Getting angels to fly

India needs to build an economic system that will provide adequate capital to budding entrepreneurs, says Ajit Balakrishnan. 

Sanjay (name changed) was in his 30s when, tired of his routine desk job and tired of implementing other people's ideas, he decided to do something on his own. His lifelong passion was food, so he decided to start a restaurant.

He checked around for capital, but the first thing his bank manager wanted was security.

But Sanjay was not deterred: to get a place for his restaurant he struck a deal with his landlord to pay him 10 per cent of his revenue in lieu of a deposit; and to decorate and equip his restaurant, he borrowed from local moneylenders -- for every Rs 100 they gave him he had to pay back Rs 110 a month.

Sanjay, like all entrepreneurs, was unfazed -- his restaurant would be a sureshot success. Once started, his restaurant pulled in people, but the business was not big enough to cover the interest and loan on his borrowings.

So a year later, in search of higher revenue, he borrowed more money and started another restaurant, this one in the continental style. The flavours of food at his restaurants were so unique that crowds flocked to his restaurant; I know, I tried getting in once and couldn't get a place.

But Sanjay soon discovered that the more he grew his business, the more he had to borrow, and the more he borrowed the more elusive became the surplus from which he could repay his loans.

Meanwhile, every evening, muscular, tall and silent men would appear to claim their share. In desperation he persuaded his aged parents to pledge his ancestral property to a bank and got enough money to pay off some of the loan sharks, but now he had one more set of instalments to repay.

Finally, the inevitable happened: the bank took possession of his ancestral home, evicting his aged parents who were living there. At this point, Sanjay had a massive heart attack and died, leaving behind his wife and two young children to face the world. 

Probably everyone in India has a story like this to recount. In fact, such stories of "failed" entrepreneurs and auctioned-off homes are such a feature of Indian life that parents caution their children never to do foolhardy things like starting businesses; better to seek safe white-collar jobs in government or in large established companies. 

Sanjay's is not an unusual case and his struggle is inherent in the entrepreneurial process. Businesses start out as a quirky notion in an entrepreneur's head and work their way through the risky stages of bringing the notion to life as a product or a service, finding the initial customers, learning to do things at scale and so on.

At every one of these stages more than two-thirds fail. So from the outside it is easy to see these failed attempts as wild-eyed schemes of impractical people. Yet without these "failures", the one-third who succeed would not happen. 

The scale of capital that a typical start-up needs in India is in the order of magnitude of Rs 50 lakh to Rs 1 crore with the important proviso that this can't be interest-bearing.

It has to be risk capital with the entrepreneur keeping a majority control for him to still think of the enterprise as "his own" and to keep him incentivised to put in his full creativity and energy.

The capital is, in countries where such entrepreneurial activity flourish, usually provided by three to five external investors ( called "angel investors") chipping in, say, Rs 20 lakh each.

Such "angels" are typically company executives, well-to-do professionals or retired entrepreneurs who bring not only money but connections that open doors for the youthful entrepreneurs and offer him tips.

But to enable such investors you need a corporate form that both limits their liability to the amount they have put and give them tax set-offs for early stage losses or if the business fails, as most will. 

In the United States, where entrepreneurial action is massive, this is accomplished through an organisational form called a limited liability company (LLC).

The LLCs, unlike regular corporations, have very light reporting requirements, the liability of its investor members is limited to the amount of capital they have put in, they do not have to pay corporate tax and, most importantly, their losses are passed through to their members' individual tax returns. 

In India, after much wrangling lasting years, the formation of limited liability partnerships (LLPs) was authorised in 2009, but Indian LLPs are taxed at the corporate level exactly like partnership firms and private limited companies are; nor are the LLPs allowed to set off losses on the LLPs against their income.

What could have been a good idea to trigger angel investments has come to nought because of these tax and legal provisions. 

The larger moral in Sanjay's tragic tale is that most jobs in an economy -- and this is true even more in India than in other countries -- are created by new small businesses.

And if our economy has to grow at a fast enough rate to create enough jobs for the 10 million or so young people who come into the job market every year, we need an economic system that will provide adequate capital to entrepreneurs like Sanjay. And the only way to make it happen is by getting Indian angels to fly. 

Illustration: Dominic Xavier/Rediff.com.

Ajit Balakrishnan, the founder and CEO of Rediff.com, is the author of The Wave Rider, A Chronicle of the Information Age. ajitb@rediffmail.com.