Startup valuations often rise when investor confidence is high and funding is easily available. However, when the economy slows, these valuations can drop sharply, in such down markets, raising capital becomes harder, investors scrutinize business models more closely, and growth plans may need adjustment. In India, this situation is not just about market trends startups must also comply with laws under the Companies Act, FEMA, SEBI regulations, and tax provisions like the “angel tax.” To navigate this phase successfully, founders need to set practical valuation targets, follow all legal requirements, communicate openly with investors, and manage resources efficiently, ensuring the business remains stable and prepared for growth when market conditions improve.

In this article, CA Manish Mishra talks about Startup Valuation in Down Markets: Surviving the Reset. 

Impact of Down Markets on Startup Valuations

Companies Act, 2013: Valuation and Share Issuance Rules 

Sections Governing Issuance

• Section 62(1)(c): Governs issuing shares to select investors via preferential allotment, ensuring pricing fairness and compliance with valuation requirements under the Companies Act and related rules.

• Section 42: Regulates private placements, limiting offers to identified persons, requiring proper disclosures, and adherence to statutory filing and reporting procedures for raising capital privately.

• Section 54: Allows issuance of sweat equity to employees or directors in exchange for their contribution, valuing such shares fairly to protect shareholder interests.

Rule Requirements

• Rule 13: Requires a Registered Valuer’s report for preferential allotments, ensuring share pricing reflects fair market value and follows prescribed valuation methodologies.

• Rule 14: Specifies procedural requirements for private placements, including offer letters, limits on the number of allottees, and maintenance of relevant statutory records.

Role of Registered Valuer

• Section 247: Defines the role of Registered Valuers, mandating independence, adherence to prescribed methods, and professional standards while determining share value.

• Valuation Methods: Includes DCF, market approach, and comparable transactions to determine fair value, ensuring transparency and justification for pricing decisions.

• IBBI Registration: RVs must be registered with IBBI for “securities or financial assets,” ensuring competence, credibility, and adherence to valuation standards.

Down Market Relevance

In downturns, valuation reports must explain lower prices by documenting market conditions, reduced forecasts, and increased risk factors to ensure compliance and investor confidence. 

FEMA: Pricing for Cross-Border Investments

Under the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019, any foreign investment in Indian startups must follow strict minimum pricing norms to ensure capital inflow is at a fair value.

Key Pricing Rule

Equity instruments issued to non-residents must not be priced below Fair Market Value (FMV). The FMV must be calculated using an internationally accepted pricing methodology and certified by a Chartered Accountant (CA), Cost Accountant, or SEBI-registered Merchant Banker. This ensures transparency and prevents undervaluation of shares when raising foreign capital.

Transfer of Shares

• If a resident sells to a non-resident, the price cannot be below FMV.

• If a non-resident sells to a resident, the price cannot exceed FMV.

This maintains fairness for both inflow and outflow of foreign capital.

Reporting Requirements

• Form FC-GPR: Filed within 30 days after allotment of shares to non-residents.

• Form FC-TRS: Filed for share transfers between residents and non-residents.

Timely filing is essential to avoid penalties under FEMA.

Down Market Relevance

Even if market conditions or negotiations suggest a lower price, the transaction price must remain above FEMA’s FMV. If the target price is below FMV, alternative structures like convertible instruments with pricing determined at a later date can be used to stay compliant while accommodating market realities.

SEBI Regulations: Listed and Pre-IPO Companies

For listed companies and those preparing for an IPO, the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (ICDR) lay down strict valuation and pricing norms to protect investor interests and ensure fair capital raising.

Preferential Issue Pricing

SEBI prescribes a floor price formula for preferential issues based on the average of weekly high and low share prices over a specified period before the “relevant date.” This prevents companies from issuing shares at an unfairly low price. Additionally, Regulation 166A mandates an independent valuation report from a qualified valuer for certain preferential issues, especially when the pricing cannot be determined from market trades or involves complex securities.

Anti-Dilution and Investor Rights

SEBI requires disclosure of investor rights in offer documents, including anti-dilution clauses, which protect early investors if new shares are issued at a lower price in the future. These rights can affect valuation by altering ownership percentages and future capital structure, so SEBI insists on transparency to ensure all investors are fully informed before making investment decisions.

Down Market Relevance

For listed companies, SEBI’s ICDR Regulations set a floor price for preferential issues, calculated using prescribed formulas based on past market prices. This prevents issuing shares at steep discounts, even in a downturn. As a result, during down markets, listed entities often prefer rights issues (offering shares to existing shareholders) or Qualified Institutions Placements (QIPs), which allow quicker fundraising within the regulatory pricing framework while still attracting capital.

Income Tax Act: Angel Tax and FMV Rules

The “angel tax” under Section 56(2)(viib) of the Income-tax Act applies when an unlisted (closely held) company issues shares to certain investors at a price higher than the Fair Market Value (FMV). The difference between the issue price and FMV is treated as “income from other sources” and taxed in the company’s hands.

Valuation Under Rule 11UA

FMV can be determined using:

• Net Asset Value (NAV) Method: Based on the company’s assets and liabilities.

• Discounted Cash Flow (DCF) Method: Based on projected future cash flows, certified by a Chartered Accountant (CA) or Merchant Banker.

The method chosen must be reasonable and well-documented to withstand scrutiny.

Safe Harbour Rule

Introduced in 2023, this allows a 10% tolerance band if the share issue price exceeds FMV by up to 10%, it will still be considered at FMV for tax purposes. This helps accommodate valuation fluctuations.

DPIIT Exemption

Startups recognized by the Department for Promotion of Industry and Internal Trade (DPIIT) can seek exemption from angel tax provisions under Section 56(2)(viib). Additionally, such startups may qualify for a three-year tax holiday under Section 80-IAC, subject to conditions on turnover, incorporation date, and nature of business.

Down Market Relevance

Legal Risks in Down Rounds

A “down round” occurs when a company issues new shares at a lower price than in earlier funding rounds. While it may help secure much-needed capital in a downturn, it carries significant legal risks:

Breach of Shareholder Agreements (SHA)

Most SHAs contain anti-dilution clauses designed to protect early investors if future shares are issued at a lower price. These may be:

• Weighted average anti-dilution: Adjusts earlier investors’ conversion or shareholding price proportionally, softening dilution impact.

• Full ratchet anti-dilution: Resets the earlier investor’s price to match the new lower price, causing higher dilution to founders and ESOP holders.

• Failure to honour these clauses can lead to contractual breaches and disputes.

Liquidation Preference Impact

In a down round, new investors may negotiate higher liquidation preferences, meaning they get paid first (and possibly multiple times their investment) before any returns go to common shareholders. This can drastically reduce payouts for founders and employees holding ESOPs during an exit.

Corporate Governance Risks

The board of directors must be able to show that approving a lower valuation was in the best interests of the company and all shareholders. This requires:

• Documenting the commercial rationale in board minutes.

• Ensuring transparency in negotiation processes.

• Demonstrating that alternative financing options were considered.

Poor governance here could expose directors to shareholder claims or regulatory scrutiny.

Down Market Relevance

In a down market, lower valuations can help startups avoid angel tax under Section 56(2)(viib) as share prices may match or fall below FMV. However, they must still calculate FMV using approved methods, obtain certification from a CA or Merchant Banker, and maintain thorough documentation to justify pricing and withstand potential scrutiny from tax authorities.

Employee Equity in a Downturn

When market valuations fall, employee equity schemes like ESOPs and sweat equity need careful handling to remain compliant and fair:

ESOP Pricing

The exercise price for Employee Stock Option Plans (ESOPs) must be based on the Fair Market Value (FMV) determined on the grant or exercise date, depending on accounting and tax rules. Correct FMV alignment ensures accurate tax deductions for employees and prevents underreporting in company accounts.

Sweat Equity

Issuing sweat equity shares to employees or directors in recognition of their contribution requires:

• A Registered Valuer (RV) report to establish fair value.

• Shareholder approval through a special resolution.

This safeguards against undervaluation and protects existing shareholders’ interests.

FEMA Compliance

If ESOPs or sweat equity are granted to non-residents, pricing must comply with FEMA rules. On exercise, the price must not be below the FEMA-prescribed FMV certified by a CA, Cost Accountant, or SEBI-registered Merchant Banker.

Down Market Relevance

In a down market, lower valuations reduce the FMV of shares, making ESOPs cheaper to exercise and lowering the company’s accounting expense. However, this can also signal weaker growth prospects, potentially hurting employee confidence and morale despite the financial benefit, affecting retention and overall motivation.

Documentation and Compliance Checklist

When raising funds in a down market, meticulous documentation and compliance are critical to ensure legal validity and investor confidence:

Valuation Report

• Under the Companies Act, a Registered Valuer (RV) must prepare a valuation report for preferential allotments and other share issuances.

• Under FEMA and Income-tax rules, a CA, Cost Accountant, or SEBI-registered Merchant Banker must certify the Fair Market Value (FMV). This ensures the issue price meets statutory minimums and withstands regulatory scrutiny.

Board and Shareholder Resolutions

• The board must approve the fundraising and recommend it to shareholders.

• A special resolution is required for preferential allotment under Section 62(1)(c) and Section 42 of the Companies Act.

Offer Letters and Registers

• For private placements, Form PAS-4 (offer letter) must be issued to identified investors.

• The company must maintain PAS-5 (record of private placement offers).

Regulatory Filings

• MGT-14: Filed with the Registrar of Companies (RoC) for special resolutions.

• PAS-3: Return of allotment filed after issuing shares.

• FC-GPR: Filed with the RBI within 30 days of allotment to non-residents.

• FC-TRS: Filed for share transfers between residents and non-residents.

Investor Agreements

Update the Shareholders’ Agreement (SHA) and Share Subscription Agreement (SSA) to reflect revised terms, valuations, investor rights, and protective provisions negotiated in the down round.

Recent Legal Updates Affecting Startup Valuation

Recent rule changes have made a big impact on how startup valuations are handled in India. In September 2023, the CBDT updated Rule 11UA to allow a 10% margin over the Fair Market Value (FMV) without attracting angel tax and also added more valuation methods for foreign investor deals, making them closer to global standards. In 2024, SEBI made new rules for preferential issues in listed companies, asking for clearer disclosures and stricter valuation checks to protect investors. The DPIIT improved its online portal so startups can get recognition faster, helping them qualify for angel tax exemptions more easily. At the same time, the IBBI has started keeping a closer watch on Registered Valuers, checking their methods and reports more carefully during uncertain market conditions.

Conclusion

In a down market, valuing a startup involves both financial realities and legal obligations. While market conditions may push valuations lower, Indian regulations set clear boundaries through minimum pricing norms, mandatory valuation reports, tax rules, and disclosure requirements that founders must follow.

Startups that align their fundraising terms with the Companies Act, FEMA, SEBI regulations, and Income Tax Act provisions can not only secure capital within the law but also maintain investor trust. By balancing market-driven pricing with strict compliance, founders can navigate the reset effectively and be well-prepared to capitalise on growth opportunities when economic conditions improve.

Frequently Asked Questions (FAQs)

Q1. What does a valuation reset mean for a startup?

Ans. A valuation reset occurs when a startup’s perceived market value decreases compared to previous funding rounds. This often happens in down markets due to reduced investor risk appetite, lower market comparables, and tightened liquidity. It does not necessarily mean the startup is failing it’s a reflection of broader market conditions.

Q2. Why do startup valuations drop during down markets?

Ans. In down markets, public company valuations decline, and these serve as benchmarks for private markets. Investors apply lower revenue multiples, increase discount rates, and prioritize profitability over aggressive growth projections. All these factors lead to lower startup valuations.

Q3. How can founders protect their company’s valuation in a downturn?

Ans. While avoiding a valuation drop entirely may be impossible, founders can protect long-term value by:

• Strengthening unit economics.

• Maintaining a clear path to profitability.

• Preserving cash and extending runway.

• Keeping investor communication transparent.

• Avoiding unnecessary down rounds through alternative financing.

Q4. Is raising capital at a lower valuation always bad?

Ans. No. Accepting a lower valuation can secure the capital needed to survive and grow during tough times. It’s better to raise at a realistic valuation and maintain business operations than to run out of funds while waiting for higher offers.

Q5. What are some alternative funding options in a down market?

Ans. Startups can consider:

• Convertible notes or SAFEs to delay valuation setting.

• Venture debt for non-dilutive financing.

• Revenue-based financing tied to actual business performance.

Q6. How do investors evaluate startups during economic downturns?

Ans. Investors focus on:

• Predictable and recurring revenue.

• Positive unit economics (low CAC, high LTV).

• Lower cash burn rates.

• Evidence of product-market fit and customer retention.