A start-up, which essentially is a company in the first stage of its operations, requires a smooth interplay of key factors like access to human capital, capital funding, business infrastructure, product markets, government regulations along with taxation structure. It is relevant to note that the United States (US), which has one of the world’s best ecosystems geared to nurture and support growth of start-ups, is the largest incubator of start-ups globally with over 83,000 registered start-ups. Leading US companies like Apple, Alphabet, Microsoft, Amazon and Facebook which are among the largest public companies by market capitalisation also embarked on their journey not long ago in the form of startup ideas.
Over the past decade, however, Asian countries like China and India with over 10,000 start-ups each have taken significant strides to help transform their entire startup ecosystem. The US, China and India enjoy the natural advantage of having a diversified pool of human capital i.e. entrepreneurs and a skilled workforce. A sizeable population across these geographies also provides access to a deeper and exhaustive product market. Across these countries, with a sizeable startup base, a concerted effort has been undertaken to simplify existing rules and regulations further and provide wider access to capital.
Leading startup countries globally
Source: Grant Thornton, Assocham India
Capital funding in US – Where start-ups thrive and flourish
In terms of capital funding, in 2004-17, venture capital firms cumulatively invested $644 billion on funding start-ups in the US. Comparatively, the total money raised from IPOs during the same period was $560 billion. This is indicative of the fact that the startup ecosystem is larger than generally expected. Thus, while the absolute startup funding may look sizeable, to put things in perspective, compared to US GDP in 2017, the cumulative amount translates to ~3%.
The US continues to successfully provide investments and timely exits, to both talented entrepreneurs as well as investors in the country. In 2017, over 8,000 venture-backed early stage companies received $85 billion in funding. This represents the highest annual total since 2000. Unicorns (i.e. venture-backed companies valued at $1 billion+) attracted a record $19 billion, translating to ~22% of total capital funding in 2017. Large unicorns (twenty one) gave exits to some of their early investors through IPO (fourteen) and M&A (seven).
Value of money raised through IPO vs. VC funded start-ups
Source: NVCA 2018
Incentivised taxation structure for start-ups in US
To promote early stage companies to invest in research and development (R&D) projects, the US Internal Revenue Service (IRS) provides tax sops through a programme called Federal R&D tax credit. Apart from the IRS programme, many local states offer a tax exemption for start-ups. In New York, a Start-upNY initiative is designed to provide 10 years of tax-free business, enabling setting up one’s business at a minimal cost. On its part, the federal government also provides several tax benefits for start-ups, on the whole. Not only are start-ups offered tax credit and tax exemptions but they are also provided easier access to funding along with partnership with bigger businesses.
Regulatory reforms – Key enabler for development of start-ups in US
There has been a significant regulatory reform even in the US on the employee equity awards front to retain and reward great talent in a startup. In December-2017, the taxation code was overhauled and passed in the US. Eligible employees of private companies were given an option to pick or defer for up to five years the recognition of income from private company stock acquired due to the exercise of a stock option. Employees faced a tough challenge since the startup was not yet public and could not sell their shares for cash to pay taxes. Now, employees of private companies will be able to defer those taxes for up to five years. To qualify for the tax break, companies must provide stock options to at least 80% of their workforce. This prerequisite would induce start-ups to widely incentivise their wealth across the firm.
Accommodative listing requirement for global firms on NASDAQ
Early stage companies i.e. start-ups in the US have access to an all-encompassing ecosystem to sustain them. Even on the listing front, constraints such as lack of profitability during early stages of a company lifecycle, the need to raise capital subsequently, etc, are addressed by the NASDAQ exchange as it offers slightly lenient listing regulations. Each company must comply with the main rules for all companies as well as at least one of the four standard requirements below.
Alibaba and Baidu are some noteworthy Chinese start-ups listed on the NASDAQ while Rediff and MakeMyTrip are some of the Indian start-ups listed on the NASDAQ due to overall benefits derived from listing in the US.
Listing conundrum for start-ups – China shows the way
Over the past decade, internet technology firms have become dominant players across industries. The untapped potential of the Asian technology sector is no longer a secret. While China has been a breeding ground for some of the world’s fastest-growing — and highest valued — technology businesses, most Chinese technology start-ups have opted to list in the US since they were unable to fulfil the listing requirements of either the Shanghai or Hong Kong exchanges at the time. They faced legal and technical barriers to list on the main bourses.
To facilitate the ambition of Chinese tech entrepreneurs to achieve scale, the government has begun a pilot scheme that provides preference to unicorn start-ups (companies worth at least $1 billion) with superior technologies to list ahead of other traditional firms lined up at the exchange. The regulator is also in discussions with top firms that have high market recognition in key sectors like cloud computing, big data, software and integrated circuit, biotechnology for issuances of Chinese depositary receipts (CDR). A CDR is a certificate issued by a custodian bank that represents a pool of foreign equity that is traded on the Chinese exchanges. Thus, Chinese companies listed abroad will be allowed to trade in domestic markets through CDRs.
In July 2018, the Hong Kong Stock Exchange (HKEX) relaxed its listing norms to promote companies from emerging and innovative sectors. High growth technology companies or biotech firms were provided a relaxation in profitability requirements. Another consideration provided by HKEX relates to equity awards, which are offered by start-ups to grow their business and incentivise talent through share compensation plan. The HKEX has also opened up an additional channel for tech start-ups to raise funds to support their R&D activities, creating an ecosystem to incubate innovation. Thus, overall, there has been a concerted effort by the Chinese government to promote its start-ups and provide a conducive environment for them to grow.
Nurturing Indian startup ecosystem
To facilitate the growth of start-ups, the Government of India has initiated ‘Startup India’. Startup India is a flagship initiative with the intention to build a strong ecosystem for nurturing start-ups in the country that will drive sustainable economic growth and generate large scale employment opportunities. Under the Pradhan Mantri MUDRA Yojana, more than 13 crore people have been provided loans of ticket size | 50,000 to | 10 lakh with ~4 crore people being first time borrowers.
Further, the government has relaxed several criteria to enhance the existing support system for start-ups. For example, an entity can be considered a startup for up to seven years from its date of incorporation from earlier five years. Also, the scope of definition has been broadened to include a scalable business model with high potential of employment generation or wealth creation. Both Indian exchanges, Bombay Stock Exchange (BSE) and National Stock Exchange (NSE) have announced the creation of a new alternative ‘Start-up’ platform that allows start-ups to list with or without initial public offering and connects them to a pool of varied investors. Both exchanges have announced a relaxation of profitability in their listing criteria. However, they still seek a company that has positive net worth. The listing of start-ups on such alternative investment platforms will broaden their reach with a diversified investor class. Securities and Exchange Board of India (Sebi) is expected to come up with new guidelines to boost listing of start-ups on the main platform of both BSE and NSE in India over the next couple of months. The regulator has been engaging with various stakeholders, including start-ups, investors and industry bodies such as Nasscom and TiE (The Ind-US Entrepreneurs – A Silicon Valley non-profit supporting start-ups) to tweak the listing norms for start-ups. Indian start-ups are also keen to tap the public market but find the existing norms challenging. Primary among these norms is net worth requirement, profitability and promoter holding norms. Taking a cue from global regulators, there is scope for significant reforms for early stage companies.
Start-ups to act as facilitators of economic development, overall well being
Globally, start-ups have challenged the traditional business models bringing in concomitant disruptions and more efficiency in the system thereby leading to accelerated economic growth. Start-ups are increasingly finding ingenious ways to directly connect sellers and buyers, thus creating a physical capital-free business model – wherein companies with limited physical capital compete with capital heavy incumbents – thus challenging the traditional asset heavy businesses. As an illustration, Alibaba holds no inventory, Airbnb owns no real estate while Uber owns no cars. Thus, start-ups generally possess an asset light business model, a product/platform enterprise and are intellectual property driven establishment. There are three broad contours, which will determine the success of start-ups, going ahead. First is capital efficiency i.e. the ability of these companies to remain lean in their asset deployment and generate incremental higher revenue than risk capital employed. Second is their ability to generate significant employment opportunities for the substantial eligible workforce. Third and last is their ability to benefit the society, in general i.e. improve economic productivity and the overall development of society. Encouraging a start-up ecosystem with a conducive environment is a precursor to equitable socio-economic growth.
The author is Co-Chair, FICCI Capital Markets Committee and MD & CEO, ICICI Securities Ltd. This article appeared in the CAPAM 2018 knowledge paper, ‘The Experts’ Voice’.