Oner­ous leg­is­la­tion for fun­ders of cap­i­tal

Lack of fund­ing hand­i­caps lo­cal start-up in­dus­try and the ven­ture cap­i­tal mar­ket

Business Day - Business Law and Tax Review - - BUSI­NESS LAW & TAX RE­VIEW - REIN­HARDT BIER­MANN & DAR­REN OLIVIER

THE new trend of tech start-up companies has seen a rise in the for­ma­tion of ven­ture cap­i­tal companies in North Amer­ica, with ex­po­nen­tial ex­pan­sion in Sil­i­con Val­ley and New York. Ven­ture funds rely on pri­vate in­vestors, gov­ern­ment funds and other cap­i­tal ini­tia­tives. Ac­cord­ing to the Mi­das List of 2012 the exit of Face­book bol­stered top ven­ture cap­i­tal firms with Jim Brey­ers of Accel Part­ners lead­ing the cap­i­tal race. Other jaw-drop­ping ex­its were the ac­qui­si­tion of In­sta­gram by Face­book and the ini­tial pub­lic of­fer­ings of Kayak and Yelp, to name but a few.

In the UK, where such companies are traded as ven­ture cap­i­tal trusts, a mul­ti­mil­lion-pound in­dus­try has come to life. Ven­ture cap­i­tal trusts are funds that in­vest in small busi­nesses or companies listed on the smaller companies reg­is­ter, with tax in­cen­tives for pri­vate in­vestors. The En­ter­prise In­vest­ment Scheme (EIS) and the Seed En­ter­prise In­vest­ment Scheme (SEIS) are also other pro­gres­sive poli­cies that have been in­tro­duced by the UK gov­ern­ment to en­cour­age en­trepreneurs and in­vestors alike. Tech start-up companies have used these schemes to their ad­van­tage and East Lon­don Tech City has seen un­prece­dented growth.

While all of this is hap­pen­ing glob­ally, what is hap­pen­ing on do­mes­tic soil? SA and other de­vel­op­ing coun­tries have seen some very in­no­va­tive ideas, es­pe­cially in the technology fields, but a lack of fund­ing has hand­i­capped the lo­cal start-up in­dus­try and the ven­ture cap­i­tal mar­ket.

Over the past few years the steep­est chal­lenge for start-ups, SMEs and min­ing ven­tures has been to over­come the moun­tain of equity fi­nance.

The South African Rev­enue Ser­vice (SARS) has tried to put in­cen­tives in place with sec­tion 12J of the In­come Tax Act No 58 of 1962 known as the “Ven­tu­ral Cap­i­tal Companies (VCCs) regime”. This is an at­tempt to pro­vide the same at­trac­tive pol­icy as ven­ture cap­i­tal trusts have done for the UK. As of 1 July 2009, South African in­vestors — in­di­vid­u­als and listed companies — can claim for in­come tax de­duc­tions of up to 40%, where they have in­vested in ven­ture cap­i­tal com­pany shares.

The three main par­ties within this struc­ture are the in­vestor, the ven­ture cap­i­tal companies and the companies or min­ing ven­tures be­ing in­vested in.

The regime hopes to put in place a struc­ture whereby in­vestors can group their funds in a spe­cific ve­hi­cle, be­ing the ven­ture cap­i­tal com­pany, which would then al­lo­cate those funds into small busi­nesses and ju­nior min­ing ven­tures. The qual­i­fy­ing in­vestors will re­ceive cer­tifi­cates from the ap­proved ven­ture cap­i­tal companies , who in turn will in­vest in qual­i­fy­ing in­vestee companies, to re­ceive qual­i­fy­ing shares.

What is the cur­rent state of af­fairs for ven­ture cap­i­tal companies and why are we not see­ing more start-ups in SA mak­ing it through the in­no­va­tion stage with such in­cen­tives in place? The an­swers to these ques­tions are not very pos­i­tive, since it is now clear that the VCC tax regime did not meet its ob­jec­tive of at­tract­ing in­vest­ment and small busi­ness. The Sil­i­con Cape Ini­tia­tive Sur­vey, re­leased in April last year, in­di­cated that 41% of South African star­tups are ac­tively look­ing for fund­ing and a mere 8% have re­ceived ven­ture cap­i­tal fund­ing.

There have been so few ap­pli­ca­tions to SARS for VCC sta­tus that not a sin­gle com­pany had been op­er­a­tional by the end of 2012. Sadly though, this was three years af­ter the pro­gramme had been rolled out. For the year 2013, only three companies have now been granted VCC sta­tus un­der sec­tion 12J of the act. Olive­wood Re­sources Ltd was granted VCC sta­tus in Oc­to­ber 2009, but it is cur­rently not op­er­a­tional. Emis­core Ltd was ap­proved in Fe­bru­ary 2012 but is in the process of be­ing sold to an­other com­pany and is also not ac­tively trad­ing.

The third com­pany, Grovest Ven­ture Cap­i­tal, is SA’s first trad­ing ven­ture cap­i­tal fund in­cor­po­rated un­der the act, with a fo­cus on tech­no­log­i­cal in­no­va­tion and high growth start-ups. The fund as­pires to achieve an in­ter­nal re­turn rate of be­tween 25% and 37%.

What seems to be scar­ing compa-

It is now clear that the VCC tax regime did not meet its ob­jec­tive of at­tract­ing in­vest­ment and small busi­ness

nies from ap­ply­ing for ven­ture cap­i­tal com­pany sta­tus?

It would ap­pear that ini­tially the fi­nan­cial ben­e­fits were just too mar­ginal, and the SARS re­quire­ments for qual­i­fy­ing small busi­ness and min­ing ven­tures were too heavy a bur­den to carry. This changed some­what, with the amend­ments brought about by the Tax­a­tion Laws Amend­ment Act No 24 of 2011. Sec­tion 12J of the act was al­tered in such a way as to do away with over-for­mal­is­tic re­quire­ments and in­cor­po­rate anti-avoid­ance pro­vi­sions

How strict are the cur­rent pro­vi­sions? Firstly, the VCC must meet cer­tain pre­lim­i­nary re­quire­ments to qual­ify for an ap­proved ven­ture cap­i­tal com­pany sta­tus for each year of as­sess­ment, as set out in sec­tion 12J(5) of the Act. The com­pany must, among oth­ers, be a South African res­i­dent and its main ob­ject must be the man­age­ment of in­vest­ments in de­vel­op­ing companies. To­gether with any con­nected per­son the com­pany must not con­trol any qual­i­fy­ing in­vestee com­pany in which it holds shares and it must be li­censed in terms of sec­tion 7 of the Fi­nan­cial Ad­vi­sory and In­ter­me­di­ary Ser­vices Act, 2002.

In terms of sec­tion 12J(6) the Com­mis­sioner can with­draw his ap­proval if the com­pany has not com­plied with the pro­vi­sions in sub­sec­tion (5) and the cor­rec­tive steps taken by the com­pany are deemed to be un­sat­is­fac­tory.

Af­ter the pre­lim­i­nary re­quire­ments have been met, the com­pany must sat­isfy fur­ther con­di­tions in sub­sec­tion (6A). Within 36 months from the date of SARS ap­prov­ing the VCC, a min­i­mum of 80% of the cost in­curred by the VCC to as­cer­tain as­sets, must be for qual­i­fy­ing shares. Each in­vestee com­pany must hold as­sets not ex­ceed­ing R300m in any ju­nior min­ing com­pany or R20m in any other qual­i­fy­ing com­pany. Sub­sec­tion (5)(c) re­quires that not more than 20% of the com­pany’s ex­penses were as re­sult of the shares bought in one qual­i­fy­ing com­pany.

If these fur­ther obli­ga­tions are not

The steep­est chal­lenge for start-ups, SMEs and min­ing ven­tures has been to over­come the moun­tain of equity fi­nance

met, SARS will also with­draw the com­pany’s VCC sta­tus. The with­drawal of the VCC sta­tus can mean that in terms of sub­sec­tion (8), the Com­mis­sioner can in­clude in the com­pany’s in­come in the year of as­sess­ment, an amount equal to 125% of the ex­penses in­curred to is­sue shares.

This is pos­si­bly one of the most dras­tic reg­u­la­tions in­cluded in the regime and it is clear how this can scare off pos­si­ble VCCs.

En­ti­ties which qual­ify to be in­vestees are placed un­der strict rules and sec­tion 12J(1) ex­plains the var­i­ous re­quire­ments for “qual­i­fy­ing companies”. The in­vestee must also be a domi­ciled lo­cally, not be a con­trolled group com­pany in re­la­tion to a group of companies and the com­pany must be an un­listed com­pany or a ju­nior min­ing com­pany. A ju­nior min­ing com­pany may, how­ever, be listed on the Al­ter­na­tive Ex­change Divi­sion (AltX) of the JSE Ltd.

In terms of para­graph (f) “the sum of the in­vest­ment in­come… de­rived by that com­pany dur­ing any year of as­sess­ment (should) not ex­ceed an amount equal to 20% of the gross in­come of that com­pany for that year.”

Af­ter get­ting the ap­proval of SARS, the VCC has cer­tain obli­ga­tions to main­tain. The com­pany must keep a record of all its in­vestors and in­vestees and sub­mit the re­ports to SARS. The VCC also has to en­sure that it in­vests in companies that sat­isfy the re­quire­ments and is­sue cer­tifi­cates to qual­i­fy­ing in­vestors.

Three new anti-avoid­ance pro­vi­sions have been in­tro­duced af­ter the ini­tial leg­is­la­tion, the first be­ing sub­sec­tion (3A) that pro­hibits tax de­duc­tions where in­vestors be­came “con­nected per­sons” as a re­sult of the in­vest­ment. The sec­ond anti-avoid­ance pro­vi­sion al­lows de­duc­tions only if the in­vest­ments in the VCC is a pure equity in­vest­ment with no el­e­ments of debt.

Thirdly, sub­sec­tion (3)(b) re­quires that the in­vestor must clearly be “at risk”. In­vested funds which are de­rived from a loan or credit fa­cil­ity must be sub­ject to the eco­nomic risks of the project. Flow­ing from this pro­vi­sion, the ven­ture cap­i­tal com­pany may in terms of sub­sec­tion (3)(bb) also not be a part to the credit pro­vided for the ex­pen­di­ture.

Erika van der Merwe, the CEO of the South African Ven­ture Cap­i­tal and Pri­vate Equity As­so­ci­a­tion has been quoted as to say that high level in­vestors are needed, be­cause the “in­vest­ing pub­lic” are at harm. How­ever, she feels that the in­cen­tives and poli­cies are not bring­ing in the in­vest­ment sought.

The cur­rent leg­is­la­tion still seems to be too oner­ous and some are of the view that we should fol­low the sys­tem in the UK where in­vestors do not have to chan­nel their money through ven­ture cap­i­tal companies, but can in­vest in firms of their own choice.

In­di­vid­u­als and in­vestors seem to be very cau­tious to put their money into this new as­set class, and the nu­mer­ous re­quire­ments show how la­bo­ri­ous it can be­come. It is, nonethe­less, a step in the right direc­tion and show­ing the gov­ern­ment’s ef­forts to bring change to the cur­rent startup land­scape.

Pic­ture: THINKSTOCK

UN­LOCK­ING THE FI­NANCE The Sil­i­con Cape Ini­tia­tive Sur­vey, re­leased in April last year, in­di­cated that 41% of South African start-ups are ac­tively look­ing for fund­ing and a mere 8% have re­ceived ven­ture cap­i­tal fund­ing Some are of the view that we...

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