Unlocking the opportunities of global challenges
As the effects of the global credit crunch begin to take their toll on the private equity investment model, the industry is starting to explore alternative methods of capital raising and investment, so as not to miss the opportunities which the current equity market affords.
One of the strategies considered by private equity firms is investment in small and medium sized enterprises with strong growth potential, in the early stages of their business life cycle.
For the venture capital sector, the opportunities presented by the global challenges of climate change and the resulting increase in clean technology innovation are significant. The challenge of addressing environmental damage is gathering international political momentum as an issue which is vital to the future quality of life on our planet. The political alliances of voters and the commercial decisions of consumers are being influenced more and more by a consideration of the impact those decisions will have on the environment.
As a result, the commercialisation of clean technologies which seek to address aspects of the climate change challenge is certain to be one of the major growth drivers of developed economies such as Australia and the United States. The role of the venture capital sector in this endeavour is crucial.
Recent changes to the way investors of early stage funds are encouraged by the federal government (namely through the implementation of the Early Stage Venture Capital Limited Partnership (ESVCLP) program) are likely to increase the attraction of early stage venture capital investment for both the private equity sector and the venture capital sector.
The ESVCLP program replaces the Pooled Development Funds (PDF) program and is aimed at stimulating Australia’s early stage venture capital sector by allowing generous tax concessions for funds meeting the registration and investment criteria set out in the Venture Capital Act 2002 (Cth) (the Act).
What is an ESVCLP?
An ESVCLP is a venture capital fund, legally structured as a limited partnership and registered with Innovation Australia in accordance with the Act.
Limited partnerships are the preferred structure for venture capital investors internationally, because of the flexibility of the ‘flow-through’ taxation position and the limited liability of investors.
The benefits of ESVCLPs
Unlike PDFs, which were a corporate vehicle, an ESVCLP will have flow-through tax treatment, i.e. the ESVCLP will not be taxed at the partnership level. In addition, income distributions and capital gains earned as a result of investment in an ESVCLP will be exempt from tax in Australia in the hands of both domestic and foreign partners.
Tax losses by ESVCLPs, however, will not flow through to nor will be deductible by partners.
The tax-free treatment is a significant legislative incentive which has the potential to both considerably increase a fund’s internal rate of return and assist it to attract a wider pool of investors.
What does ‘early stage’ mean?
An ESVCLP must be registered with Innovation Australia and have its partnership deed and investment plan approved before it commences its investment activities. It is vital to ensure that these documents clearly disclose the partnership’s focus on early stage investment.
The Act does not specifically define ‘early stage’, however it does provide that ESVCLPs may invest in entities whose gross assets are up to $50 million at the time of the first investment. This is, arguably, quite a high threshold, indicative of an entity further along its business life cycle than one which would ordinarily be considered to be ‘early stage’, and therefore opens up a significant range of investment options.
In determining the extent to which an investment plan focuses on early stage venture capital, Innovation Australia will have regard to a number of key indicators including:
- the stage of development of the proposed investee entities
- the level of technology in the entity
- the proportions of intellectual property to total assets of the entity
- the levels of risk and return of the entity
- the amount of tangible assets and collateral against which borrowings may be secured by the entity
- the partnership’s investment hold strategy, and
- whether or not the investment plan is connected with any other investment plans which would result in the partnership exceeding the financial investment limitations set out in the Act.
It is important to ensure the partnership deed and the investment plan not only address the specific legal requirements of the Act, but also have regard to the policy which underlies the legislation and the areas of discretion Innovation Australia has over the registration process.
What it takes to qualify
There are also a number of legislative requirements which determine both the financial structure of ESVCLP investments and the nature of the investee entities. Among those requirements are:
ESVCLPs may only invest in entities whose predominant activity consists of eligible activities. Activities which are not eligible include property development, land ownership, banking, providing capital to others, leasing, factoring, securitisation, insurance, construction, acquisition of infrastructure or related facilities, and making investments directed at deriving income in the nature of interest, rents, dividends, royalties or lease payments.
The size of the ESVCLP fund must be between $10 million and $100 million.
No single partner’s interest in an ESVCLP may exceed 30% of the total committed capital, subject to exceptions which include superannuation funds.
In addition, ESVCLPs are required to lodge quarterly and annual reports with Innovation Australia.
What types of securities can an ESVCLP acquire?
In making an investment, an ESVCLP may acquire the following kinds of securities:
- shares in a company
- units in a unit trust
- options (including warrants), and
- convertible notes, provided they are not debt interests.
It is noteworthy that a PDF was not permitted to acquire convertible notes or units in a unit trust.
Generally, venture capital funds will make their first investment in an investee entity by way of convertible note. Acquiring a convertible note minimises the risk associated with early stage investments by giving the investor the opportunity to conduct further due diligence on the entity to determine whether or not it wishes to convert the note into equity securities. At the same time, the investor retains an entitlement to receive the fixed or floating interest rate as well as an option to have its investment repaid on maturity of the note. An ESVCLP now has this investment option.
In addition, an ESVCLP may make a loan to a proposed investee entity whether or not it holds an existing security in that entity, provided the loan is repaid within six (6) months. This gives an ESVCLP the option to make its initial investment by way of pure debt, rather than by convertible note.
How much can an ESVCLP invest in one group?
The total amount an ESVCLP invests in interests (including debt and equity interests) of an entity, and any associate or other member of the same wholly-owned group of that entity, must not exceed 30% of the total committed capital of the ESVCLP.
The divestiture rule
ESVCLPs cannot hold investments in an investee entity whose gross assets together with the assets of an associate of, or a member of the same wholly-owned group as, the investee entity exceeds $250 million.
Once this limit is exceeded, the partnership must dispose of the investment within 6 months of the end of the partnership’s income year in which the limit was exceeded. Innovation Australia may extend the divestiture period by an additional 3 months on request of the general partner.
Investments in entities which exceed the $250 million threshold but demonstrate the potential for significant additional growth may be transferred to a related purchase structure.
Conclusion
The new ESVCLP investment vehicle brings the Australian venture capital industry one step closer to having a world-class venture capital investment vehicle. The ESVCLP model compares favourably with the PDF model and represents a compelling proposition for investors prepared to focus on early stage investment opportunities with high growth potential in eligible activities.
The first ESVCLP was registered in January 2008, merely 6 weeks after the introduction of the necessary legislation amending the New South Wales partnership legislation, and the interest in this new investment vehicle has been significant. As the market familiarises itself with the benefits of the new regime, the ESVCLP is bound to become the preferred vehicle for venture capital investment.
For further information, please contact your usual PricewaterhouseCoopers adviser or:
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John Cannings, Partner
PricewaterhouseCoopers Legal
Corporate and Commercial
Tel +61 2 8266 6410 |
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Steven Maarbani, Associate
PricewaterhouseCoopers Legal
Corporate and Commercial
Tel +61 2 8266 6843 |
