From tax arbitrage to IPO jackpot: The playbook behind India’s startup valuation

India’s startup ecosystem is entering a decisive phase. With record venture capital inflows and another wave of IPO-bound companies on the horizon, a fundamental question is resurfacing, does the system reward genuine business strength or clever financial engineering? As valuations soar and profitability takes a back seat, a growing number of founders and investors are beginning to question whether India’s startup boom is built for endurance or simply for exit. 

The startup boom is built on a clever but controversial foundation, a tax structure that rewards unprofitable growth and punishes profitability. It’s turning into a system where distorted valuation often trumps value, and where the path to riches runs not through dividends and steady accumulation, but through exits.

Zerodha founder Nithin Kamath recently sparked a debate on how India’s tax code shapes startup behavior. He decoded how a 37% point tax arbitrage between dividends and capital gains has rewired incentives across India’s venture ecosystem. If a company makes profits and distributes them as dividends, it faces roughly 25% corporate tax plus 35.5% personal income tax, leading to an effective outflow of about 52%. But if the same company grows fast, shows losses, and sells shares later at a high valuation, the capital gains tax is just around 15%. That difference 52% versus 15% is what’s quietly shaping India’s startup economy.

The outcome is predictable. Founders are no longer rewarded for profits but for valuations. VCs push for top-line acceleration rather than bottom-line strength because their returns come from capital gains, not steady dividends. The faster a company grows, the higher its valuation, and the bigger the exit payday. As a result, cash burn has become a feature, not a flaw. Startups spend heavily on marketing, user acquisition to inflate scale and creating the illusion of unstoppable growth.

Responding to Nithin Kamath’s post, Ixigo co-founder Aloke Bajpai argued that it is not venture capitalists but companies themselves that choose to reinvest earnings in market creation and long-term value building rather than distributing dividends. He noted that when the total addressable market (TAM) is large and expanding, it is strategically sound for companies to reinvest profits to fuel growth instead of returning cash to shareholders. Bajpai cited global precedents- Google and Meta did not pay dividends until 2024, and Steve Jobs famously opposed dividends, believing that capital should be deployed toward innovation and expansion until growth opportunities are fully exhausted.

However, this model comes with a significant downside, as it breeds financially fragile companies that rely heavily on external capital and struggle to survive during prolonged funding slowdowns. It also drives capital misallocation, where businesses built on hype attract disproportionate investment while those focused on innovation or sustainable growth are overlooked. The cycle further distorts competition, as smaller startups find it increasingly difficult to compete against well-funded incumbents that burn cash to protect market share. Besides balance sheets, this is changing employee behaviour as well. Managers used to a growth mindset without worrying too much about costs can be completely out of ideas when they hit a wall. Quite simply, the ability to ride out a storm like the pandemic,  a festive season impacted by unforeseen events, or simply a competitor willing to burn more, faster. Real innovation is increasingly invisible until it is too late or obvious. 

Consider how India’s R&D expenditure is at just 0.7% of GDP, compared to 2.4% in China and 3.4% in the U.S. The ecosystem risks rewarding marketing muscle over genuine innovation. 

With limited mergers and acquisitions in India, IPOs have become the default exit route for venture-backed startups, most of which hope to go public within 10 to 12 years of their first funding round. It has been shame to see firms contort accounting and operational reality to turn marginally profitable or reduced cash burn just before listing to signal stability, after which founders and early investors cash out through Offer-for-Sale (OFS) mechanisms  paying only 15% capital gains tax. The offer for sale, itself a rarely heard or used term in the public markets until a couple of years back, has crossed over to respectability where it would draw questions earlier.  

According to industry data, nearly 68% of PE/VC exits in 2024 came via IPOs, amounting to over Rs 68,000 crore since FY22. While this cycle benefits founders, funds, bankers, and institutional investors, the long-term risk is ultimately borne by public shareholders, particularly retail investors drawn in by the growth narrative and hype or FOMO, whatever you want to call it. That has led to some calling the Indian market the most underdeveloped in terms of investor sophistication. 

The government’s intent may have been noble to encourage investment and spending over cash hoarding but the balance seems off. The system is now optimized for exits, not endurance. Correcting this imbalance will require structural tax reform: narrowing the gap between dividend and capital gains tax.

A landscape where valuation trumps viability could not have been the objective here. Too many companies chasing short-term growth often achieve inflated valuations but remain unprofitable and vulnerable once market conditions tighten. The collapse of growth-at-any-cost models, both globally (WeWork) and domestically (Byju’s), underscores this fragility.

The venture capital model amplifies the cycle. Funds backed by institutional limited partners are mandated to generate 5–10X returns within a decade, making valuation appreciation not profitability their true performance metric. As a result, unprofitable growth is rewarded with 3X higher valuation multiples than steady, profit-driven expansion. To say this is how it works in other markets downplays the sheer capital starved nature of the Indian markets even today, when compared to the US or many other developed markets. Firms pushing to show profitability for an IPo knowing fully well it is not sustainable is nothing less than a market distortion that risks hurting those left behind in the rush. Perpetuating the sheer unfairness of it all for conservative founders who have built solid but smaller businesses.  

The current  approach might be delivering quicker exits and paper wealth, but it is also breeding structurally fragile businesses reliant on perpetual external capital and positive market sentiment.  A combination that is difficult as clean air in the NCR region for over 60 days at a stretch. That is one reason why a GDP growth rate of even 6-7% is not enough to keep these businesses going, a question that many people are beginning to ask and wonder about now.