Paring hazards linked to PE/VC investment valuation norms

PE/VC investments have generally been emerging out of discussions and agreements between the promoters and the investors. In the Indian context, the promoters are typically from the same family unit.

In deals involving overseas PE/VC investors , the domestic player also makes a simultaneous infusion into the company along with the PE/VC. While valuation and pricing norms have been prescribed for overseas PE/VC investors, (under the exchange control regulations), there was nothing similar in place for the domestic investor.

Fortunately, this changed earlier this year. The change in the tax laws is aimed at bringing in place valuation and pricing norms for domestic investors, thereby taxing any share premium above the Fair Market Value (FMV) infused in closely held companies.

Domestic investors, in this context, would include domestic PE/VC investors and all those who invest using an Indian entity.

Domestic investors are now permitted to subscribe to shares of Indian companies at a price derived on the basis of the Discounted Cash Flow (DCF) of the shares.

In this context, FMV of shares may be defined as below:

(a) the price as per any prescribed method or

(b) as may be substantiated to the satisfaction of tax officer based on the value of the company.

The method prescribed to determine the FMV was indicatively the net asset value of the shares. Recently, the tax regulators have clarified that the FMV could be calculated either as per the said net asset value method or as per the DCF method at the option of the tax payer.

Analysis and Impact

PE/VCs generally invest in companies under complex terms and conditions which are usually tackled by capital structuring mechanisms among other structuring tools. As a result the promoters or PE/VCs often end up investing in the company at a premium.

In the context of non-residents investing in closely held Indian companies, the exchange control regulations prescribe the use of DCF method as a floor for valuation purposes. However, investment at premium by non-residents does not result in tax implications in the hands of target companies.

Under the existing tax laws, capital structuring by means of infusion at a price more than the stipulated FMV of shares by domestic investors could result in taxability in the hands of the target companies. Cumulatively, this dichotomy in tax treatment in the hands of residents versus PE/VCs could have impacted commercial negotiations or investment structures. With the recent amendment, there could be relief for domestic investors, giving them headroom to make investments up to the DCF price without any adverse tax consequences.

Further, this being a substantive change in law it may be possible to argue that the amendment is applicable from April 1 2012.

As stated earlier, these changes could also apply to Indian companies making downstream investments.


The introduction of the DCF method of valuation in the case of infusion by residents is a welcome change. It is another example to indicate that DCF is becoming an important tool for measuring investments. This amendment would take away the additional tax hurdle in negotiating deals in cases where it would apply. It will also facilitate deal makers to continue discussion on increased partnerships and joint venture structures as part of their portfolio investments.

(Anil Talreja – Partner Urmi Rambhia –Manager and Pratik Gadhia – Assistant Manager are from Deloitte Haskins & Sells. Views expressed are personal.)

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