We get a lot of credit for bootstrapping Zerodha and building the business without raising professional money. I have always wondered why fewer startups opt to bootstrap instead of raising venture capital, especially in a country like ours, where historically businesses were built using personal capital and debt, and the VC/PE industry is relatively new. What is the reason for such a dramatic and quick shift?
I just finished reading Sapiens: A Brief History of Humankind by Yuval Noah Harari — by far the best book I have read. Thousands of years of history shows us that from the time there was money, human beings have always found ways to acquire it using the path of least resistance and most efficiency. Of course, the world has been flush with liquidity in the last decade and this money has found its way to India due to the growth prospects of our country. This capital has made it easier for entrepreneurs to raise money. But I also think there is a far simpler reason for this dramatic shift. Everyone, from promoters of businesses to professional investors, now chase “growth” and increase valuations to sell their stake in the business instead of trying to earn profits and taking the earnings out through dividends — to save on taxes and earn more efficiently.
Let me explain with an example. Assume company “A” has 5 promoters, each holding a 20% stake in the business. This company earns a profit before tax (PBT) of Rs 100 Cr in FY 2019/20. The promoters decide to dividend out the profits as the business doesn’t really require additional capital. Here are the taxes that will have to be paid:
- Corporate tax of 25%: 25 Cr
- Dividends taxed in hands of the promoter at 34.5% (highest slab with cess): 26 Cr
Total tax = Rs 51 Cr
So the money promoters actually receive from the PBT of Rs 100 crores = Rs 49Cr. Or a whopping tax of 51% on PBT.
Promoters can also take a salary. In the above example, it would be at the highest individual tax slab of ~43% (taxes of 43 Cr).
An alternate means for the promoters to take the money out is described below.
Assume that the company is growing 50% YoY (Year on year). They value it at say 50 times its pretax profits or 5000 Cr and sell a 2% stake to a professional investor. This gain on selling the shares is considered Long Term Capital Gain, which is 20% for unlisted companies before indexation benefit. Assuming the company is 5 years old, the net tax after indexation including surcharge would be around ~25% (with no indexation it is 28% including surcharge) or Rs 25 Cr. If this company IPOs, then LTCG including surcharge will be ~12% (10% LTCG + surcharge) or Rs 12 crores.
That is 25 Cr (unlisted) & 12 Cr (listed) vs 51 Cr (Dividend earning) & 43 Cr (Salary earning) — a whopping lesser tax payout!
The professional investor
The mandate for a professional investor is to earn the maximum returns in the most efficient way possible for the money they manage. Naturally, this investor, like the promoters, now looks for a return on investment (ROI) in terms of selling his or her stake at a higher price to someone else rather than trying to earn from dividends due to the tax inefficiency. Growth is a fatal attraction for all professional investors. So our company A uses the Rs 100 crores of pretax profits and spends the money to grow faster than 50% YOY, not only becoming attractive to a new investor but also avoiding paying corporate tax on this 100 crore profit. Thanks to the excess liquidity in the world economy over the last 10 years, and with professional investors competing with each other chasing companies showing growth, the definition of growth itself have changed in a short time. It isn’t just revenue growth anymore — it can also be user growth. Users who potentially can be monetised at a later time but used for calculation of valuations today.
By the way, this isn’t just a startup phenomenon either. Look for how many of the largest new-age publicly listed tech businesses give out dividends or show profits. The few that do show profits end up saving a lot of taxes by using a complex tax structure generally involving a tax haven. Facebook, Netflix, Google, Tesla, and Amazon haven’t paid out any dividends. But these have been some of the best-performing companies in terms of stock price over the last couple of decades. As an investor, professional or retail, the job is to select stocks that can give you the best ROI. The method to pick a company to invest in today’s world isn’t really Price-to-Earning (PE) ratio, dividend yield, etc. — it’s growth! It doesn’t matter if the company has no revenues or profits or doesn’t give out dividends. As long as the company is able to continue growing fast by redeploying the revenue generated and capital raised, the value of the investment will most likely go up as there will always be another investor willing to pay a premium. For good or bad, this is capitalism at its best. By the way, you probably now also have an idea on why almost every term sheet offered by a VC/PE has a clause around the company going IPO (listed for lowest tax).
Why not do the same at Zerodha?
Firstly, until April 2019, we were a partnership firm. This meant no dividend distribution tax, which is almost like double taxation, to worry about. We have been profitable right from the start, which meant we could take out profits in a tax-efficient way for over 9 years. We converted to a public limited company in 2019 mainly because we had gotten too big to remain as a partnership firm and regulators wanted us to convert. By the way, partners in a firm have unlimited liability as compared to being a director or shareholder in a company where it is limited to the capital in the business. This is also the reason for lesser taxes for a partnership or proprietorship over a company that gets the benefit of limited liability. Also, regulations in India didn’t allow partnership firms to offer the Margin funding (MTF) product for buying stocks with more money than what is present in the account on an overnight basis. Something we intend to launch soon. If not for these reasons, we would have loved to remain a partnership forever, simply because of the much more tax-efficient structure.
A tax arbitrage definitely exists between trying to earn by chasing growth and selling a stake in the business over trying to earn profits and taking out dividends. Should this exist or not is debatable. Since promoters and investors in companies are covered in terms of having a limited liability by the government, it is maybe fair to have additional taxes. But by taxing dividends as high as today, especially since this is quite close to double taxation, people are naturally compelled to find alternate ways to avoid these high taxes. So it doesn’t really help the government earn that tax anyways. The country needs both types of companies, ones that are aggressively spending on growth, and those that focus on profits and dividends. The way to make this happen is by not having such a huge tax arbitrage. Companies aggressively spending on growth will ensure that capital is ploughed back into the economy and help the country grow. While those focusing on profits and dividends are going to be resilient if the growth stops for a bit.