Structuring Advisor equity in startups to maximize gain and minimize pain - My experiences

a never-ending saga of tax and regulatory issues in both Indian Cos and Inversion structures — explained with case studies

Overview

Accelerators across the world like SOSV, YCombinator, Techsparks, and their likes work on program wherein they infusion “x” USD against “y”% of the equity in a startup and apart from that take equity for the program separately. Now, the challenge with an Indian startup is how to give equity in the Indian Company, considering regulatory issues which don’t factor the everchanging world.

In another case, an Indian startup got a celebrity from Australia to take equity and help build credentials for the product worldwide. Again the same problem, how can equity be issued to a non-resident without taking any money. Intangibles are something which is beyond imagination for the regulators.

Leave alone the non-resident advisors, Indian advisors (on whom exchange control implications don’t arise) face similar challenges because of not only regulatory issues (Company law) but also the taxation issues (both direct and indirect).

Imagine the complex maze from a lawyer’s perspective and now explaining it to the founder who is non-technical, and that founder in turn telling the advisor that how difficult it is going to be. The advisor finally getting a question in his mind — if this is so difficult entering, how complex it would be to exit (which actually is, and that I am leaving for another time — considering withholding tax issues arising therein and obtaining tax registration numbers in India)

Now that we understand the context of the problem, let’s move forward

Background

Advisors also come on board during the startup journey. Like Employees, they also put in the sweat and are being paid in form of advisory equity. The form of compensation is acceptable worldwide, and the same is being considered akin to when options are being given to employees apart from salaries. Now the question is if the payout is acceptable, how tax and regulatory authorities in India and worldwide, see this. There can be multiple scenarios.

  • I — Indian advisor getting equity in Indian Company
  • II — Overseas advisor getting equity in Indian Company
  • III — Indian advisor getting equity in Overseas Company i.e. inversion structure (US / Singapore)
  • IV — Overseas advisor getting equity in Overseas Company

there are regulatory and tax filings that trigger and companies have gone out of the way in making creative structures around this issuance. Let’s see what the problems are;

India — tax and regulatory issues outline creative structures

Company law issue in India — Indian Company law doesn’t provide for ESOP issuance in case of advisors, it can be issued to only a person who is in the whole-time employment of the company. Now, this blocks the issuance to advisors under an ESOP pool.

Whenever shares are issued, Company law provisions require a valuation to be undertaken by a Registered valuer in case of the private placement. So, the alternate option of doing Rights issue is being adopted (wherein valuation doesn’t trigger) but then that still requires every Equity shareholder to forego it’s right to subscribe to the shares or renouncing in favor of advisor.

You can go through the sweat equity route, but not advisable in view of various tax issues that trigger on the date of equity issuance. Also, there is another problem that no one wants to give equity on Day 1 and everyone looks at issuing equity only when the vesting conditions have complied.

Indian Income Tax issue — Indian Tax implications also trigger when shares are being issued to the advisors. If the advisor is India, so far the options are not vested, nothing triggers. But the moment it converts into shares, not only the fair market value (on date of exercise) becomes business income on the date of exercise of the options. There is no deferment of tax liability even when the liquidity event has not been achieved.

Nevertheless, there is another aspect of the exposure as whether the company also needs to withhold taxes, considering it is making the payment in form of kind to a consultant.

India GST issue — there is another angle of GST implications @18% which becomes a cost if the startup is not able to absorb the same against its output tax arriving on revenues.

FEMA issue — the third problem is exchange control. If an overseas advisor is getting equity free of cost in an Indian company, that is another challenge as the regulations don’t allow free equity to be issued to the non-residents by Indian companies unless consideration equivalent or more then the FMV is being paid by the non-resident. Case studies already discussed in the initial part of the discussion.

Options that are being worked out

  • Phantom options — this means that everything remains contractual. Phantom options are not recognized under company law, but the company can still contract to give the difference between exit price and exercise price, to the advisor on the sale of options/liquidity event.
  • Keep it “Options” till exit — just keep the equity in form of options, don’t convert it till the time liquidity happens. IN that case, it may also happen that the options are being canceled by the acquirer and the option holders/advisors paid off. The flipside is that GST and withholding tax will get triggered as it will be more or like advisory fees being paid. If GST credit is not been borne by the company (which anyways is available for set-off against output tax liability on revenues), this will become a cost for advisors
  • Structuring the share issuance at the early stage of the company in form of investment — Issuing shares today when the book value of the company is low and buying unvested shares later. The only problem is that when a buyout happens if the company has considerable book value, that may need to be factored for the purpose of a buyout. This may become problematic considering that the liquidity and tax issues creep in.
  • Doing it OCPS way — another option is to issue Optionally Convertible Preference shares to the advisor and factoring vesting conditions/schedule in the conversion ratio. So there is no requirement to buy out, but it falls flat when multiple advisors have to issued options with different vesting schedules. In that case, OCPS class has to be kept separate, making the entire thing complex.
  • Inversion structures — this is kind of becoming the norm as Singapore and USA are pretty flexible in issuing the shares to consultants without any consideration and without even triggering any tax or regulatory implications. Globally, the option to advisors can even be issued under the ESOP scheme, as against in India, wherein advisors cannot partake in an ESOP scheme. This is without considering the fact that the advisors are just like employees, who are putting in sweat as against the fee and are participating in the journey of startups.

Final comments

The issues are not only complex but also makes it difficult for founders to legally implement what has been commercially decided. The legal fraternity ideally has multiple issues at hand but is unnecessarily spending time in sorting this out. Even after that, whatever structure has been adopted, the exposure remains. Will continue this journey with subsequent posts on connected issues.

Leading the legal and Transaction advisory practice of the firm with a special focus on funds and startup ecosystem