Rather than bother to refine a key incentive, Treasury ditches it

Over the past few weeks, I have watched with some interest the start-up community’s response to the National Treasury’s announcement that the section 12J tax incentive will not be renewed come the scheme’s June deadline. The scheme essentially gave individuals and companies a full tax deduction for all amounts invested in approved venture capital companies (VCCs) that in turn invested these monies in qualifying SMEs. However, opportunistic people found loopholes to invest in all sorts of things, including property developments and asset leasebacks, while still getting the tax break. This undermined the impact of the tax incentive, and some bright spark at the Treasury decided to can the whole thing.

“The intention and spirit of the section 12J incentive was always to overcome one of the main challenges to the economic growth of South African SMEs — access to equity finance — by making the VC asset class accessible for retail investors. Unfortunately, only a handful of VCCs have investment mandates to legitimately claim that they invest in SMEs. If there were more of these VCCs out there focused on SMEs, I believe that this would have been a permanent incentive for the benefit of the ecosystem driving innovation, job creation and economic growth,” says Keet van Zyl, co-founder of leading VC firm Knife Capital.

So, if the problem was the mandates of the VCCs, why did the government not keep the incentive and introduce new rules that would curb its abuse and more narrowly define what makes for a qualifying SME investment? At least this way, the good guys can keep benefiting from the incentive, and deserving small businesses can get access to the equity.

“The incentive should have been adapted and aligned to the original intent long ago. The June 2021 sunset clause should have been extended with refinement of the ‘qualifying investee’ definition to stamp out abuse and … encourage VCCs to stick to the spirit and intent of the tax incentive. Why would you not continue to back the 37% of SME qualifying companies that created jobs post-investment?” says Van Zyl.

Well, at least for fund managers like Knife Capital, this doesn’t mean the end of the road. The move will definitely hamper their fundraising efforts in the medium term, but they are “a VC fund manager first and a 12J VCC second”, says Van Zyl. The firm recently raised another $10m (R147.5m) from blackowned investment firm the Mineworkers Investment Company — a visionary move that could trigger a new source of capital in BEE investment firms being major investors in venture capital.

But what about the ecosystem that is so in need of early stage capital? The South African business landscape has never been short of capital for good investments. Its allocation is the problem, especially when it comes to early stage venture capital.

If you look closely at the many funds announced lately, more and more are looking for investments in the sweet spot between early stage VC and more traditional funding such as private equity. They are doing this because it makes business sense. Start-ups that have gone through the seed and series A rounds have already reduced risk to an acceptable level for a private investor.

However, in SA, that’s still too risky a stage, because banks and private equity players want profitable businesses with a track record before they invest. So VC funds can pick up the investment from the early stage investors — very often the “family, friends and fools”, or FFFs — then help the businesses grow to a scale where a more traditional investor like a private equity firm or a global trade player would pick them up. However, what happens to the start-up that doesn’t have cash-rich FFFs? For me, that is where the s12J incentive would’ve played a key role.

The government got lazy here. Someone in a position of power decided it would be too much trouble to apply their mind to the changes that would achieve the strategic objectives originally intended by the incentive. Whatever the reason for this odd decision, SA has thrown the baby out with the bath water.