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by Investors Offshore editorial staff, April 2013, 02 April, 2013
In the common imagination there are a lot of myths surrounding the venture capital industry. Probably the biggest mistake people make is to confuse venture capital with private equity, and to use the two terms interchangeably. While it is true that the venture capital is in essence a form of private equity, the former is only one part of the wider private equity industry, and the investment techniques used are quite distinct.
Private equity investors, so often portrayed as the “bad guys” of the investment universe, typically invest in established companies, struggling or otherwise, and often using leverage, before selling the target company on at a profit. Venture capitalists on the other hand almost always invest in small or start-up companies (so-called “early stage” investment) with a view to building the target company up and realizing a profit when their shares are eventually sold.
Contrary to the popular perception that venture capitalists are out to make a fast buck at the expense of ailing companies, investment timeframes are usually long-term, and investors will normally have to wait at least five years to see a return, and often more like ten years. Indeed, venture capitalists like to paint themselves as a force for good, backing companies and ideas that traditional funds and more risk averse investors wouldn’t normally touch. In doing so, they help to bring new innovative products and processes to the market place to the benefit of society and the wider economy and society as a whole. The industry also points to figures to back up its claims: according to the 2011 Venture Impact study, produced by IHS Global Insight, originally venture-backed companies accounted for 11.87m jobs and over USD3.1 trillion in revenue in the United States – equal to 21% of gross domestic product and 11% of private sector employment.
It is an unfortunate fact that the majority of start-ups will never get off the ground, or not very far off it at least. So by its very nature venture capital investing is a high risk business. The National Venture Capital Association (NCVA), which acts as the voice for the venture capital industry in the US, says that 40% of venture-backed companies fail; 40% will make a moderate return, and only 20% tend to produce high returns. However, using portfolio management techniques, the managers of venture capital funds are able to spread this risk by pooling funds received from investors, and using it to invest in many companies, rather than putting all their eggs into one basket, so to speak.
Venture capitalists normally raise most of their funds from institutional investors like pension funds, endowments and insurance companies. But they also invest money on behalf of high net worth investors and family offices. In a typical venture capital fund structure, investors are limited partners in the fund, and the ones investing the money are normally referred to as general partners. The general partners of a venture capital fund have a fiduciary duty to their limited partners. It is normal for such structures to be registered offshore, especially in jurisdictions with well-established mutual fund legislation in place, the Cayman Islands being a notable example. There are, of course, tax as well as regulatory benefits from locating the partnership offshore.
The bulk of venture capital is invested in high technology companies including software, biotechnology, medical devices, media and entertainment, wireless communications, and networking. More recently the industry has begun to invest in the clean technology sectors such as renewable energy, environmental and sustainability technologies and power management. Venture capitalists also invest in innovative companies within more traditional industries such as consumer products, manufacturing, financial services, and healthcare services and business products and services.
Venture capitalists usually take a hands-on approach to managing their investments, and general partners may assume key management roles in the companies in which they are investing in order to help steer the investment through to fruition. It is common for these managers to have had a background in the particular sector of the company they are investing so they can pass on their knowledge and expertise to the founders, and manage the company appropriately. It is generally the aim of the fund managers to take a target company public by selling its shares to the public on a stock exchange – hopefully at a higher price than what they purchased them for! However, venture capitalists may also exit an investment by merging the target company with another company, or by allowing it to be acquired by another company or investor.
Because of their emphasis on investing in high-tech, information technology-related companies, venture capital firms were stung by the bursting of the tech bubble on the stock markets at the turn of the century. According to the NVCA, there were 462 active US venture capital firms investing at least USD5m in companies in 2010. This compares with 1,022 such firms at the height of the tech bubble in 2000. However, now on a more solid foundation, the industry is growing again, and the NVCA says that the 2010 count rises to 791 if venture capital firms that raised money in any of the previous eight years are included. These firms managed USD176.7bn in committed capital.
In 2010, the NVCA figures show that venture capitalists invested approximately USD22bn into nearly 2,749 companies in 2010. Of these, 1,001 companies received funding for the first time. The average venture fund size was USD149m.
Another less formal type of venture capital is that of angel investment. Angel investors are typically wealthy individuals who fill a financing gap for start-ups which might be too small to attract interest from a venture capital fund, which normally invest a minimum of USD1m in a new venture. There are no “rules” as such for angel investors however, and some may be prepared to put in considerably more than USD1m into a new company. It is said that in the US just as much money is raised by start-ups from angel investors as from venture capitalists, but because of the smaller amounts invested, 60 times more companies received money from angel investors. In some countries, angel investing is becoming slightly more formalized as individuals group together to form angel investing networks. In this way, angel investors are able to pool expertise as well as investment capital.
Many governments now provide tax and other incentives to encourage investment in small businesses and start-ups, particularly if these businesses are in the high-tech sector. Some examples of these tax breaks are illustrated below.
There are no specific federal corporate tax incentives for venture capital in the United States as such. Still, in spite of the absence of tax incentive schemes and a recent moderate increase in taxation for individuals with income of more than USD400,000 per year, the tax regime for venture capital investments in the US is quite benign.
Capital gains are included within income in the US and are subject to income tax; however, the maximum rate of tax on gains from investments held for more than 12 months is between 0% and 20%, depending on the individual’s income (the Taxpayer Relief Act signed into law in January 2013 increased the maximum capital gains tax rate from 15% to 20% for those earning more than USD400,000 annually). Under temporary legislation first enacted in 2010, 75% of capital gains can be excluded if a qualifying small-business asset is held for more than five years. This exclusion rate was later increased to 100% exclusion of capital gains and the Taxpayer Relief Act extended the qualifying period to investments made in 2012 and 2013.
The corporate forms used for venture capital investment are almost always 'pass-through', i.e. the limited partnership or similar is fiscally transparent, so that its gains or losses are attributed to investors without intervening taxation. Evidently, this does not apply to publicly-listed venture capital funds which take the form of mutual funds (often, funds of funds), and are taxable in their own right.
There are however dedicated tax incentives schemes on offer to venture capital investors by state Governments. These usually take the form of a tax credit against state tax liability if the investor meets certain criteria, although it is important to note that some schemes close once a certain amount has been given away in tax credits unless renewed by the state legislature.
One example is Maine’s Seed Capital Tax Credit Program, which is designed to encourage equity and near-equity investments in eligible Maine businesses, directly and through private venture capital funds. Under the Program, state income tax credits may be given to investors for up to 60% of the cash equity they provide to businesses. Investments may be used for fixed assets, research or working capital. To qualify for the credits, the business must be located in Maine, investors must own less than 50% of the business and the business must have annual gross sales of less than USD3m, among other stipulations. In addition, the aggregate investment limit per business is USD5m and investments must be held for at least five years.
However, the Maine tax credit scheme reached its statutory limit of USD30m as of January 28, 2013, and the state is refusing to process further applications until the state legislature approves an extension to it.
The United Kingdom has two main schemes designed to promote investment in start-up and early stage enterprises: the Enterprise Investment Scheme (EIS) offers a range of tax reliefs to investors who purchase new shares in smaller higher-risk trading companies, with a view to helping such businesses raise finance; and the Venture Capital Trust (VCT) scheme, which also provides tax reliefs to those individuals investing in a VCT, and is designed to encourage investment in small unquoted companies.
These two schemes were recently improved with the blessing of the European Commission following a State aid investigation which concluded in July 2012.
Under the changes, the employee limit has increased from fewer than 50 employees to fewer than 250 employees at the time of investment. The gross limit has risen from no more than GBP7m (USD11m) to no more than GBP15m immediately before the relevant investment, and from no more than GBP8m to no more than GBP16m immediately after investment. Also, the amount which any company may receive in the twelve month period ending with the date the relevant investment is made has more than doubled, from GBP2m to GBP5m.
The changes follow a consultation held in the summer of 2011 on Chancellor George Osborne's plans for reform of the schemes. Treasury figures show that since their introduction in the 1990s, the EIS and VCT scheme have supported over GBP11.5bn of equity investment into UK businesses.
Additionally, in September, 2011, the European Commission provided approval for an expansion of the tax relief permitted to angel investors investing in the start-up stages of a small, high growth business under the EIS. It rose from 20% to 30%, with retroactive effect from April, 2011, and the annual limit on investment increased from GBP500,000 to GBP1m. The changes took effect in respect of investments made on or after April 6, 2012.
Furthermore, a new scheme was launched in 2012 designed to help small, early-stage companies to raise equity finance by offering a range of tax reliefs to individual investors who purchase new shares in those companies. The Seed Investment Enterprise Scheme (SEIS) is effective for shares issued on or after April 6, 2012 and provides individual income tax relief of 50% of the amount invested up to a maximum of GBP100,000 per tax year. In certain cases, the scheme allows investors to split the relief between the tax year of investment and the preceding tax year. This applies regardless of the rate of tax at which the individual is taxed.
The SEIS was recently improved in the Government’s Budget for 2013, whereby investors will be permitted to claim 50% capital gains tax relief on gains made in 2012/13 when they reinvest those gains into seed companies in either 2013-14 or 2014-15.
Under Australia’s Early Stage Venture Capital Limited Partnership (ESVCLP) program, a fund is entitled to flow-through treatment for tax purposes, and its investors receive a complete tax exemption on their share of the fund's income (both revenue and capital), regardless of whether they are resident or non-resident. Australian businesses with assets of less than AUD50m (USD52m) may be able to access capital from funds registered under this program if their primary activity is not finance or property development.
Fund managers seeking to raise a new venture capital fund of at least AUD10m for investing in Australian businesses with assets of up to AUD250m may be eligible for registration under the Venture Capital Limited Partnership (VCLP) program. Registration entitles a fund to flow-through tax treatment. Further, eligible foreign limited partners receive a capital gains tax exemption for gains made on eligible investments. Like the ESVCLP, Australian businesses with assets of less than AUD250m may be able to access capital from funds registered under this program if their primary activity is not finance or property development.
In February 2013, the Australian Government announced changes to the tax treatment of venture capital, measures unveiled alongside the publication of the Board of Taxation's review of the system.
The Government's reforms come as part of the Venture Australia package proposed by the Prime Minister, the Treasurer and the Minister for Industry and Innovation. The aim is to increase investment in the venture capital industry.
Under the package, three major changes will be implemented. Firstly, the minimum investment capital required for entry into the ESVCLP program will be lowered from AUD10m to AUD5m. The intention here is to facilitate increased funding from "angel" investors.
Secondly, the ESVCLP and VCLP programs will be administered as a single regime, to provide clearer entry for investors and managers wishing to use these investment vehicles.
Finally, the Pooled Development Fund program, closed to new registrants since 2007, will be phased out over a number of years.
The Board of Taxation reviewed the taxation arrangements currently available under the venture capital limited partnerships regime, concluding that a number of improvements can be made to the operation of the VCLP and ESVCLP regimes, so that they better meet the objective of increasing investment in high risk start-up and expanding businesses in the Australian venture capital sector.
In the case of VCLPs, the Board recommended that any gains or losses made by a VCLP on the disposal of an eligible venture capital investment held for 12 months, which flow through to partners, should be deemed to be on capital account for eligible domestic partners. Further, an Australian Managed Investment Trust (MIT) should be able to invest as a limited partner in a VCLP and retain its MIT status, while the restriction for foreign venture capital funds of funds should be removed provided a fund is widely held.
Turning to ESVCLPs, the Board concluded that, subject to conditions, an investee entity should have greater flexibility to invest in other complementary ventures. The holding company exception should also be modified, to allow an ESVCLP to invest in a holding company that has existing interests in multiple subsidiaries. The Board further believes that Innovation Australia should have discretion to allow ESVCLPs to exceed the 20% foreign investment cap, provided the investment has a material national benefit as associated with the commercialization of Australian research and development.
In addition, an Australian MIT should be able to invest as a limited partner in an ESVCLP and retain its MIT status. Finally, in a more explicitly tax related vein, the Board recommended that where a limited partner in an ESVCLP is a trust (which is not taxed as a corporate), the investors in that trust should not be prevented from accessing the special tax treatment accorded under the ESVCLP regime.
The Government says that it agrees with all of the Board's recommendations, either in full or in principle. According to Assistant Treasurer David Bradbury: "These reforms will help Australia grow new innovative businesses and will promote Australia as a location for investment in innovation."
Although Israel does not appear on many investors’ radar, it has in fact put in place a generous system of tax incentives for venture capital investment. Between 2003 and 2012, Israel's venture capital funds attracted USD6.77 billion. The capital available for investment by Israeli VCs at the beginning of 2013 was USD2.1 billion, of which USD484 million is earmarked for first investments and the rest for follow-on investments.
In 2012, 575 Israeli high-tech companies raised USD1.92bn from local and foreign investors, a 10% decrease from USD2.14bn raised by 545 companies in 2011. VC-backed deals in which at least one venture capital fund participated, accounted for USD1.37bn from a total of USD1.92bn raised in 2012. These venture-backed deals were down 22% from USD1.76bn in 2011. Israeli VC fund investments amounted to USD516m in 2012, 19 % below the USD638m invested in 2011.
Ofer Sela, partner in KPMG Somekh Chaikin’s Technology group, commented: "The year 2012 was a record one in terms of the number of companies raising capital over the past decade. In early stage investments, micro-VCs and angel investors succeeded in filling the void left by Israeli VCs. The Internet sector proved, by far, to be the most attractive sector as more than twice as many early stage Internet companies were funded in 2012 than in 2011. Technology developments in recent years in both cloud-based infrastructure and content delivery platforms have enabled Internet companies to mature and develop their intended technology with greater capital efficiency than any other sector.”
Investment funds in Israel are usually established as partnerships and therefore will not be taxed as corporations. The taxable income will be levied on each one of the partners in the fund. Therefore foreign investors in a given fund will be taxed on the income earned in Israel from the investment fund according to the standard tax rates that are customary as per the different types of income.
However, the investment fund is entitled to approach the tax authorities and receive a private ruling in regard to the taxation of foreign fund partners. The approval is, in effect, given to the fund and not to the individual investor. Therefore it is important for the foreign investor to determine if the fund into which they intend to invest has obtained a private ruling from the tax authority and if so what exactly the terms of the ruling are.
In principle there is a distinction between venture capital funds and other investment funds (e.g. private equity funds, secondary funds, mezzanine funds etc) as regards the tax benefits for foreign investors.
The private rulings state that the foreign investors in a venture capital fund will be exempt from all taxes on their share of income that the fund derives from its investments in companies located in Israel and companies associated with Israel (which means for a foreign company that most of its assets or activities are located in Israel or most of its technology was purchased or developed in Israel).
For the fund to receive such tax exemption status the total sum raised by the fund must exceed USD10m, of which at least 50% will be from foreign investors. Also, at least 50% of the funds raised must be placed in "acknowledged investments," which is defined as establishing or expanding plants in Israel involved in industry, communications, information technology, medical technology and biotechnology or research and development in these fields. Additionally, at least 30% of the total funds raised by the fund must be invested in companies incorporated in Israel and most of their activities must be in Israel.
When these conditions are met, any foreign partnerships transferring or selling all the investor's rights in the fund – or part of them – will be exempt from Israeli taxation. In other words Limited Foreign Partners in the fund are exempt from all Israeli taxes.
Malaysia is a country which is keen to attract investment in industrial as well as more modern hi-tech ventures, and as a consequence the Government provides generous tax incentives designed to lure foreign investors, including for venture capital investment.
There are two schemes open to venture capital investment in Malaysia. The first one is aimed at Venture Capital Companies (VCC) investing in venture companies. Qualifying investors there are given full tax exemption on all sources of income for 10 years of assessment or the years of assessment equivalent to the life span of the fund (if any) established for the purpose of investing in the venture company, whichever is the lesser. Where a VCC incurs a loss from the disposal of shares in a venture company in the basis period for any year of assessment within the exempt period, these losses can be carried forward to the post-exempt period. At least 70% of the funds invested in venture companies must be in the form of seed capital, start-up or early stage financing, and the VCC should not invest in a venture company which is its related company at the point of first investment.
VCCs must obtain annual certification from the Securities Commission that the conditions imposed for the incentives have been complied. The letter of certification must be attached with the income tax return form for submission to the Inland Revenue Board.
The second incentive scheme is aimed at other companies and individuals investing in Venture Companies. Under the scheme, companies and individuals, having invested in a venture company at start-up, seed capital and early stage financing, are entitled to a deduction from the adjusted income equivalent to the value of the investment made in the venture company. If the company or individual does not have sufficient adjusted income to offset the investment, the deductions will be allowed to be carried forward. The investment must be in the form a share acquisition and the shares must be unlisted. The investor must not dispose of these shares until they are listed on the official list of a stock exchange.
Singapore was recently named as the most dynamic economy in the world in the Grant Thornton Global Dynamism Index 2012 and the Government has put in place an array of tax incentives regimes designed to encourage investment in small firms, especially in “new economy” industries like IT. In conjunction with Singapore’s already favorable tax regime, the city-state offers a particularly attractive environment for venture capitalists.
Tax incentives are available to venture capital and private equity funds under section 13H of the Singapore Income Tax Act as well as within the Pioneer Services Incentive and the Economic Expansion Incentive Act.
Section 13H allows an approved fund a tax relief period of up to a maximum of 10 years in respect of: gains arising from the divestment of approved portfolio holdings; dividend income from approved foreign portfolio companies; and interest income arising from approved foreign convertible loan stock.
The Pioneer Service Incentive allows an approved fund management company a tax relief period of up to a maximum of 10 years in respect of: management fees derived from an approved venture capital fund; and performance bonus received from the said approved venture capital fund.
To qualify for the section 13H incentives, the venture capital fund must be incorporated in Singapore and must commit to investing a certain percentage of its subscribed funds in Singapore-based companies and/or overseas companies with economic spin-offs to Singapore. To qualify for the Pioneer Services Incentive, an approved fund management company must also employ a certain number of local venture capital professionals to manage the fund.
Under the Angel Investors Tax Deduction Scheme (AITDS) investors can qualify for a 50% tax deduction on investment costs at the end of a two-year holding period, up to a maximum of SGD500,000 (USD400,000) in each years of assessment. The minimum investment must be at least SGD100,000 within 12 months of becoming an approved investor. To qualify for the AITDS, investors must be able to demonstrate a track record as an entrepreneur and early stage investor and the investee must have been incorporated for less than three years and not be listed on any stock exchange in Singapore.