From Unicorn to Insolvent: Why India Needs a Separate Insolvency Framework for Startups

Author~ Mayank Panwar

Abstract

India's startup ecosystem has grown to the scale of being a concern for insolvency policy, with more than 185,000 startups registered on the Startup India platform by DPIIT. However, the Insolvency and Bankruptcy Code, 2016 remains to be an asset-heavy approach to the distress of startups. That mismatch is important because a startup's actual value can be in intangible assets like software, data, intellectual property, network effects, and human capital, which can deteriorate quickly once its insolvency process starts. The Code's current mechanisms, including corporate insolvency resolution, the fast-track process and pre-pack, are not equipped to deal with innovation-driven companies where speed, confidence and continuity are the keys to value. India should now explore a dedicated pathway for startup insolvencies that prioritizes intangible enterprise assets, honest failure versus fraud and the preservation of viable innovation before value is lost in the market. A bespoke mechanism would not compromise the rights of creditors; rather, it would enable the possibility of rescue for venture-backed and technology-driven companies and ensure the integrity of the insolvency regime.

Keywords: startup insolvency; Insolvency and Bankruptcy Code; intangible assets; resolution; venture capital; innovation economy.

Introduction

While India's startup ecosystem has become one of the largest in the world, with over1.85 lakh startups recognized by DPIIT contributing to innovation, employment, and economic development, there is a less discussed reality that startup failures are extremely frequent. According to reports, almost 90% of startups in India fail within five years of their inception, especially in the face of funding constraints, profitability challenges, and investor skepticism.

Despite this unique commercial environment, financially distressed startups in India remain subject to the Insolvency and Bankruptcy Code, 2016 (“IBC”)[1], which was introduced to provide for time-bound resolution of distressed companies and maximisation of asset values and balancing the interests of all stakeholders. However, the framework largely assumes traditional businesses with tangible assets and stable revenue streams. Startups function differently. They tend to be asset-light, valuation-heavy and rely on IP, technology, user information and investor faith, not physical assets. As a result, conventional insolvency procedures often destroy more value than they preserve. The insolvency regime in India still considers a failure of startups to be a normal corporate failure, but startup failure has a distinct set of business realities. India therefore needs a separate startup insolvency regime that acknowledges innovation-driven enterprises as a unique legal and economic entity.

The Structural Mismatch Between Startups and the IBC

The IBC revolutionized the insolvency regime in India by creating time-bound Corporate Insolvency Resolution Processes (“CIRP”), creditor discipline, and enhanced recovery avenues. The recovery rates under the IBC were found to be around 32–36.5% of the admitted claims, which are sometimes higher than liquidation rates, as of FY 2024–25. However, its architecture is based oncreditor control, resolution professionals, committees of creditors and maximisation of liquidation value.

In Swiss Ribbons Pvt. Ltd. v Union of India[2], the Supreme Court held that the main thrust of the IBC is revival and continuation of the corporate debtor and not merely a recovery mechanism for creditors. This model is applicable to the traditional companies which have factories, machines, inventories, land or large operational assets. In contrast, startups derive much of their value from intellectual property, software infrastructure, algorithms, data, market traction, future scalability, brand visibility, and investor perception.

Intellectual property, network effects, consumer data, platform ecosystems, proprietary algorithms, and other non-traditional, intangible assets are often a startup's core enterprise value. Traditional insolvency valuation processes, which are mostly based on the value of recoverable assets, often overlook this future value. This can lead to a perilous legal paradox: a startup can be technically bankrupt but have commercially viable technology that has the potential to create significant value in the future.

India’s Startup Ecosystem Was Built for Risk — Not for Traditional Insolvency

The Government of India has acknowledged startups as separate economic entities. In terms of Startup India, a startup is not just about size, it is also about innovation, scalability and technological development.Failure is an inherent feature of startup ecosystems. Venture capital ecosystems are based on a high-risk model, in which only a fraction of the startups will succeed. Indian insolvency law, however, still has an old corporate paradigm in which insolvency is perceived as a financial failure as opposed to an entrepreneurial risk.

This has two very serious implications. Founders often delay insolvency proceedings due to reputational stigma and fear of losing control. Second, investors tend to keep funding unsustainable cycles just to maintain high valuations. This often leads to the emergence of “zombie startups” — businesses that live on investor money, despite their poor business models, ongoing losses, and inability to ever see a positive return on any investment.

Why Conventional Insolvency Destroys Startup Value

One of the biggest problemswith using ordinary insolvency when it comes to startups is that startup value dissipates very rapidly during financial downturn. Unlike traditional businesses that derive value primarily from tangible assets, startups rely on consumer confidence, employee retention, market relevance, technological adaptability, and growth of investor trust. Consequently, the very initiation of insolvency proceedings triggers the loss of key employees, customer trust, future funding opportunities, and market credibility.

When a normal Corporate Insolvency Resolution Process (“CIRP”) completes, the relevance of a startup in the business landscape may have already been lost. Further, the IBC's creditor-centric approach is not suitable for firms backed by their ventures. The financing of startups is often in the form of preference shares, convertible securities, ESOP commitments, SAFE-like instruments, and several rounds of dilution by investors.

The current system is not well equipped to deal with these contemporary financing challenges. As a result, commercial inefficiencies and legal uncertainty arise in insolvency proceedings. Indeed, IBBI statistics indicate that the IBC has made a significant difference in the overall outcomes of insolvency proceedings, but the system is not as effective in resolving insolvency of startups with intangible and time-sensitive value as it is in resolving the insolvency of traditional asset-intensive businesses.

In Lalit Kumar Jain v. Union of India[3], the Supreme Court had held that personal guarantor's liability shall not be discharged by the approval of the corporate resolution plan.This indicates that the IBC is not just wiping out linked liabilities upon approval of resolution plan. It underscores the multi-layer nature of startup insolvency, in which founders, investors, employees, and guarantors are all involved, and thus necessitates a multi-layer approach instead of a one-size-fits-all approach.

India’s Existing Relief Mechanisms Are Inadequate

It can be said that the IBC already has underlying mechanisms like Pre-Packed Corporate Insolvency Resolution Processes (“PPIRP”)[4] and the Fast-Track Corporate Insolvency Resolution Processes. There are however no specific mechanisms for startups. The emphasis of the fast-track insolvency under Section 55[5] of the IBC is more on the size of assets and income and not on models of innovation that drive the business. Likewise, the current framework of PPIRP is mainly applicable to MSMEs. Despite its introduction in 2021, PPIRP has witnessed extremely limited utilisation, with only a small number of recorded cases even by 2026. But the scheme does not cover the peculiarities of a venture-backed start-up, a technology start-up or a platform-based start-up. The law still sees startups as little corporations, not as a different type of business.

That assumption is flawed.

Why India Needs a Separate Startup Insolvency Framework

India needs a dedicated startup/innovation-driven company insolvency regime. Critics, however, could contend that a separate regime for startups would weaken creditor protection and allow for irresponsible risks to be taken as it would shield failed startups from the discipline of ordinary insolvency law. However, this concern is overstated. A regime specific to start-ups would not remove accountability, but it would help to separate honest from dishonest business failure, preserve commercially viable innovation, and avoid unnecessary value destruction.

The Startup Insolvency Code should have the following elements:

i.       Recognition of Intangible Asset Value

Valuation and resolution should also include recognition of intellectual property, software infrastructure, customer databases, algorithms and platform ecosystems as key assets.

ii.       Founder-Friendly Restructuring Mechanisms

Start-up failures are not just about fraud, they can be due to market volatility, lack of funding or failed experiments. The legislation should differentiate between business failure and fraudulent business activity.

iii.       Streamlined and Agile Resolution Timelines

Capital value of a startup deteriorates quickly in the course of a long insolvency process. A more efficient restructuring and strategic acquisition process should therefore be in the agenda of a startup-specific process.

iv.       Investor and Employee Protection

The framework should clarify ESOP liabilities, investor exits, shareholder rights, and employee protections.

v.       Innovation Preservation

The law should focus on business continuity, IP transfer or restructuring of the business rather than liquidation where possible. For startups, it is often better to keep the innovation alive than to recover the assets.

Comparative Perspective: Lessons from Global Insolvency Systems

Comparative jurisdictions have been increasingly recognizing the distinctiveness of startup distress. Chapter 11[6] bankruptcy restructuring in the U.S. affords more flexibility in business continuation and debtor-led restructuring.

Increasingly, modern insolvency processes place a high value on rescue measures, rather than liquidation, which focus on maintaining enterprise value. The World Bank's good governance principles for effective insolvency regimes also highlight predictability, efficiency, transparency and business rescue features of insolvency systems[7].

Indian insolvency regime is still very creditor friendly in its structure and implementation.

Conclusion

Indian insolvency law has not been able to catch up with the startup ecosystem. The IBC changed the way business insolvencies are resolved in India, but the underlying principles of the IBC are those of conventional business models and predictable revenue streams.

In the innovation economy of today, failure does not always mean incompetence, it is sometimes the price of experimentation. If the legal system applies the same rules to all startups that it does to all corporations, it will deter the startups from starting in the first place. India cannot aspire to become a global innovation hub while relying on an insolvency framework designed for industrial-era businesses. Indian insolvency law must therefore move beyond asset recovery and toward preservation of innovation, talent, and technological enterprise value. If India seeks to sustain its innovation economy, insolvency law must evolve from merely recovering assets to preserving entrepreneurial value.

[1]The Insolvency and Bankruptcy Code, 2016, No. 31 of 2016 (India).

[2] Swiss Ribbons Pvt. Ltd. v. Union of India, (2019) 4 SCC 17.

[3] Lalit Kumar Jain v. Union of India, (2021) 9 SCC 321.

[4]Insolvency and Bankruptcy Board of India (Pre-Packaged Insolvency Resolution Process) Regulations, 2021.

[5]The Insolvency and Bankruptcy Code, 2016, s. 55 (India).

[6] 11 U.S.C. ch. 11 (United States Bankruptcy Code).

[7] World Bank, Principles for Effective Insolvency and Creditor/Debtor Regimes.

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