted instead of the break-up value method, the Company received additional money through the issue of these shares. Also, the AO claimed that the valuation report was incorrect and not justified and the actual premium of the shares should have been lower than what was mentioned in the valuation report. The Company submitted a revised valuation report to the commissioner of income tax, appeals (“First Appellate Authority”) in which a bona-fide error in the earlier report was corrected. The Company also contended that the amount of share premium is a commercial decision which does not require justification under law and the shareholders has the discretion to subscribe to the same. However, the First Appellate Authority directed the Company to prepare the valuation report based on the actual figures and not on estimates. Based on this revised report, the First Appellate Authority held that the earlier valuation report prepared was incorrect, based on imaginary figures and without any basis.

The Company appealed against the order of the First Appellate Authority to the Appellate Tribunal. One of the contentions of the Company was that the Rules allow the Company to choose between the DCF method or the break-up value method. The valuation method adopted by the Company cannot be challenged by the AO as long as it is a recognized method of valuation. Also, the Company contended that the requirement of the tax authority to give valuation report based on the actual figures and then comparing the same with the valuation report prepared through DCF method is not correct since the valuation under DCF method is based on future estimates based on revenue, expenses, investment, etc. The value is derived from the future profitability or cash flows of the Company. Also, since this is a newly formed company, the DCF valuation method had to be used as the capital base of the Company would be very less.

The Appellate Tribunal agreed with the contention of the Company stating that the assessee has the right to choose the method of valuation.  The Rules clearly provide an option to the assesse to follow either the DCF valuation method or the break-up value method. The only condition cast upon an assessee is that the valuation report has to be given by a merchant banker or a chartered accountant using the DCF method who have expertise in valuation of shares and securities. When a particular method of valuation is provided under law and when the assessee has chosen a particular method, directing the assessee to follow a particular method is beyond the powers of the income tax authority. The AO can scrutinize the valuation report if there are arithmetical errors and make necessary adjustments or alterations. However, if the assumptions made in the report are erroneous or contradictory, the authority may call for independent valuer’s report or invite his comments as the AO is not an expert. Also, the First Appellate Authority’s direction to the Company to give the valuation based on actual figures and then comparing such valuation report with that of the earlier report is contrary to the provisions of law since the DCF valuation method is based on future estimates. Therefore, the Appellate Tribunal held that the valuation report prepared by the chartered accountant using the DCF method was proper and the action of the AO and the First Appellate Authority was invalid.

It remains to be seen whether the judgment of the Appellate Tribunal goes up to the Supreme Court. However, as of now, this comes as a relief, in light of the many nuances that we discussed in our earlier post on Early Stage Valuations: Legislative Context and Continuing Saga of Angel Tax.

Note: The Board of Direct Taxes (CBDT) issued a notification on 24 May 2018, whereby the word “or an accountant” from Rule 11UA was omitted. Therefore, if a company is issuing equity shares to resident individuals, merchant banker valuation would be mandatory.

Author: Paul Albert

REMUNERATION TO INDEPENDENT DIRECTOR

The role of Independent Director features prominently in Corporate Governance Codes. In India, the Companies Act 2013 (the Act) and SEBI (Listing Obligations and Disclosure Requirements) Regulations 2015 have completely revamped the country’s corporate governance code.

Corporate governance generally places a fair amount of emphasis on the independence of a Board and the corporate governance models in India have drawn large references from the recommendations of the Cadbury Committee (1992) of the UK and the Sarbanes-Oxley Act of 2002 of the USA.

A director is independent only if the Board affirmatively determines that he or she has no material relationship with the company that adversely affects his or her ability to be independent from management in connection with the performance of duties as a Board member and committee member.  This assessment is fact specific and when assessing the materiality of such relationship, the Board should consider the source of the director’s compensation including any consulting, advisory or other compensatory fees.  This includes consideration of whether the director receives compensation from any person or entity that would impair his ability to make independent judgments about the company’s management decisions.

Please see our recent post on the independence of Independent Directors here.

It is pertinent to note that only listed companies and public companies having a paid-up share capital of ten crore rupees or more or having turnover of one hundred crore rupees or more, or having in aggregate, outstanding loans, debentures, and deposits, exceeding fifty crore rupees have to mandatorily appoint at least two Independent Directors (or such higher number as mentioned specifically under Rule 4 of the Companies (Appointment and Qualification of Directors) Rules 2014]. Private companies are exempted from appointing Independent Directors. However, private companies may appoint them if the Board is of the opinion that there is a requirement of an Independent Director or if any investment agreement mandates such appointment.

Independent Directors devote their valuable time to addressing the strategic issues in the course of the Board and Committee meetings and use their expertise while guiding the management of the Company from time to time. Independent directors, who are truly independent, can be an effective barricade against corporate frauds. However, active oversight and prudent judgment may suffer when remuneration comes into the picture, as it is an important factor which needs consideration. The extent of remunerating Independent Directors determines their retention and motivation to discharge their duties without cloudy judgments.

As per the Companies Act 2013, “remuneration” means any money or its equivalent is given or passed to any person for services rendered by him and includes perquisites as defined under the Income-Tax Act, 1961. Now, let us examine the various remuneration models of Independent Directors in India.

The remuneration of an Independent Director is restricted to the following emoluments:

  1. Sitting Fee: Sitting fee to an Independent Director may be paid for attending meetings of the Board or committees thereof, such sum as may be decided by the Board of directors of and shall not exceed INR 1,00,000 per meeting of the Board or committee thereof.The sitting fee to be paid to Independent Directors shall not be less than the sitting fee payable to other directors.
  2. Commission: The Act allows a company to pay remuneration to its Independent Directors either by way of a monthly payment or a specified percentage of the net profits of the company or a combination of both. Further, it states that where the company has either a managing director or whole-time director or manager, then a maximum of 1% of its net profits can be paid as remuneration to its Independent Directors. In case there is no managing director or whole-time director or manager, then a maximum of 3% of net profit can be paid. Thus, the basis of payment to the Independent Directors is the net profit of the Company. The Company is however not obligated to remunerate its Independent Directors. Hence the Company may pay profit related commission to the Independent Directors with prior approval of the members. Given this, the commission should be profit-linked only and not revenue based. The Act does not eliminate profit-related commission which could create a conflict of interest since the commission is linked to the company’s performance.
  3. Consulting Fee: The remuneration of Independent Directors has been restricted to sitting fees, reimbursement of expenses for participation in the board and other meetings, and profit-related commission. Therefore, it can be noted that Consulting Fee is not allowed to be paid to Independent Directors.
  4. ESOP: The Act and SEBI (Listing Obligations and Disclosure Requirements) Regulations 2015 prohibit the issuance of stock options to Independent Directors, in a bid to address the concern that it might be causing a conflict of interest and will affect their independence. An alternative option could have been to place restrictions either on the total amount of issue of stock options or put a time limit on exercising stock options, rather than having a complete prohibition.
  5. Sweat Equity: The Company may opt to remunerate its Independent Director by way of issuing sweat equity shares. However, such issuance shall be in accordance with the procedure prescribed under the Act. The total percentage of voting power of such independent director together with his relatives shall not exceed more than two percent.
  6. Refund of excess remuneration paid: If the Independent Director draws or receives, directly or indirectly, by way of fee/remuneration any such sums in excess of the limit as prescribed or without the prior sanction, where it is required, such remuneration shall be refunded to the Company within two years or such lesser period as may be allowed by the company and until such sum is refunded, hold it in a trust for the Company. The Company shall not waive the recovery of any sum refundable to it unless approved by the Company by special resolution within two years from the date the sum becomes refundable.

Thus, to sum up, apart from the restriction on stock options, the remuneration of independent directors has been limited to sitting fees, reimbursement of expenses for participation in the board and other committee meetings, profit-related commission, and issuance of sweat equity shares as may be approved by the shareholders.

Additionally, the SEBI (Listing Obligation Disclosure Requirement) Regulation 2015 requires every listed public company to publish its criteria for payment of remuneration to Independent Directors in its Annual Report. Alternatively, this may be published on the company’s website and reference may be drawn thereto in its annual report. Section 197 of the Companies Act, 2013 and Regulation 17(6)(a) of SEBI (Listing Obligation Disclosure Requirement) Regulation 2015 states that the prior approval of the shareholders of the company is required for making payment to its Independent Directors, as recommended by the Board of the Company.

Authors: Ms. Ifla.A (Associate at NovoJuris Legal)