Onerous legislation for funders of capital
Lack of funding handicaps local start-up industry and the venture capital market
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.
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...