Tag Archives: Valuation of Securities

Valuation of shares: Choosing the Valuer

Valuation in early stage companies should be market driven, as in, there is an investor willing to invest and a company which is primed to grow. The discussion between them should be the guiding factor.

However, this point is highly regulated and the valuation has to be proven to the satisfaction of the tax officers. Such discretionary powers are causing heart-burn.

Due to the many changes, there is confusion of which valuation method to use, who to take the valuation certificate from, etc.

Prior to October 2017, any practising chartered accountant having an experience for more than 10 years or a merchant banker, was recognised to determine the valuation of the shares.

On 18 October 2017, the Ministry of Corporate Affairs (MCA) mandated that the valuation report has to be obtained from a Registered Valuer[1] in certain cases. This entailed that any company issuing securities under section 42 or section 62(1) (c) of the Companies Act 2013 (the Act), would require the valuation report from Registered Valuer, who is registered with the Insolvency and Bankruptcy Board of India as per Companies (Registered Valuers and Valuation) Rules, 2017 (“Registered Valuer Rules).

However, in terms of Rule 11 of the Registered Valuer Rules, there was a transitional arrangement until 31 January 2019, to get a valuation report from a practising CA with 10 years experience.

In addition to these requirements and conditions, the Central Board of Direct Taxes (CBDT) on 24 May 2018 amended the Rule 11 UA of Income Tax Rules, 1962, by omitting the words “or an accountant” from rule 11UA (2)(b). This change meant that the valuation report has to be obtained only from a merchant banker.

Now comes the difficulty with compliance. Compliance under section 42 of the Act and Rule 11 UA is difficult, since there are very few merchant bankers, who are Registered Valuers too.

As a result, many investors ask the companies to get valuation certificates from all the different valuers.

Scenario 1: Requirement of valuation certificate from both Merchant Banker and Registered Valuer

Any company which is not a start-up India registered[2] and issuing equity shares/preference shares to persons who are residents in India (excluding SEBI registered funds) and such issuance is under Private Placement basis. As this issuance entails compliance under section 42, 62(1) (c) of the Act and section 56(2) of the Income Tax Act 1961, the valuation report from both merchant banker and registered valuer is mandatory.

Scenario 2: Requirement of valuation certificate only from Merchant Banker.

Any company which is not a start-up India registered and issuing equity shares/preference shares as rights issue under section 62(1) (a) (Rights Issue) of the Act either to persons residents in India or persons residents outside India, then valuation report from merchant banker is sufficient.

Scenario 3: Requirement of valuation certificate only from Registered Valuer

Under the following circumstances, the valuation report from Registered Valuer is sufficient:

(a) Any company which is not a start-up India registered and issuing debentures on private placement basis in terms of section 42, 62(1) (c) of the Act;

(b) Any company which is a start-up India registered and issuing equity shares /preference shares/ debentures;[3]

To present this as a checklist:

Type of Company Scenarios Valuation Report Requirement
Merchant Banker & Registered Valuer Only Merchant Banker Only Registered Valuer who is a Chartered Accountant
Start-up India registered Company (see point below) Issuance of Equity Shares/Preference Shares (Private Placement Basis) X X Yes
Issuance of Equity Shares/Preference Shares (Rights Issue) X

 

X Yes
Issuance of Debentures X X Yes
Other Companies Issuance of Equity Shares/Preference Shares (Private Placement Basis) Yes X X
Issuance of Equity Shares/Preference Shares (Rights Issue) X Yes X
Issuance of Debentures X X Yes

 There are several open points.

Question on applicability of section 56(2)(x)

An open point on valuation report from merchant banker in case of issuance of shares by start-up India registered companies, still requires clarification. This is because, section 56(2)(x) of the Income Tax Act, 1961 mandates to a person who receives shares from a company to get the valuation report from a merchant banker. While the start-up company is exempted only under section 56(2)(viib), receipt of such shares by a person is not exempted. This point still requires clarification from CBDT.

Other open questions:

While it seems that the requirement of valuation report is clear under various enactments, there is still ambiguity in terms of say: (a) whom to approach in case of a person who received shares from Startup India registered company; (b) how to deal when there is difference in fair market value arrived by Registered Valuer and merchant banker. This might require approaching a valuer who is recognised under Companies Act and Income Tax Act, who is both a Registered Valuer and a merchant banker.

Happy to hear your thoughts.

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[1] Registered Valuer means a person registered with the Insolvency and Bankruptcy Board of India in accordance with Registered Valuer Rules.

[2]  Companies registered with Department for Promotion of Industry and Internal Trade as Start-up.

[3] Start-up companies are exempted from section 56(2)(viib) of Income Tax Act 1961 pursuant to notification from CBDT dated 11 April 2018.

Deal structuring with the ‘startup tax’

The Finance Act 2012 brought in an amendment to tax the share premium which is above the fair value of investment by the resident angel investors and not proven satisfactorily to the tax assessing officer.  This amendment is effective 1 April 2013.

The fledgling Indian startup ecosystem has now started to thrive on the early stage investments by the angels, who invest based on startups creating value. Startup tax is anti entrepreneurship.

Many of you came back asking for possible structuring of investment deals for residents.  Before suggesting, here’s the relevant context (boring) but please read, and may be you can come up with some suggestions yourself.

The amendment to section 56 of the Income Tax Act, which is effective from 1 April 2013 provides for the following terms:

–       Consideration for issue of ‘shares’ in a ‘private limited company’ from a person being ‘resident’ in India.

–       Which exceeds face value, (the aggregate consideration received for such shares as exceeds the fair market value of the shares)

–       Fair market value means (i) “a value determined with such method as may be prescribed” or (ii) “as may be substantiated by the company to the satisfaction of the Assessing Officer, based on the value, on the date of issue of shares, of its assets, including intangible assets being goodwill, know-how, patents, copyrights, trademarks, licences, franchises or any other business or commercial rights of similar nature, whichever is high”

–       Amendment to section 68 of the Income Tax Act, requires explanation about the nature and source of money.

This now requires a substantiation of the valuation at which investors invest in the new and smart startups where the product, service, IP is to be proven with revenues. That is quite a task!

When we read the Direct Tax notification on “valuation of shares and securities

The fair market value of unquoted equity shares = (Assets-Liabilities) * (Paid up value of equity shares)/ (paid up equity capital)

Well, not that simple and each of the term has a norm to be followed for calculation.  But you get the idea…

However, the valuation rules for ‘securities other than equity’ is based on ‘price it would fetch if sold in open market’ supported by a valuation report from merchant banker or CA. (This was as per 2010 Direct Tax notification)

The updated Direct Tax notification refers to “the fair market value of the unquoted equity shares determined by a merchant banker or an accountant as per the Discounted Free Cash Flow method.” However, no clarity on valuation for securities other than equity shares is provided for.

Reading through the above requirements, then there are some possible structuring of investments that can be beneficial to the startup and the resident investors.

–       If the investment is from non-resident, NRE, FCNR account, then the startup tax is not applicable.

–       If the investment is from a VC, then the startup tax is not applicable.

–       We could ‘assume’ that if a resident angel investor, co-invests with a VC, then the valuation is somewhat proven. But sources of funds is still be explained to the Income tax authorities.

–       If the investment is in equity shares, then the valuation will be very low.  Then, proving to the satisfaction of the income tax officer will be hard.

–       Securities other than equity shares is valued at fair market value with valuation certificate by a merchant banker or a CA. Compulsorily convertible preference shares (CCPS) and compulsorily convertible debentures (CCD) are construed as ‘equity’ as per RBI norms, but the Direct Tax Circular refers to ‘equity shares’.  So, a possibility is to use CCPS and CCD as an instrument.  Other instruments that can be used are optionally convertible debentures, debentures, redeemable preference shares.

–       If the issuance is at a convertible debt, which converts to equity, then the conversion ratio and conversion price has to be carefully looked at.

–       One of the things to look at, in terms of control (voting), is to have a small number of equity shares (can be less than 10 numbers too) with differential voting rights.

We would love to hear your comments, leave them in the comments section.

DisclaimerThis is not a legal opinion and should not be considered as one.  Please check with your attorney before taking any actions.