You will soon be able to claim a tax advantage if you invest in venture capital companies that, in turn, invest in certain kinds of small and medium enterprises. However, the venture capitalists will have to meet certain conditions before you, as an investor, can qualify for the tax deduction.
The government wants to give small enterprises a helping hand by encouraging investors by way of a big tax break to regard the sector as an investment opportunity. Legislation is due to come into force in the next tax year that will offer you a 100-percent deduction against taxable income if you invest in a registered venture capital company. The annual maximum deduction will be R750 000, with a lifetime limit of R3.25 million, and the tax break is destined to end for new claimants after 12 years.
Venture capital companies will, in turn, invest your money in small and medium enterprises.
Although secondary trading in the shares of venture capital companies will be allowed, the tax deduction applies only to the purchase of new shares from a venture capital company.
The South African Revenue Service (SARS) will recoup the deduction if you dispose of your shares. The reason is to ensure you stay invested for the long term and to prevent you from seeking to profit from a short-term tax advantage. If you do withdraw an investment, you will again be able to take up the maximum tax-deductible amounts if you reinvest in a venture capital company at a later stage.
Neither an unlisted company nor a trust qualifies for the tax deduction if it invests in a venture capital company. The tax incentive is restricted to individuals and listed companies.
The small and medium businesses that will qualify for venture capital company investments are:
- Enterprises with gross assets that do not exceed R10 million immediately after an investment made by a venture capital company; and
- Junior mining exploration companies with gross assets that do not exceed R100 million after an investment by a venture capital company.
A number of different businesses are excluded from venture capital investments. These include:
- Property developers and land speculators, except for tourism-type activities such as game farms, bed and breakfasts, and hotels;
- Financial services activities, such as banking, insurance, tax advice, broking, management consulting, accounting and related activities;
- Casinos and any games of chance;
- Liquor, tobacco and arms or munitions companies; and
- Franchise operations, except for franchisors.
The tax incentive is not a free lunch. There are plenty of risks when investing in small and medium enterprises. The risks include:
- Business failure. About 60 percent of all start-up businesses in South Africa fail in the first two years. J-P Fourie, the executive officer of the South African Venture Capital and Private Equity Association (Savca), says venture capital investors should accept their investment is long term and high risk - but with high potential returns.
- Valuations. Investments in what is called private equity - investments in enterprises that are not listed on stock markets - do not have the buy-and-sell demand valuation structure of a stock market. Instead, investors have to rely on valuations provided by the enterprises and the venture capital companies.
Fourie says Savca has adopted the international private equity and venture capital valuation guidelines to give investors some comfort that the valuations are realistic.
- Investor control. You have no right to interfere in the underlying investments, particularly if or when things go wrong. For example, you cannot attend board meetings. Once you have made your investment, you are in effect locked in for the longer term.
However, without a formal venture capital market the risks of investing directly in small and medium enterprises would be extensive. A formal venture capital market reduces the risks in the following ways:
- The venture capital companies are hands-on investors on your behalf and play an integral part in selecting, developing and managing the enterprises.
- The National Treasury has taken a number of steps to reduce investment risk and to encourage investment flows into small and medium enterprises.
Venture capital companies that offer tax-incentivised investments to the public will have to register with SARS. They will also have to comply with the provisions of the Financial Intermediary and Advisory Services Act to ensure you are provided with appropriate advice, and proper and full information about your investment.
To register with SARS and to remain registered, venture capital companies must adhere to the following conditions:
- At least 10 percent of the total assets held by a venture capital company must be in small companies with a gross asset value of no more than R5 million after the venture capital company investment; and
- At least 80 percent of the total assets held by a venture capital company must be in small companies with a gross asset value of no more than R10 million after the venture capital company investment.
The National Treasury also requires an investment structure (the venture capital company) similar to collective investment schemes (for example, unit trust funds). The intention is to eventually bring venture capital fully within the Collective Investments Schemes Control Act. The proposed National Treasury structure reduces risk in two ways:
- A large number of individual investors place their money in a single pool, as with unit trust funds. The venture capital company then invests the money in a multitude of different enterprises. This spreads the risk, because if one company fails or fails to perform, you do not lose your boots.
- A venture capital company cannot hold more than 50 percent of the share capital of any one enterprise that it finances. This is similar to the way in which a unit trust fund is restricted from investing more than five percent of its money in a single company. This reduces the fund's exposure to risk by ensuring it has a diversified investment portfolio.
There are also obligations on the enterprises financed by venture capital companies, such as a necessity to invest the money within 18 months.
The local venture capital market is fairly well developed, enabling it to make products available to individual investors. Savca has 62 full members.
Over the five years to December 2007, the venture capital industry attracted R2.8 billion in investments.
Fourie says venture capital is used as seed capital to launch an enterprise and for businesses that have been in operation for a limited time to ensure they have enough money to remain viable, particularly in the early years.
Fourie says new businesses are unlikely to make a profit in their early years. Venture capital investors must be prepared to commit their money for about 10 years, which will give the companies time to reach their maximum potential.
This article was first published in Personal Finance magazine, 4th Quarter 2008. See what's in our latest issue