Bootstrapping vs Funding – a tax arbitrage

August 7, 2020
Rainmatter

Edited: 1st Feb 2022 after the budget announcement that surcharge on LTCG (Long term capital gain) of unlisted companies to be capped at 15%. Overall LTCG for unlisted companies now drops from 28.5% to 23.92%. 

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 the 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. Say this company earns a profit before tax (PBT) of Rs 100 Cr in FY 2019/20. Say the promoters decide to dividend out the profits. Here are the taxes that will have to be paid:

  • Corporate tax of 25.17%: ~Rs 25 Cr
  • Dividends taxed in hands of the promoter at 35.88% on Rs 75 cr (the highest slab with cess): Rs 26.91 Cr

Total tax = Rs 51.91 Cr

So the money promoters actually receive from the PBT of Rs 100 Cr = Rs 48 Cr. Or a whopping tax of 52% on PBT.

An alternate means for the promoters to take the money out is by selling a small stake in the business.

Assume that the company is growing 50% YoY (Year on year). They value it at say 50 times its pretax profits or Rs 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 (surcharge capped to 15% Post-2022 Union Budget). Assuming the company is 5 years old, the net tax after indexation including surcharge will be 21% of Rs 100 crore or Rs 21 crores.  If this company IPOs, then LTCG including surcharge will be ~12% (10% LTCG + surcharge) or Rs 12 crores. 

That is Rs 21 Cr (unlisted) & Rs 12 Cr (listed) vs 51 Cr (Dividend earning) — a whopping lower tax payout by selling a stake in the business vs taking profits as dividends.

This might not seem a fair comparison because the promoters selling a stake still need to pay corporate tax of 25% on the Rs 100 crore in the above example. But what if they spent all the cash flow on growing fast trying to increase the valuation even further? There won’t be any corporate tax to pay then! 

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, for example, our company A uses the Rs 100 crores of pre-tax profits that weren’t taken out as salary or dividend and spends the money to grow faster than 50% YOY, becoming attractive to a new investor at a higher valuation. An efficient way even for the investor who came in at Rs 5000 crore valuation to generate returns.

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 has changed in a short time. It isn’t just revenue growth anymore—it can also be increasing user counts irrespective of revenue. Users who potentially can be monetised at a later time, but used for calculation of valuations today.

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 the hallmark of capitalism. 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 apart from better liquidity. We had written this post with things to keep in mind when investing in high growth, low/no-profit businesses that are now trading on Indian exchanges. 

Why not do the same at Zerodha?

Quoting from our 2020 anniversary post

If you were to ask me about our journey, I’d say we are most proud of building a large and resilient business that has zero debt, is profitable, and continues to innovate and prioritise customer interest over business growth constantly—a business that can ask itself “growth at what cost?”, helps grow the ecosystem it is in (Rainmatter Fintech) and gives back to society (Rainmatter Foundation).

All of this wouldn’t have been possible without your love and support. We can run our business this way primarily because we were fortunate enough not to have to raise external capital from VCs, PEs, or an IPO, all of which come with the pressure to grow fast at any cost. And this has been possible because we could grow our business to over 8 million customers without having to spend any money on marketing and advertising, relying solely on the word-of-mouth referrals of happy customers. The fact that we are now cited as an example of how one can build a large business while being rooted in first principles is heartening and humbling.

So …

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 arbitrage exist or not is debatable. 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 ensure there are more profitable startups is by not having such a huge tax arbitrage. Otherwise, as they say, money is like a river, it flows where the conditions are conducive to its flow. Companies aggressively spending on growth (apart from the money given back to Apple, FB, Google, etc. in the form of advertising spends which indirectly goes back to the investors funding the growth) will ensure that capital is plowed back into the economy and help the country grow. While those focusing on profits and dividends are going to be resilient and help the economy even if the growth stops for a bit. 

Nithin Kamath

CEO @ Zerodha and partnering startups through Rainmatter to help grow and improve the capital market ecosystem in India. Love playing poker, basketball, and guitar. @Nithin0dha on Twitter. | Personal website: https://nithinkamath.me

43 comments

  1. Sachin says:

    Superb article👍
    Hope Nirmala Sitaraman ji reads it😃

  2. Vishal says:

    Now of the 43cr if take 18% GST on service/good of the promoter, the tax should be ~8 cr. Almost (57+8) i.e 65% goes in taxes. What a realisation!

  3. Satish says:

    Your customers pay Sales tax , GST, STT, stamp duty.
    Your employees pay Income Tax etc
    You pay corporate tax
    Where the hell all this tax money going.

  4. Vinay Upponi says:

    @Nithin,
    Haven’t ever come across a more succinct explanation of this issue. The question that begs to be askedHow does a conventional profit-seeking firm compete with a growth-chasing firm, which has no compunction about making profits and hence has tremendous capacity to outspend unlike the former?

  5. Ajay says:

    You have shed light on something which has been enigma even for people like Kishore Biyani. Not saying that he did not know what Amazon (or Ola/Uber for that matter) was doing and why, just that he never believed in that model. Yet, this investor culture is bound to pick up if liquidity stays. And, this arbitrage-benefit must be reduced. Hopefully by reducing Profit and Dividend taxes drastically. But will any socialist mindset government listen? Tough!

  6. Dhananjay says:

    Hi Nithin,
    Interesting insights on taxation,
    What is if company A have parent company registration in Singapore or other where taxation is more favorable, & child company in India?

    • It is very tough to set up tax structures to avoid taxes unless you are one of those large international tech businesses that have operations around the world.

    • Tushaar Talwar says:

      The income will be taxed anyway as arising or accruing from business in India and taxed at 40% plus cess and surcharges.

      • Shamshul Azam says:

        I dream that there should not be income tax or corporate tax there should be expense tax only for the benefits of country and people as it used to be in the era of Chanakya

        • Ayur Rastogi says:

          Because of the human tendency of saving, everyone will just save the money and spend a little part of that money because of high taxation rates, resulting in a stagnant economy. And it’s not easy for the government to track all the real expenditures.
          PS: Then you will just create a subsidiary and transfer funds as salaries (employees will not be taxed) and then you will make the subsidiary NPA and then BOOM you saved tax.

  7. Sumeet says:

    This article provides a great insight to the tax structure and modern business valuation.

    The question is when the business cycle matures and there is little growth left, how the valuations are going to affect then and what about the investors who invested at the those times when the business is just about to mature.

    • As the growth drops, so does the valuation. Such businesses start getting valued more like traditional businesses. Investors jumping in late typically end up seeing lesser ROI, but the margin of safety is higher with mature companies.

  8. Romesh S A Sankhe says:

    Hello Mr. Kamath,

    Well articulated & thank you for sharing your perspective.

    Tax arbritrage on dividends may not be a primary factor for Startups at all the times. Tax on dividends can be mitigated by Salary to Promoters which will give deduction to Company & tax in the hands of Promoter resulting into marginal net tax impact. Later Prometers can sale their stake (or buyback) & be taxed as Capital Gains like investors.

    Startups who are capital intensive or having longer gestation period due to initial losses needs cost free capital (vs interest bearing loan) hence they are forced to opt for Capital because most people may not pour in all their owner capital on a busienss idea (including of their own) due to uncertainty.

    Tax rates in India nowadays are reasonable however most of the Startup Promoters ignores (or miss) the effective Entity & Transaction structuring (including IP ownership planning) in initial stages & hence faces difficulties later when Company grows exponentially/rapidly.

    Also with recent changes of taxability of dividends in the hands of shareholders (which was earlier exempt), more listed companies in India may choose not to declare dividends like in USA, etc.

    P.S. Tax is on income & it’s a certainty as well as our responsibility towards Source Nation, however if it’s planned considering the life cycle of entity/transaction then it can be optimally mitigated.

  9. Rajesh patel says:

    Hey, Nithin Bro)
    Wonderful Read!
    Thank’s for sharing wisdom Nuggets .
    Is there any possible way that you can notify/ suggest me books you read ?
    Hopefully you remember me)

  10. Sandeep says:

    Thank you for sharing critical knowledge in simple words .

  11. Srinidhi says:

    Thank you for the article. However, with the abolishing of Dividend Distribution Tax for corporates now, do you see any change in how the profit is being utilised and hence the valuation?

  12. Rajesh says:

    Very well articulated with examples, It’s the dilemma most startups go through build a profitable business solving real problems, but for most raising money is always taken as a milestone and sign of achievement, when you fail there it ends up a life style business.

  13. Aman Sagar says:

    a freaking 51% worth of taxes, omg, i cannot imagine, this is literally the real pain in the ass, paying 50% to govt straightaway, i can’t imagine, it’s suicide

  14. Parag Saraiya says:

    Nithin

    Traditionally Indian banks (PSU) while assessing proposals for loans to companies, used to evaluate tax paid (hence insistence on ITR of last many years) and hence many businesses were advised by their consultants to show certain level of profit and pay income taxes so that they remain eligible to get loans From SBI or Canara Bank etc. Same goes for individuals. Banks typically have limited way of assessing growth of companies, RATHER they shy away from using that metric to derisk their lending. hence they lent to historically successful companies(profits, assets) and saw their money disappear in many cases.

    Parag Saraiya

  15. Arun Tankha says:

    Hi Nithin, a beautiful article. I have a couple of points to make:
    1. High growth companies like GOOG, AMZN etc you mentioned haven’t paid dividends (tax efficiency is a part of the reason) but they invested that revenue in business growth. Hence the stock price appreciated.
    2. For Indian startups I wonder how long this dance will last. With out revenue, just forecasting user growth and finding an investor who buys it from you at a higher price has to stop at some time. I wonder if this is the reason why very very few Indian startups made it to public in the last decade. Because ultimately increasing valuations need to be supported by increasing revenue.

    For Indian PE sector, I have come to believe that the game is to find a fooler investor rather than finding a growth business (by growth, I mean growth supported by growing business and revenue). Would love to hear your views on it.

    Thanks
    Arun

  16. Abhishek G. says:

    Loved the article, Nitin. Learnt so much. Feels like I was in a pond!

  17. Rahul Bansal says:

    Nithin,

    Nice article. I am unable to understand the calculation for 17cr.
    In the para “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 would be around 17% or Rs 17 Cr.”
    Can you provide some rough calculations for it?

  18. Abhishek Soni says:

    @Nitin,
    Whereas the coverage is really great, but taking out profits as a salary remains the best option, considering:

    (Taking your latest 100 Cr. Salary payout as an example)

    — Currently, on 100 Cr. company got the tax benefit by way of claiming the expenditure, and Mr. Nitin and team paid tax as salary income at slab rate.

    –In case of dividend, tax would have come to nearly 65% (30% company and 35% Mr. Kamath)

    — For buy back, maximum 25% of capital which can be bought back. And you’re the 100% shareholder.

    Also, for a VC, the end goal would always be to sell stake & earn growth for its partners/firm, its never to earn a certain % ROI, that’s not what the characteristics of that money, allows to do so 🙂

    Looking forward if there are any value additions to it 🙂

  19. MANU GUPTA says:

    Such a wonderful article and beautifully illustrated. Thank you so much for presenting these scenarios.

  20. RAMESH agarwal says:

    INDEED GREAT SURPRISE ON COMMENTS OF KUNAL SHAH.KAMATH,S AE PURELY A PRIVATE FIRM/NOT EVEN CO ., IT IS AN SHINING EXAMPLE AND PROOF ,LUCK IS INDEED GOD BLESS BOON IRRESPECTTIVE OF ONE,S QLAFS. ONE SHOULD ACKNOWLEDGE AND APPRECIATE IT IS KARMA / HENCE NO ONE SHOULD POKE IN PRIVATE AFFAIRS OF SUCH GOD BLESSED FIGURES.

  21. Prabal Basu Roy says:

    Of course a correct premise brought out by Nitin. However the dividend scenario at 51% ( total tax) has the Corporate tax component of 25% too. This 25% Corporate tax needs to be added to the LTCG part of 12% tax adding upto a total of 37% ( 25% + 12% )for the LTCG tax outgo to make it comparable to the dividend option @ 51%.

    Similarly for the unlisted option at 25% tax too we need to add the 25% corporate tax thus ading upto 50%…which is similar to the dividend option at 51% effective tax.

    So the benefit comes from being listed given the favorable ( still ! ) CG dispensation for LTCG

  22. Shashi says:

    Hi @Nithin

    Can this growth chasing tax arbitrage model be seen as a Pyramid Scheme atleast for those internet companies who may become irrelevant due to new tech or goliath like Amazon etc. However, with such capital and expertise, dont investors realize this ?

    As your brother Nikhil said, start-ups are seeing insane valuation and investors would be unable to exit.

    Remember dotcom bust of 2000.

  23. Yash says:

    Nailed it, Animesh!! xD

  24. Farhan says:

    Hi Nithin,

    The entire premise of an article was beautifully constructed. Thank You!!!

    So, when can we expect for Zerodha to come up with an IPO. I believe, Zerodha has enormous competitive advantage among its competitors. When peers are burning cash on advertising & acquiring new customers but here zerodha is improving its bottom line whenever new customer is registering on their platform. Introducing Varisty to derive an organic growth by educating customers in a proper way. Launching Kill switch, tags can only come from those who has deep customer insights and this is indeed a great advantage to have as firm. The list goes on and on.

  25. rahul says:

    didn’t undertand

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