Moving your startup to US / Singapore — a regulatory/legal perspective
Explained with cases [2 of 3 part series]
Overview
In continuation of the earlier medium post, this one captures the essence of how legal and regulatory issues have been haunting startups operating in India, forcing them to move abroad.
First, there is a regulatory framework, which the investors fail to understand. Even if we leave the tax laws (which are going to be discussed in the next post), you have Company law (as part of Securities law) and FEMA (which is under Exchange control regulations) which creates a complex myriad for anyone to pierce into.
Second, we have courts or arbitrations, which fail to conclude in a timeframe. The startups are operating in an environment, where speed is the key. Any decision which ought to take months or years to conclude is not worth the efforts.
Let us start taking the issues one by one
Contracts enforceability
Investors believe shareholder rights are better protected and enforced in a country like the US or Singapore as against that in India in view of not only better judicial machinery but also clarity in understanding of concepts used in VC deals (example — Indian courts have not dealt with rights like anti-dilution and liquidation preference, which in turn forms the foundation of commercial contracts executed with investors)
Even for the execution of commercial contracts with international or Indian parties, the startups with HQ in the US or Singapore are at an advantage for the same reasons as mentioned above (provided the jurisdiction to govern the agreement is in those overseas countries)
Securities & Exchange control laws
For reasons best known to Indian regulators, they are out of sync from reality. While countries across the world are leaving no stone unturned to get the global capital, we are making every effort to stifle it. There is no flexibility in the issuance of instruments like convertible notes as there are multiple conditions required to be complied with. In the end, the startups end with structuring the CN as CCPS or CCDs, but the entire idea of doing the round in the shortest possible time frame gets over.
Structuring of cap tables is complex due to pricing guidelines. A Non-resident cannot acquire shares in an Indian startup (whether by way of primary or secondary) below the FMV (which in turn has to be validated by a Chartered Accountant as per internationally acceptable valuation method). Now, this creates a problem as most of the time, startup founders may need to onboard an investor at a valuation lower than that agreeable for other investors, as the former brings some sweat on the table. In such cases, commercially the round cannot be at different values. So, the only way you can structure it is by issuing advisory equity. Now, this is not possible as the valuation benchmark has to be achieved for issuance of equity to Non-residents.
We have seen this happening even when Indian startups are participating in the programs of various global accelerators like YCombinator, SOSV, and TechCrunch. The startups have to part with their equity for free, against the value these accelerators bring on the table by way of leveraging their connections. But this is not being factored in the regulations, which means leaving the startup with no option but to externalize.
Startups often pilot in markets and sometimes also set up entities for running the operations. In a few cases, the pilot doesn’t work out, which means the startup needs to shut the entity down. The problem is that from the Indian exchange control regulations perspective, the write-off of overseas investments needs RBI approval. As compared to this, had the startup invested directly from the overseas HQ company, the shutting down would have been easy.
Also, under ODI regulations in India, any overseas investment is also required to be on basis of certain valuations to be arrived at by a CA. Also, the net worth requirement triggers in, wherein an Indian company can invest in an overseas entity only if it is having positive net worth, and that too up to a limit of 400%. So on every step, you have a hundred things to sort out while doing business from/in India.
We got stuck in one of the company wherein the burn has eroded the net worth, but the startup wished to setup Ops in US as there was a large contract which came in his lap. Now, it became an impossible thing to setup a subsidiary and since there were investors, we can’t even set it up outside the group. Finally, investors were convinced that the company will be made subsidiary eventually, but right now, it be allowed to get opened by founders in their personal name. However, the commercial reasons prevailed for which we have to disregard the concern coming on back of our head that how this transfer will happen later once US company starts getting cash flows and it’s valuation jumps. The tax will trigger as and when the transfer would have happened.
Collections / Payments internationally an issue
Any collections coming from overseas customers in India have to face bank scrutiny on not only KYC / AML norms, but explaining the purpose of the transaction along with evidence. This makes it virtually impossible for any startup to get payments on a recurring basis from overseas (leave aside the continuous loss on exchange rates and bank fees).
On international payments, the situation is even worse. Apart from KYC / AML filings with evidence, there is a host of other documentation to be filed with a bank which after scrutinizing may ask for other details/questions and then process the transaction meaning, considerable delay in remittances. Imagine for a startup, trying to do multiple payments overseas for certain services. Need a dedicated person, just to co-ordinate with the bank on these fronts. This is also one of the main reasons that if Global Companies are pitching Indian customers, they also face the same issue of delay/complexity in payment systems and thus losing out on leads.
Payment regulations not aligned with Global reality
Indian payment laws are archaic. There have been issues for global payment gateways to work seamlessly in India. For Global PGs to operate in India, it is difficult to get it done in an Indian Company, in turn making a case for setting up an entity abroad.
A digital subscription company in India was to obtain payments from Indian customers. The problem is that for recurring payments, debit card authorizations don’t work above a specified limit as per an RBI circular. Finally, the startup had to set up a company overseas and get the PG implemented over there. Now, the PG is able to get the payments collected from Indian customers on a recurring basis as well.
Listing on International exchanges
Exit by way of listing in overseas stock exchanges is only possible when — (1) overseas structures are set-up; or (2) international listing of Indian companies by ADR / GDR issuance requires an India listing as well. The government has been trying to change the rules now, but no one knows what will be the regulatory framework in the Indian context.
Case in point is MakemyTrip setting a Mauritius HQ Co for listing on NASDAQ in view of Indian regulations creating a problem
Concluding remarks
Above regulatory issues are just sample ones and gives an account of what all is going wrong.
Will discuss the next post on the Tax side of things, while moving HQ overseas.
