Taking the U-turn - The 'Reverse Flipping' of Indian Startups

July 15, 2023 · 5 min read

Indians are obsessed about moving abroad and so are Indian startups. The recent economic survey of India suggested that Indian startups are looking at ‘reverse-flipping’ and highlighted ways to stimulate this process, such as easier corporate laws, simplification of taxation of ESOPs, etc. But what exactly is this new startup sensation that is driving Indian startups back home?

In this blog, we will explore the nitty-gritties of this new jargon of ‘Reverse Flipping’, the process, the reasons why startups are considering this major shift, and the legal factors at play which determine the future of these startups.

Flipping is when a domestic company transfers its entire ownership to an overseas entity, accompanied by a transfer of its intellectual property (IP) and data owned by it. The founder and investors retain the same ownership via the foreign entity after having swapped all shares. There could be several reasons behind this move. Typically, flipping happens when startups are at an early stage, motivated by taxation, commercial and personal preferences of founders and investors. Few companies decide to ‘flip’ if the major market of their product is offshore. Investor preferences, such as having access to incubators can cause companies to "Flip" because they demand a specific domicile. In the past, factors like better protection of IP and tax treatment of Licensing revenue from IP, the residential status of founders, flexible corporate frameworks.

Rationale behind ‘flipping’

Many Indian companies in the tech sector primarily B2B, software as a service (SaaS) players and deep tech businesses tend to move out to the US, while some move towards Singapore. They start in India to leverage entrepreneurial talent, an active investing ecosystem, solid tech employees, and most importantly the ability to develop and run pilots at competitive costs. However, Indian markets are comparatively small for these businesses and not economically viable to continue to invest in tech and to compete with global players. So, they venture into uncharted waters like that of US and Southeast Asia offer large ready markets to these startups. Moreover, the attractive tax regimes (lower income tax and capital gains tax) that certain countries offer, government incentives like rent reimbursements, grants based on local employment, etc. attracts startups to move and their founders eventually acquire the NRI status.

The Process

The process of flipping the headquarters of an Indian startup to the US involves a number of steps and has various legal and administrative consequences. Initially, the Indian entity needs to be reclassified as a wholly-owned subsidiary of the foreign entity, resulting in implications for current investors and shareholders. The founders and investors of the Indian entity receive shares in the new US entity for a nominal fee. The US company then establishes an Indian subsidiary to handle crucial operations while owning the intellectual property and brand. To cover operational costs, a service agreement is established between the US company and the Indian subsidiary. It takes a lot of paperwork to recreate the capitalization table in the US parent company, and it may be difficult to categorise the Indian entity as a subsidiary if it already has revenue operations in India. In the end, the headquarters flipping forces the former Indian company, where Indian investors held shares, to close.

The opposite to this, i.e., reverse flipping is when these ‘flipped’ startups relocate their headquarters back to India. This trend has lately emerged among prominent players in the Indian startup ecosystem. PhonePe moved its headquarters to India in late 2020 in order to go potentially public in the country, thus setting the trend. However, However, the procedure of splitting the online shopping giant Flipkart from the leader in digital payments was difficult and expensive.

Razorpay, the Y Combinator-backed businesses, is the second largest fintech unicorn to flip back to India. This trend of firms relocating to India came to light earlier this year when Silicon Valley Bank collapsed which had adversely affected businesses backed by Y Combinator.

Reverse flipping of startups can be attributed to the expanding nature of the country’s PE (private equity) and VC (venture capital) ecosystem. In the first half of 2023, VCs and Pes have invested approximately $33 billion in capital across 1076 deals, an improvement over $23.4 billion in 2019. Additionally, numerous companies want to list on the Indian stock market, just like in the case of PhonePe, which is aiming for an IPO in 2024-25.

The Other Side of the Coin

Despite of a promising outlook, reversing the flip may uncover as a liability. It could lead to the loss of established networks and connections in the company's original market, requiring time and effort to rebuild them in India. Additionally, operating in a smaller market may limit growth potential, especially if the product or service is better suited for international markets. Wading through the complex tax and regulatory frameworks in India can pose challenges and increase compliance costs. Moreover, some investors may perceive the reverse flipping as a lack of stability or strategic direction, potentially impacting the company's ability to attract future investments.

Possible Remedies to Accelerate the Phenomenon

Nevertheless, to encourage startups to reverse the flip, the regulatory bodies of Indian government and other stakeholders must take a collective action as it would not only help India retain valuable intellectual property developed by Indian companies but also contribute to the growth of Indian economy by attracting foreign investment and thus signal India’s commitment to fostering a favourable business environment. Today India harbours over 90000 startups which have generated 2.69 lakh jobs in 2022 alone.

Here are some measures that can help accelerate ‘reverse flipping’:

1. Simplifying the process for granting "Inter-Ministerial Board (IMB) certification" to start-ups.
2. Further simplifying the taxation of Employee Stock Options (ESOPs).
3. Streamlining tax procedures and reducing uncertainty arising from tax litigation,
4. Simplifying capital flow procedures, taking inspiration from countries like the US and Singapore, with more lenient corporate laws and fewer restrictions on capital inflows and outflows, as well as the treatment of Hybrid Securities.
5. Encouraging collaboration and partnerships with established private entities to develop effective start-up mentorship platforms and share best practices.
6. Exploring the incubation and funding opportunities available for start-ups in emerging fields such as social innovation and impact investment.

Conclusion

India has emerged as the world’s 3rd largest startup ecosystem and carrying on this legacy would require India’s legal environment to upgrade itself for startups to thrive and for those preparing for homecoming, which will continue to serve as a testament to India’s entrepreneurial dynamism.