In Australia, we have a structured venture capital fund entity called the “Early Stage Venture Capital Limited Partnership”. This entity allows fund managers to raise between $10m and $100m to invest in early stage businesses excluding industries like property development and construction. When you read about it, aside from the actual capital raising part, the barriers to entry look quite minimal, so why aren’t we seeing more of these in the tech sector and what, if anything is wrong with the scheme.
First of all, let’s talk about what’s attractive. The ESVCLP allows for carry and returns to be completely tax free for both investors and partners. For the fund managers any fees or interest on carry are treated as tax free as well. So basically, any return generated by or through these funds are fully tax free! Obviously investors and partners can’t claim losses as a tax deductible – this is an upside structure, so that makes sense.
There is one significant item within the structure that needs to be addressed and that is around the mandatory disposal of high value assets. It is completely flawed that is a requirement to offload investments that exceed $250m in assets. This virtually eliminates the massive home run – companies like Zynga and Facebook would have exceeded that threshhold very early on. I totally understand that the government is trying to use this structure to encourage investment in smaller companies, but if someone has had the foresight to invest early on in a winner, making them cash out early is very harsh and counterproductive.
On the other hand, employees of small startups who are keen to take an option on some equity in the employer are really rather harshly treated. In the ESVCLP scheme, a fund manager gets his carry (about 20% of the positive return the fund makes), fees and interest on carry all tax free, but the humble employee who put in the hard yards, was granted some options, allowed them to vest and waited until a liquidity option was available gets slugged all over the place with taxes. That hardly seems fair, the VC who invested someone else’s money gets his fees and return (plus any interest) tax free, but the employee with options pays capital gains tax.
I think the ESVCLP structure is good and I’m surprised that we don’t see more people setting up funds under that umbrella. When you consider the abysmal rate of return on our superannuation funds over the past decade, it would seem to make sense for a few shekels to get flicked into a potentially high return basket. I think the ESVCLP really needs to be changed to allow investors to fully reap the benefit of picking a winner – hey if Lotto winnings are tax free, why not well placed early stage strategic investments. The other piece of the puzzle is allowing the staff of these early stage companies that do well to participate in the win without the taxman clobbering them. The tax rules around employee shares and options needs to be amended to afford small startups the luxury of incentivising staff with shares.
Once that’s done, then there should be no excuses about government rules and regulations.
