SEBI, Start-ups & Valuation for IPOs: Part III OF III
Valuation mechanism existing in India
Mr Anuroop Omkar, Partner
Ms Anushree Jugade, Senior Associate
India, particularly, has witnessed a steep rise in the number of start-ups in the past few years. According to a FortuneIndia report, the number of recognised start-ups in India rose significantly from 471 in 2016 to 72,993 in 2022 recording a 15,400% growth as per the data of the Ministry of Commerce. These numbers speak for themselves and it would not be wrong to state that start-ups with their unique selling points (USPs) are the torchbearers in the field of inclusive innovation.
On the flip side, it is important to determine, how many of them survive and reach break even. In the initial days, start-ups are funded by the Founders. However, going forward, there may be no or low inflow of revenue that is not enough to expand or sustain the business. In such times, external financial assistance is required ranging from friends/ family or institutional investors or private investors.
In order to obtain assistance, a valuation of the company has to be undertaken to identify the key value-generating areas of the business. The simplest way to evaluate a company’s value is to subtract liabilities from assets. However, this method might not provide a complete picture of a company’s value and thus, a variety of other ways such as the book value method, discounted cash flows analysis, etc are followed. It is important to note that the law does not prescribe any set process. Thus, as per the industry practices following process is being followed presently.
Steps involved in a Valuation Process
Understanding the purpose of valuation;
Requesting information from the company;
Undertaking financial analysis and uniform adjustments;
Understanding market/sector-specific characteristics and trends;
Evaluating and forecasting the performance of the company;
Determining applicable valuation mechanisms and applying the same; and
Preparing valuation reports on the basis of the analysis undertaken.
With no specific process or mechanism for valuation, there is a major ambiguity when it comes to conducting the valuation of a business in India. Further, with an increased number of start-ups and consequent increases in the investment rounds, the requirement of an exhaustive valuation methodology is stronger than ever and should not remain left to the judgement of a valuer.
Presently, the valuation is undertaken by a valuer with the qualification of a chartered accountant, SEBI registered merchant banker or a registered valuer under the Companies Act, 2013.
Further, the methodology of valuation differs under different laws. For example, under the Income Tax Act, 1961, Rule 11UA prescribes a mechanism for the valuation of company shares in case of transfer; Foreign Exchange Management (Non-Debt Instrument) Rules, 2019 prescribe the pricing to be as per the internationally accepted pricing methodology at arm’s length basis, whereas no specific methodology is prescribed under the Companies Act.
In light of the above, we refer to the various laws prescribing different methodologies and evaluate the most appropriate of them all or whether there is a need for a uniform methodology suited for the valuation of shares.
The Companies Act, 2013
Section 247 of the Companies Act, 2013 holds the provision for valuation by registered valuers.
As per Rule 16 of the Companies (Registered Valuers and Valuation) Rules, 2017, (“Valuation Rules”) the registered valuer shall undertake valuation as per the valuation methodology prescribed by the central government. Kindly note that no such methodology has been prescribed. Thus, as an alternative or in the meantime, the registered valuer shall undertake the valuation as per (i) an internationally accepted valuation methodology; (ii) valuation standards adopted by any valuation professional organisation; or (iii) valuation standards specified by Reserve Bank of India, Securities and Exchange Board of India or any other statutory regulatory body.
Thus, allowing registered valuers the discretion and flexibility to determine the valuation methodology. However, this does not curb the issue of inconsistency and may lead to uncertainty. 2. The Income Tax Act, 1961
As per the Income Tax Act, 1961, the sale/ issue of the shares/ movable shall be at fair market value defined as the value of a property as determined by the marketplace at the time of sale.
Rule 11UA/11UAA of the Income Tax Rules, 1961 prescribes the valuation methodology or formula for the determination of the fair market value. Rule 11UA (2) provides two options for the valuation of unlisted shares i.e., as per the provided formula or by a merchant banker as per the discounted free cash flow method.
3. Foreign Exchange Management Act, 1999
As per Foreign Exchange Management (Non-Debt Instruments) Rules, 2019, the fair value of equity instruments which includes all compulsorily convertible instruments whether debt or equity, shall be determined in accordance with internationally accepted valuation methodologies. This valuation of fair value has to be certified by a chartered accountant or SEBI registered category I merchant banker, where the shares or the capital instrument are not listed on any recognized stock exchange in India.
4. Insolvency and Bankruptcy Code, 2016
Insolvency and Bankruptcy Code (“IBC”) has classified the valuation under the following three asset classes:
● Land and Building Valuation;
● Plant and Machinery Valuation; and
● Securities or Financial Assets Valuation.
Regulation 35 (1)(a) of Insolvency and Bankruptcy Board of India (Insolvency Resolution Process for Corporate Persons) Regulations, 2016 (“CIRP Regulation”), requires the resolution professional to determine the fair value and liquidation value of the assets with the help of a registered valuer.
Regulation 35 of the CIRP Regulation provides that the above two values shall be determined in accordance with internationally accepted valuation standards, after physical verification of the inventory and fixed assets of the corporate debtor.
Fair value is the estimated realizable value of the assets of the corporate debtor as on the insolvency commencement date between a willing buyer and willing seller on arm’s length. Liquidation value is the estimated realisable value of the asset on the date of insolvency commencement date as if the assets were to be liquidated.
Further, it is important to note that this valuation should be acceptable to the stakeholders in a corporate insolvency resolution process such as a committee of creditors, insolvency professionals, financial creditors, operational creditors, etc, or else it can be disputed in any or all adjudication proceedings under the IBC 2016.
Upon perusal of the valuation methodologies mentioned under the statutes above, it is evident that the internationally accepted pricing methodology or discounted cash flow method is a popular and widely accepted method of valuation.
However, it is important to note that even though every statute prescribes a mechanism, no clarification has been prescribed in the case of the application of two or three laws. For example: in case a company wishes to issue shares, the valuation of such shares shall be undertaken using either of the methodologies prescribed under Rule 16 of Valuation Rules. However, if they wish to determine the tax liability, the fair market value shall be as per Rule 11UA of the IT Rules.
In the above-mentioned situation, it will be difficult and wasteful to undertake valuation twice and will lead to unnecessary uncertainty with respect to the validity and applicability of valuation.
With the increased investments in India from abroad, it is important for the central government to prescribe uniform or sector-specific methodology for the valuation of shares considering factors of tax, foreign investment, market practices, company structure, etc.
The way forward- what it looks like:
● The National Institute of Valuers (NIV) was proposed to be established by the Ministry of Corporate Affairs as the regulatory body for the valuation profession as per the recommendations of a Committee of Experts (CoE).
● This CoE was headed by M S Sahoo, chairman of the Insolvency and Bankruptcy Board of India and was commissioned by the MCA to come up with a regulatory framework for the valuation profession last year.
● The said recommendations were part of the Draft Valuers Bill, 2020 which proposed to regulate and develop the profession similar to that of the Institute of Chartered Accountants of India.
The note is prepared for knowledge dissemination and does not constitute legal, financial or commercial advice. AK & Partners or its associates are not responsible for any action taken based on its contents.
Image credits: CB Insights
For further queries or details you may contact:
Mr Anuroop Omkar,
Partner, AK & Partners