Zerodha co-founder Nithin Kamath has sparked a discussion about India's IPO boom, linking it to the country's tax structure and its impact on how startups prioritize growth and profitability. In a detailed analysis shared on X (formerly Twitter), Kamath explained how the current tax system could be inadvertently encouraging companies to focus on growth at the expense of profitability.
Kamath highlighted a significant disparity in tax rates based on how investors extract money from a business. He pointed out that taking money out as dividends incurs an effective tax rate of 52%, which includes a 25% corporate tax and 35.5% on personal income. However, if the same amount is withdrawn through capital gains, the tax rate drops significantly to 14.95% (inclusive of cess).
This difference, according to Kamath, incentivizes venture capitalists (VCs) and startup founders to minimize profits, as it is more tax-efficient to reinvest earnings in user acquisition and growth. This strategy allows companies to build a compelling growth narrative and potentially sell shares at a higher valuation, benefiting from the lower capital gains tax. Kamath described this as a "tax arbitrage game" that is often overlooked, with many VC-backed startups that have recently gone public showing little to no profit.
Kamath also noted that this aggressive spending makes it difficult for smaller competitors to survive, even if their spending isn't directed towards genuine innovation. He emphasized that a large portion of the expenditure is allocated to market expansion rather than research and development (R&D), which remains notably low in India at 0.7% of GDP.
Furthermore, Kamath addressed the limited exit options available to investors in India. He stated that startups, especially those aged 7-8 years from their first funding round, face constant pressure from VCs to provide an exit. With limited mergers and acquisitions (M&A) opportunities in India, an IPO often becomes the primary route for VCs to recoup their investments.
Kamath also noted that unprofitable growth often gets higher valuations than steady profits. A company with ₹100 crore revenue and 100% growth might get a valuation of 10-15x, while a profitable company with 20% growth gets 3-5x. According to Kamath, VC's are not only saving on tax, but also creating a 3x higher exit valuation. This dynamic can force even sustainable businesses into a "growth at all costs" mindset. To defend market share, companies might have to match the spending of competitors who are burning cash.
Kamath cautioned that running a business in this manner makes it difficult to change course. He also expressed concern that the current system might be creating businesses that are not very resilient. He warned that many of these unprofitable companies could struggle to survive a prolonged market downturn.
Kamath's analysis comes at a time when India's IPO market is experiencing a boom. However, he suggests investors should be cautious of structurally loss-driven models. He believes the government may have designed the tax arbitrage to incentivize companies to spend money rather than accumulate and distribute it, but he is unsure if the balance is correct.
