Submission: Uniform Pricing Norms for Unlisted Equity

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Submission: Uniform Pricing Norms for Unlisted Equity

Tejasvi

@tejasvi

September 9, 2021

Public Policy

Background:

NASSOCM has submitted suggestions to the Arun Jaitley National Institute of Financial Management (AJNIFM), an autonomous institute of Ministry of Finance (MoF), on the topic of uniform pricing norms for unlisted equity in India. Our submissions highlighted the need for and the challenges faced by early stage companies in getting business valuation. More specifically, our submission covered the following:

Valuation of a company depends on a number of factors such as:

Historic trend of the company;
Growth prospects;
Management experience;
Size of the opportunity;
Market share of the company;
Business cycle;
Macro level changes, Government regulation/policies, etc.

The above factors are difficult to assess for early-stage companies since some may be startups and may be at an ideation stage with no or negative revenues. Even startups that are profitable most likely have short histories and may be dependent on individual investors, venture capital or private equity. Accordingly, the need for valuation of a startup, keeping into consideration a holistic set of parameters, becomes critical.

Applicable Legal provisions for valuation in India:

There are different methods of valuation prescribed under Indian laws:

Income Tax Act, 1961 (IT Act)- As per S. 56(2)(viib) of the IT Act, where a company in which public are not substantially interested, receives any consideration from any resident person for issue of unquoted shares exceeding the face value of such shares, the aggregate consideration received for such shares as exceeds the Fair Market Value (FMV) of the shares is taxed under the head “Income from Other Sources”. The FMV of unquoted equity shares is determined as per Rule 11UA of Income Tax Rules, 1962 (IT Rules) as follows:

Net Asset Value method: or
Discounted Cash Flow (DCF) method as determined by a merchant banker.

Foreign Exchange Management Act (FEMA) - Under Foreign Exchange Management (Transfer or Issue of a Security by a Person Resident Outside India) Regulations, 2017, the Reserve Bank of India (RBI) prescribes use of internationally acceptable pricing methodology for valuing shares for regulating issue of shares to non-residents. The valuation shall be duly certified by a Chartered Accountant or SEBI Registered Category I Merchant Banker.

Companies Act, 2013 - As per S. 247 of the Companies Act, 2013, valuation in respect of shares shall be done by a person having qualifications and experience, registered as a valuer and is a member of a recognised organisation.

Generally Accepted Valuation methodologies

Given below are some of the methodologies that are internationally accepted for valuation of start-ups or early-stage companies:

Discounted Cash Flow;
Net Asset Value;
Berkus Approach;
Cost approach;
Scorecard method;
Venture Capital method;
Risk Factor Summation method;
First Chicago method;
5x Your Raise Method;
Probability weighted expected return method or scenario analysis;
Multiples (Comparable Companies and Comparable Transactions);
Industry Valuation Benchmarks, etc.

All the methods may not be applicable in all cases. Startups at different stages may prefer to use a particular method depending on the factors relevant for them and availability of information.

Challenges in following uniform valuation methodology

The following characteristics of an early-stage company makes it challenging to follow a uniform methodology of valuation:

Limited history - Most start-ups have limited years of operation and therefore, limited information is available regarding its operations, financial activity, track record, management, etc. Valuing such early stage companies is difficult due to lack of clarity of business model, lack of adequate historical revenue and expense trend, leading to uncertainty on the valuation process.
No revenues/ loss making – Majority of startups have very little or no revenue which results in negative Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). As a result, certain methods of valuation based on cash flow projections like DCF are rendered subjective.
Lack of Benchmark - Given the unique nature of business idea, there may be limited comparable companies and transactions available to benchmark performance and value of the startup.
Hidden costs in forecasting - There may be hidden costs associated with start-ups. For e.g. agreement between founders to start drawing salary at an increasing rate on achievement of specific milestones. Such hidden costs need to be accounted for in valuation methodology.

Some other major factors also play an important role in valuation of a start-up, such as, understanding the business idea, understanding the business model, projected/estimated demand of product, marketing risk, management experience, number of outlets/centres etc. Moreover, besides using conventional methods for valuing companies, start-ups valuation may need to be benchmarked in light of additional valuation matrix which are specific to the type of business model, especially in the digital economy. For example, number of subscribers/customers (both free and paid), customer traction on website, number of patents in the name of the company etc.

Recommendation

Given the uniqueness of business ideas/models and lack of precedence while valuing startups, we have highlighted that one fixed method of valuation may not be suitable in every possible situation. The goal in selecting valuation approaches and methods should be to find the most appropriate method under the particular circumstances of the company being evaluated, after considering:

The respective strengths and weaknesses of the possible valuation methods;
The appropriateness of each method in view of the nature of the business and the relevant market;
The availability of reliable information needed to apply the methods;
Where multiple approaches are applicable, a combination of methods can be applied, or primary approach can be cross checked with other methodologies, particularly when there are insufficient factual or observable inputs for a single method to produce a reliable conclusion.

Further, different regulations prescribe different set of qualifications for valuers. The government could consider prescribing a common set of parameters for valuers under different Acts, so as to avoid ambiguity. The company should be given flexibility to choose the valuation methodology as long as the valuation is carried out by a prescribed valuer and adequate justification has been provided.

For more information, or if you have more inputs related to valuation of unlisted equity in India, kindly write to tejasvi@nasscom.in and garima@nasscom.in.

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Tejasvi