Mounting competition and tapering growth have made investors sceptical.
At a workshop where over two dozen directors from the country’s top companies had gathered, a question by a director, who sat on the board of a start-up, brought everyone alive.
This director was concerned about the valuation mark downs in the start-up space. She wanted to know what her liabilities are as a director of the investee company as typically issue of shares come up for board approval.
“These days, there are even talks about tax implications. Are we supposed to question the valuations?
"Can we be held liable if some minority investor marks it down unilaterally?” She wanted to know.
The question drew in other directors, who came up with various suggestions.
While some felt they were safe as long as there was a third-party valuation report, others said these cannot fully absolve directors of responsibilities.
Over the past few months, the Indian start-up scene has woken up to the reality that valuations can move both ways.
E-commerce giant Flipkart has seen its valuation marked down twice this year by global investors.
Mounting competition and tapering growth are among factors that have made investors sceptical.
These markdowns of the market leader have adversely impacted investor perceptions of other companies.
This reverse move, where so-called unicorns are facing pressure and smaller companies are shutting shop overnight, have set the proverbial cat among the board populace of these new economy firms.
Some directors are also reviewing clauses in the officers’ liability insurance policies their companies have entered. Others are looking at ways to improve internal processes to avoid valuations overstretching prematurely and minimise risks.
To insulate directors from liabilities, companies subscribe to directors and officers liability insurance against any loss the organisation may incur, on account of mistaken actions.
While a start-up is liable to pay any tax arising out of change in valuations, the company can potentially get into negative net-worth territory, triggering liabilities for directors, says Alok Mittal, an angel investor and entrepreneur.
Mittal said directors on the boards of start-ups are concerned by the developments as valuation reports are approved by them.
“It is the obligation of directors to validate valuations,” he added.
Mittal said there have to be safeguards against money laundering and related party transactions, while looking at capital-raising by start-ups.
“But, it is fundamentally wrong to tax any capital raised by start-ups. Any fluctuation in valuation is part of business.”
Experts say technically, directors are liable for any tax claims in a private company, such as a start-up.
Any value above fair market value can attract attention of tax officials.
However, directors can escape such claims if they are able to establish that the liability did not arise due to negligence.
“Directors have to show they had undertaken appropriate due-diligence in the matter.
"If there was any stretching of valuation, the onus is on them to prove they were not part of the decision or even aware of the matter,” says Sanjay Khan Nagra, senior associate at Khaitan & Co.
A tax lawyer, who advises start-ups, says the issue is more pronounced in start-ups raising funds from domestic angel investors.
Many such firms are facing the prospect of a call from the taxman, seeking more information on how they arrive at their valuations.
This follows rounds where start-ups were valued at a lower level than previously.
The contention of tax officials has been that excess premium, more than fair value, is deemed to have been paid in the earlier round.
This is treated as deemed income of the start-up and taxed accordingly.
All this has increased the premium on due-diligence practices followed by directors.
Arun Duggal, an independent director on listed firms such as ITC, said, “Directors on such ventures should insist on basic sound business fundamentals.
"Build a sound business with clear path to profitability, efficiency and cost control, deliver unique value to the customer, fund growth from internal cash generation and not from repeated external capital infusion.”
Duggal also says directors should insist on an exit plan.
“You need to watch the remains on the run way carefully and have a worst case plan to wind down with least pain to employees and customers.
"Directors should focus on the Founding Team and try to hold it together through ups and downs. Directors and founders should never give personal guarantees for borrowings.
To protect themselves from scrutiny directors could get an independent valuation done through a third-party.
“Directors must be seen to be proactive, rather than reactive,” says Nagra.
