The ownership of startups - domestic Vs foreign

I had blogged here about the practice of development finance institutions (DFIs) and foreign investors using safe-havens to channel funds to developing countries. It posed the issues of tax avoidance (and tax loss for the developing country) and opacity in ownership. 

There may be an even bigger problem with this practice, associated with transfer of wealth from the developing country. As startups become an increasingly important part of the Indian economy, foreign transfer of their ownership becomes an increasingly important matter of concern.

Entrepreneur Sanjeev Bhikchandani raises the issue of ownership of startups. He draws attention to the practice of 'flipping', whereby foreign investors register an entity outside India and force startups to transfer ownership to the foreign entity. 

Y-Combinator, the famed entrepreneurship incubator program, mandates that selected startups should shift their headquarters to the US (or Singapore, Canada, and Cayman Islands), flipping their India-registered entity into a wholly-owned subsidiary of a new US parent. Kushal Baghia, an early stage investor, explains 

After creating the US company, the founders and current investors (who have put their money into the Indian entity) would have to be ‘gifted’ some shares of this new U.S. entity for a nominal amount. Next, the US entity (of the startup) will have to open an Indian subsidiary that will carry out all essential operations like hiring employees or building products. Interestingly, the U.S. company will own the IP (intellectual property) and the brand, and will have a service agreement with the Indian subsidiary through which it will pay for the cost of operations with the money raised outside India

Apart from forced mandates like Y-Combinator, the primary motivation for flipping is the ease of raising foreign funding. But it effectively reduces the Indian entity to the status of an offshore development centre, which owns the employees and low-value hardware but none of the high-value IP and brand, and other transferable software. 

Bhikchandani estimates that Rs 17 trillion of market capitalisation can be transferred overseas through such foreign domiciling of Indian start-ups by foreign investors. He describes it as institutionalised transfer of Indian wealth through global exploitation of intellectual property (IP) created in India by Indians but transferred overseas. He says, 

Shades of the East India Company type of situation here - Indian market, Indian customers, Indian developers, Indian workforce. However 100% foreign ownership, foreign investors. IP and data transferred overseas. Transfer pricing issues foggy... Basically institutionalised transfer of wealth away from India while living off the Indian market and Indian labour somewhat like the days of the Company rule... You take an Indian start-up and transfer ownership of all its shares to an overseas company that has been usually freshly floated just for this purpose. So now the Indian company becomes a 100 per cent subsidiary of the overseas entity... All IP developed and all data captured by the Indian entity in the future will also belong to the overseas entity. This overseas company is substantially outside of Indian jurisdiction and the influence of Indian regulators...

So you have a bunch of foreign investors who tell our best young start-ups that they will invest in their companies provided they shift their company domicile overseas. The reason being that they don't want to be subject to Indian laws, taxes and government rules except to the minimum extent required they say they do not trust the Indian government and the legal system... If this happens on a massive scale, you end up with a situation where the company, the investors, the value capture, the IP and the data are all domiciled overseas with little accountability to Indian regulators whereas the customers, the workforce, the development of IP and the capture of data are all in India... These companies will operate in India and access the market, however, they will not be Indian companies. A domicile shift and transfer of IP and data to an overseas company is a permanent loss and as a company grows so does this loss.

The underlying motivations are clear,  

The investors want access to Indian market and customers, but not the Indian government, regulators or tax authorities.

Whatever Bhikchandani's motivations in raising this, and clearly he as an Indian funder of such enterprises would prefer Indian laws to foreign ones, the concerns raised are very important.

His suggestions, 

Bikhchandani said the policy has to comprise a package of both incentives and disincentives to encourage certain types of behaviour and discourage other types. "And possibly enforce an outright ban on certain other constructs," he said, adding that the government should insist that data and the IP should belong to the Indian subsidiary and cannot be owned by the overseas entity in sensitive sectors like fintech. This could be done retrospectively, he said.

The obvious response of critics and liberalisers would be that it would scare away foreign investors, with all attendant consequences. 

I'm not sure whether this should be a big enough concern. Especially because foreign venture capital interest in Indian startups is very high, and India is easily the only large developing country market which can absorb the large volumes of VC capital sloshing around. The large population is an irreplaceable advantage. There may be a fortunate monopsony problem that foreign VC funds face with respect to India, which lowers the cost of unilateral policy making by India. 

This is part of the bigger issue of regulating foreign capital flows. The source of most VC funds investing in developing countries are offshore or onshore tax havens. The OECD's Base Erosion and Profit Sharing (BEPS) project seeks to harmonise global policies on cross-border capital flows so as to limit the loss of tax revenues for national governments as well as promote transparency in such flows.