Venture Capital Companies – a (working) perspective

stock-photo-background-concept-wordcloud-illustration-of-venture-capital-glowing-light-76313254

Yesterday I had the privilege of attending the launch of GroTech, one of the latest South African Venture Capital Companies that have emerged following the South African Revenue Service’s (SARS) revision of Section 12J of the SA Income Tax Act.

The timing of the launch was convenient as we are also intrigued by S12J and the possibility of creating our own fund to take advantage of the tax dispensations allowed. Therefore, as we are doing our own research, I thought it would be good to put down in one article what our findings are. I am by no means an expert in this, so if you find an error or want to comment, please do so. The heading of the article also shows that this is a working treatise and I will make updates as an when more information comes to light.

The legislation

SARS-LOGO

The obvious first port of call is the actual legislation itself, which can be found here. Let’s begin by summarising the intention of the taxman, so here’s some extracts from that site (with my emphases in italics):

What are Venture Capital Companies?

  1. One of the main challenges to the economic growth of small and medium-sized businesses and junior mining exploration is access to equity finance
  2. To assist these sectors in terms of equity finance, government has implemented a tax incentive for investors in these enterprises through a venture capital company (VCC) regime
  3. VCCs are intended to be a marketing vehicle that will attract retail investors (although SARS does go on to state that “any taxpayer qualifies to invest in an approved VCC”, which would indicate that institutional investors can also invest)
  4. An investor is any taxpayer who qualifies to invest in an approved VCC
  5. They have the benefit of bringing together small investors as well as concentrating investment expertise in favour of the small business sector
  6. There are no special tax benefits for VCC, only standard tax rules will apply

Who are they for?

  1. Investors can claim amounts incurred on acquiring VCC shares as a deduction from income
  2. This deduction will not be subject to recoupment if the VCC shares are held for longer than five years
    1. Therefore, the investment deduction will be permanent as long as that investment is held for longer than 5 years
    2. Any investment exited before 5 years (both in the VCC and investments by the VCC) means the deduction will be revered)
  3. A company must meet all of the following preliminary requirements to be able to get an approved VCC status for each year of assessment:
    1. The company must be a resident
    2. The sole object of the company must be the management of investments in qualifying companies (i.e. investees)
    3. The company’s tax affairs must be in order
    4. The company must be licensed in terms of section 7 of the Financial Advisory and Intermediary Services Act
  4. The VCC regime is subject to a 12 year sunset clause that ends on 30 June 2021
  5. Qualifying investors can claim income tax deductions in respect of the expenditure
    actually incurred to acquire shares in approved VCCs
  6. Where any loan or credit is used to finance the expenditure in acquiring a venture
    capital share and remains owing at the end of the year of assessment, the deduction is
    limited to the amount for which the taxpayer is deemed to be at risk on the last day of
    the year of assessment
  7. No deduction will be allowed where the taxpayer is a connected person to the VCC at
    or immediately after the acquisition of any venture capital share in that VCC
  8. Standard income tax and CGT rules apply in respect of VCC shares

When can VCC approved status be withdrawn?

SARS can withdraw the approved VCC status for non-compliance with the following:

  1. If, during any year of assessment, after the approval of the Venture Capital Company status, the company fails to comply with the preliminary  requirements as listed above
  2. The company must satisfy the following additional requirements at the end of each year after the expiry of 36 months from the first date of the issue of VCC shares by the VCC:
    1. A minimum of 80% of the expenditure incurred by the VCC to acquire assets must be for qualifying shares, and each investee company must, immediately after the issuing of the qualifying shares, hold assets with a book value not exceeding:
      1. ZAR500 million in any junior mining company; or
      2. ZAR50 million in any other qualifying company (this was originally ZAR20m, but was increased after lobbying)
    2. The expenditure incurred by the VCC to acquire qualifying shares in any one qualifying company must not exceed 20% of any amounts received by the VCC in respect of the issue of VCC shares

What happens if there is non-compliance?

  1. SARS will issue a written notification to the VCC stating the requirements that have not been met and provide a grace period for the VCC to meet the requirements
  2. If the approved VCC does not take the acceptable corrective steps within the period provided for in written notice, the approved VCC status will be withdrawn from:
    1. The commencement of that year of assessment, or
    2. The date of approval of the Venture Capital Company status where the VCC does not meet the additional requirements after the expiry of 36 months from the date of first issue of VCC shares
  3. If the approval is withdrawn the VCC must include in its income an amount equivalent to 125 percent of the expenditure incurred by investors to acquire VCC shares

Who qualifies to be an investee?

  1. The Investee must be a company
  2. The company must be an SA resident
  3. The company must not be a controlled group company in relation to a group of
    companies
  4. The company’s tax affairs must be in order (a tax clearance certificate must be
    requested from SARS to support this requirement)
  5. The company must be an unlisted company or a junior mining company
    1. A junior mining company may be listed on the Alternative Exchange Division
      (AltX) of the JSE Limited
  6. During any year of assessment, the sum of the “Investment Income” derived by the
    company must not exceed 20% of its gross income for that year of assessment
  7. The company must not carry on any of the following impermissible trades:
    1. Any trade carried on in respect of immoveable property, except trade as a hotel
      keeper (includes bed and breakfast establishments)
    2. Financial service activities such as banking, insurance, money-lending and hire-purchase financing
    3. Provision of financial or advisory services, including legal, tax advisory, stock
      broking, management consulting, auditing, or accounting
    4. Operating casino’s or other gambling related activities including any other
      games of chance
    5. Manufacturing, buying or selling liquor, tobacco products or arms or ammunition
    6. Any trade carried on mainly outside SA
  8. There are no special tax rules for investee companies. The standard tax rules will
    apply

Crucial differences between the SA VCCs and the UK VCTs

In the next section I have set out, in detail, the UK Venture Capital Trust (VCT) regime, which you can go through if you like. The SA VCC legislation was based on the UK VCT legislation. However, there are some crucial differences:

  1. SA investors are not afforded the following tax reliefs:
    1. Exemption from dividends paid on the VCC shares they hold
    2. Exemption from capital gains tax from the disposal of their VCC shares
  2. After 3 years, only 70% of the UK VCT’s investments have to be in qualifying holdings, vs 80% for SA VCC’s
  3. The UK regime allows for investment in AIM and Plus Market listed entities. The SA regime only allows for investment in junior mining companies listed on the JSE’s AltX
  4. UK VCTs must be listed on a regulated exchange. There is no similar requirement for SA VCCs
  5. UK VCTs can invest up to £5m per investment but each individual investment cannot make up more than 15% of VCT assets
  6. The gross assets of the company into which the VCT invests must not exceed £15m, and the company must have no more than 250 employees. SA VCCs are limited to ZAR500m for junior miners and ZAR50m for other companies
  7. If an investment is held in a company that becomes quoted on the London Stock Exchange then it can continue to be treated as a qualifying VCT investment for up to five years

So here are the problems, then, for the SA VCC regime:

  1. Investors don’t get the full tax relief as per the UK as they lose out on dividend and CGT relief. Quite a big difference there
  2. The SA VCC has to invest up to 80% in qualifying investee companies, significantly more than the 70% requirement in the UK
  3. The only listed entities allowed are those junior miners listed on the JSE’s AltX. Given the dismal failure of the AltX Board, this is a huge disappointment as SARS could do a lot to generate interest in this VC-focused Board
  4. As SA VCCs do not need to be listed, they are not subject to the public disclosure and other corporate governance requirements enforced by a stock exchange – increasing the risk faced by the investor
  5. UK VCTs can diversify up to 15% of their assets, whereas, by my reading, SA VCCs can only do so up to 20%. Individual investment sizes are also not absolutely pegged (£5m in the UK)
  6. The gross assets of the investee companies immediately preceding the investment by a UK VCT must not exceed £15m. At an exchange rate of ZAR16:£1 (yes, I know this is around 24:1 now, but I have used this ratio as this was the approximate exchange rate during 2015 before the Rand fell out of bed), this is equivalent to ZAR240m. A massive difference to the paltry ZAR50m the SA VCC is allowed (ignoring the miners)
  7. I cannot see what happens when an investee company is listed in SA – i.e. if there is also the five year grace period

By the way, the Wikipedia page on VCTs states that”[i]n the 2013/14 tax year, £393m was raised by Venture Capital Trusts. This is a significant increase on the 2012/13 tax year when the total raised was £270m”. Compare this to the relatively very small amounts raised by the few SA VCCs who have done any fund raising, which I have set out below.

The UK VCT legislation

hmrc

The UK HMRC created Venture Capital Trusts (VCTs) in 1995. I used this archived HMRC link to set out the brief details of VCTs below:

  1. It is designed to encourage individuals to invest indirectly in a range of small higher-risk trading companies whose shares and securities are not listed on a recognised stock exchange, by investing through VCTs
  2. Previously VCTs were companies listed on the London Stock Exchange, but from April 2011 VCTs are companies admitted to trading on a regulated market
  3. Tax reliefs available for investors:
    1. Tax reliefs are only available to individuals aged 18 years or over and not to trustees, companies or others who invest in VCTs
    2. Income Tax reliefs:
      1. Exemption from Income Tax on dividends from ordinary shares in VCTs (dividend relief)
      2. ‘Income Tax relief’ at the rate of 30 per cent of the amount subscribed for shares issued in the tax year 2006-07 and onwards (for subscriptions for shares issued in previous tax years the rate is 40 per cent). The shares must be new ordinary shares and must not carry any preferential rights or rights of redemption at any time in the period of five years beginning with their date of issue. You can get this relief for the tax year in which these ‘eligible shares’ were issued, provided that you subscribed for the shares on your own behalf, the shares were issued to you, and you hold them for at least five years
      3. The Income Tax relief at 30 per cent is available to be set against any Income Tax liability that is due, whether at the lower, basic or higher rate
      4. You can get Income Tax relief for a tax year if shares in VCTs for which you subscribed up to a maximum of £200,000 are issued to you in the year
      5. Income Tax relief can be claimed only if you subscribe for new shares
    3. Capital Gains Tax reliefs:
      1. You may not have to pay Capital Gains Tax on any gain you make when you dispose of your VCT shares (disposal relief)
      2. You can get two of the reliefs, dividend relief and Capital Gains Tax exemption, for both newly issued shares and second-hand shares acquired, for example, through the Stock Exchange
  4. Conditions for HMRC approval of VCTs
    1. Its income for its most recent accounting period must have been wholly or mainly from shares or securities
    2. Throughout that period, at least 70 per cent (by value) of its investments must have been ‘qualifying holdings’, that is shares or securities in companies which meet the conditions of the scheme and which were issued to the company and have been held by it ever since. From 6 April 2007 any money that a VCT holds (or is held on its behalf) will be treated as an investment for the purpose of these tests
    3. Qualifying holdings:
      1. The company must be unquoted
        1. However, AIM or Plus Market (Plus Traded and Plus Quoted) listed companies do comply
        2. Shares or securities in a company which ceases to be unquoted can continue to be treated as being comprised in the VCT’s qualifying holdings for the following five years
      2. Trading activities
        1. The company must exist for the purpose of carrying on a ‘qualifying trade’ or be the parent company of a trading group whose business as a whole meets the scheme’s rules
        2. The relevant company (in this instance the one receiving funds from the VCT) must have a permanent establishment in the UK
      3. Excluded trading activities
        1. Dealing in land, financial instruments, or in goods other than in an ordinary trade of retail or wholesale distribution
        2. Financial activities, property development, or providing legal or accountancy services
        3. Leasing or letting assets on hire, except in the case of certain ship-chartering activities
        4. receiving royalties or licence fees, except where these arise from an intangible asset such as a patent or know-how, where most of it has been created by the company (or one of its subsidiaries)
        5. farming, market gardening, or forestry
        6. operating or managing hotels, guest houses, hostels, or nursing or residential care homes
        7. providing services to another company in certain circumstances where the other company’s trade consists to a substantial extent in excluded activities
        8. shipbuilding, producing coal or steel
        9. generating or exporting electricity which will attract a Feed-in Tariff
        10. providing services to another company in certain circumstances where the other company’s trade consists to a substantial extent in excluded activities
      4. Gross assets
        1. The value of the company’s gross assets must not exceed £15m immediately before the VCT makes its investment, and
        2. £16m immediately afterwards
      5. Independence
        1. The company must be controlled by another company, or
        2. Another company and a person connected with that company
    4. Throughout that period, at least 70 per cent (by value) of its qualifying holdings must have been holdings of ordinary shares with limited preferential rights to dividends or to the company’s assets on its winding up, and no right to be redeemed. (The proportion is 30 per cent in relation to shares subscribed for by the VCT before 6 April 2011 or from money raised prior to that date)
    5. At no time in that period must its holding in any company have represented more than 15 per cent (by value) of its investments
    6. Throughout that period, its ordinary shares must have been listed on a recognised Stock Exchange
    7. It must not have retained more than 15 per cent of the income it derived in that period from shares or securities
    8. Throughout that period the VCT has not made an investment in any company which exceeds the £5 million maximum annual investment which the company is permitted to receive via any government support measure approved as compatible with the European Community Guidelines on Risk Capital Investments in Small and Medium-sized Enterprises. This takes effect in respect of investments made by the VCT on or after 17 July 2012

List of approved VCCs

The following is a list of approved VCCs from the SARS website, together with the VCC websites where I could find them. From the list it is clear that:

  • S12J is gaining momentum, with a burst of approvals through 2015 and early 2016
  • Of the 28 VCCs already approved, only one (Grovest Venture Capital) seems to have actually raised money and made investments. I may be wrong in that one or two others have also done so but just haven’t disclosed anything, although I doubt very much it has gone beyond that
  • There are a few VCCs in fund-raising mode
  1. Olivewood Resources Ltd
    1. Approval date – 20 October 2009
    2. Focus – junior mining
    3. Amount raised – unknown
    4. Number of investments to date – unknown
  2. Iridium Private Equity
    1. Approval date – 8 February 2012
    2. Focus – unknown
    3. Amount raised – unknown
    4. Number of investments to date – unknown
  3. Grovest Venture Capital
    1. Approval date – 18 March 2013
    2. Focus – high growth SMEs
    3. Amount raised – ZAR22.35m
    4. Number of investments to date – 5 (have a look here)
  4. Carbide VC 1
    1. Approval date – 10 October 2013
    2. Focus – diversified portfolio of SMEs
    3. Amount raised – unknown
    4. Number of investments to date – unknown
  5. Harbour Energy One
    1. Approval date – 13 November 2013
    2. Focus – unknown
    3. Amount raised – unknown
    4. Number of investments to date – unknown
  6.  Engeli Venture Capital
    1. Approval date – 21 July 2014
    2. Focus – unknown
    3. Amount raised – unknown
    4. Number of investments to date – unknown
  7. Smart Capital
    1. Approval date – 1 August 2014
    2. Focus – unknown
    3. Amount raised – unknown
    4. Number of investments to date – unknown
  8. Redwood Empire Investments
    1. Approval date – 15 January 2015
    2. Focus – unknown
    3. Amount raised – unknown
    4. Number of investments to date – unknown
  9. Obelus
    1. Approval date – 16 January 2015
    2. Focus – unknown
    3. Amount raised – unknown
    4. Number of investments to date – unknown
  10. Sanari Growth Partners
    1. Approval date – 19 January 2015
    2. Focus – diversified portfolio of high-growth SMEs
    3. Amount raised – ZAR200m (target, from what I can see the fund has not closed yet)
    4. Number of investments to date – unknown
  11. K2014087988
    1. Approval date – 10 February 2015
    2. Focus – unknown
    3. Amount raised – unknown
    4. Number of investments to date – unknown
  12. Gateway International Education Fund
    1. Approval date – 23 February 2015
    2. Focus – SA private education sector
    3. Amount raised – unknown
    4. Number of investments to date – unknown
  13. Titanium VC 1
    1. Approval date – 23 February 2015
    2. Focus –  ventures and projects to develop independent private power solutions in SA
    3. Amount raised – unknown
    4. Number of investments to date – unknown
  14. Westbrooke Alternative Rental Income Assets
    1. Approval date – 8 April 2014
    2. Focus – a portfolio of yield producing asset-backed businesses which have underlying contractual or predictable revenue streams
    3. Amount raised – unknown
    4. Number of investments to date – unknown
  15. HC 100
    1. Approval date – 19 June 2015
    2. Focus – unknown
    3. Amount raised – unknown
    4. Number of investments to date – unknown
  16. Oaktree Venture Capital Investments
    1. Approval date – 13 July 2015
    2. Focus – unknown
    3. Amount raised – unknown
    4. Number of investments to date – unknown
  17. Grovest Hospitality Holdings
    1. Approval date – 3 August 2015
    2. Focus – a portfolio of hospitality businesses situated in prime locations in South Africa yielding double digit returns where the risk is mitigated by accretive property underpins
    3. Amount raised – ZAR50m (target, by February 2016)
    4. Number of investments to date – unknown
  18. KZN Venture Capital Fund
    1. Approval date – 12 August 2015
    2. Focus – unknown
    3. Amount raised – unknown
    4. Number of investments to date – unknown
  19. Providence Hospitality Holdings
    1. Approval date – 13 August 2015
    2. Focus – unknown
    3. Amount raised – unknown
    4. Number of investments to date – unknown
  20. I-Cubed Consulting
    1. Approval date – 22 September 2015
    2. Focus – unknown
    3. Amount raised – unknown
    4. Number of investments to date – unknown
  21. Kingson Capital
    1. Approval date – 6 October 2015
    2. Focus – communication technology, engineering and healthcare
    3. Amount raised – unknown
    4. Number of investments to date – unknown
  22. Energia VC1
    1. Approval date – 7 October 2015
    2. Focus – unknown
    3. Amount raised – unknown
    4. Number of investments – unknown
  23. Nesa Venture Capital Investments
    1. Approval date – 19 October 2015
    2. Focus – early stage and expansion stage SMMEs, specifically targeting the SA government’s “100 black industrialists”
    3. Amount raised – unknown
    4. Number of investments – unknown
  24. Pallidus Venture Capital Fund 1
    1. Approval date – 23 October 2015
    2. Focus – unknown
    3. Amount raised – unknown
    4. Number of investments – unknown
  25. Lucid Ventures
    1. Approval date – 11 December 2015
    2. Focus – unknown
    3. Amount raised – unknown
    4. Number of investments – unknown
  26. Westbrooke Capital Hospitality
    1. Approval date – 7 January 2016
    2. Focus – unknown
    3. Amount raised – unknown
    4. Number of investments – unknown
  27. KNF Ventures
    1. Approval date – 13 January 2016
    2. Focus – unknown
    3. Amount raised – unknown
    4. Number of investments – unknown
  28. Carbide Resources VC 1
    1. Approval date – 13 January 2016
    2. Focus – unknown
    3. Amount raised – unknown
    4. Number of investments – unknown

In addition, as I mentioned at the outset, GroTech is also launching a VCC and will be applying to SARS shortly:

  • Focus – high growth innovative digital technology companies
  • Amount to be raised – between ZAR100m and ZAR200m

Conclusion

It is clear from my research that the SA VCC regime has its issues and is far from the overall relief and benefit provided by the UK VCT legislation. Does that mean it is a waste of time?

On balance, I think it is worthwhile. There is still a significant tax relief, but unfortunately a lot less than the UK. Further, the SA VCC has some fairly limited ability to move within the far more strict parameters. But, at least we have something to work with, and something is better than nothing.

The inability to invest in an AltX company (or similar Boards which may appear in the coming months given the number of alternative stock exchanges going through the SA Financial Services Board) is just silly as well as tragic – we need all we can to generate our SME sector and retail investment therein.

Another big concern is regulation and corporate governance surrounding the VCC itself. Requiring them to be listed a la the UK would go a long way to derisking them for investors. Caveat emptor is not enough, I’m afraid. Ironically, requiring them to be listed on something like the AltX could also benefit the AltX or its equivalent as well.

However, SARS is being continually lobbied in this regard, so let’s hope some sanity prevails and the regime is made more accommodating to engender even more interest than has occurred of late.

Is this something we, ourselves, should pursue? After doing the research and with our significant access to dealflow, as well as our supreme frustration with the SA VC industry as a whole, I suspect the answer is “yes”. Now to debate at our Board of Directors.

Watch this space.

Carpe Diem!

 

About vcmaven

I am an experienced investment banker. I provide investment banking advice and access to funding to companies and entrepreneurs
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3 Responses to Venture Capital Companies – a (working) perspective

  1. nuclearpengy says:

    Thanks for putting this together; there is a serious need for more South African content related to PE and VC.

    On the point of listing the VCC. I’m not convinced that listing is the way to go, is there something specific that you feel would really add value by listing?

    Like

  2. vcmaven says:

    Hi, thanks for the comment. The UK requires a VCT to be listed which immediately means that the VCT is subject to regulation by the stock exchange, which means public disclosure and adherence to governance standards. By not requiring a VCC to be listed, this means that these additional safeguards are not in place and investors face additional risk.

    Bear in mind that listed entities not only have to comply with listings requirements at the time of listing, but also with continuing listing obligations, such as publication of financial statements, announcements regarding acquisitions and disposals, shareholder approvals for issues of shares etc. Most importantly, this places them in the public eye, which allows analysis by investors and the financial press and other commentary.

    Inherently this must be a less risky environment for an investor.

    So, at the end of the day, if you want the tax break, you have to list and be subject to public scrutiny. We haven’t enforced that.

    Like

    • nuclearpengy says:

      Ah ok. I kind of see where you’re coming from in terms of transparency but I don’t personally think that listing adds much value in terms of trust. I’ve done work with listed corporates in the past and they’re the worst in terms of negligent/wasteful expenditure and bad business practices.

      I think VC investing is a lot more about relationships than any other type of investing so the investors really need to trust the people they choose to invest with.

      Most VC companies are run by small teams of accessible/approachable people so the investors can actually meet and get to know them personally; when investing in typical listed institutions, this level of access isn’t usually available so one has no choice but to reference publicly available information as indicators of trust and potential performance.

      Like

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