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19 June 2015 Wind in the sails: recent developments help steer start-ups in the right direction

By Andrew Draper, Senior Associate and Nicholas Mark, Solicitor


In Brief

In the first two articles in our series focussing on issues relating to start-up businesses we looked at the various funding sources and funding models available in relation to start-ups. Following the delivery of the Abbott Government's second budget last month, our latest instalment provides insight into a number of recent developments which will have a particular impact on Australian start-ups.


Introduction

The 2015 Budget focussed heavily on growing jobs and small business and included specific measures designed to encourage and support new start-up businesses and entrepreneurship, and to facilitate further venture capital investment in emerging Australian companies.  Based on the government's own estimation that some 13% of Australia's adult population are involved in starting or running a small business, these developments have the potential to be particularly effective.

The developments include the taking of steps to remove the barriers to, and to encourage crowd-sourced equity funding in Australia; changes in the tax treatment of both options issued under employee share schemes and professional expenses incurred by start-ups; and changes to complying investments for the Significant Investment Visa program.

Crowd-Sourced Equity Funding

Crowd-Sourced Equity Funding (CSEF) is an online-facilitated method of equity funding, drawing on (comparatively) smaller financial equity investments from a large number of investors, usually individuals.  Australia currently lags far behind the rest of the world in terms of CSEF and the regulatory infrastructure surrounding it.  CSEF platforms are already operational and regulated in similar jurisdictions such as Canada, France, New Zealand and the USA.  Online venture capital crowd-funding platforms such as VentureCrowd, Ingogo and CrowdMobile are already successfully reaching sophisticated and other eligible investors in those jurisdictions.

Currently, there are significant obstacles preventing the implementation of a CSEF regime in Australia. 

Firstly, the prohibition in s 113(1) of the Corporations Act 2001 (Cth) (Act) on proprietary companies having more than 50 non-employee shareholders imposes a substantial barrier to any CSEF regime, since this limit is likely to be easily breached in any CSEF process.  The very nature of CSEF is its reliance on smaller investments by a large number of investors.

Second, the fundraising provisions in Chapter 6D of the Act require (subject to certain exemptions) the issue of a disclosure document in relation to offers of equity securities and other financial products.  Whilst this obligation provides some protection to potential investors, by requiring clear and concise notification of any risks, it is both impracticable for potential issuers of CSEF, and inaccessible to CSEF investors interested in smaller companies.

In addition, s 113(3) prohibits a proprietary company from engaging in any activity that would require disclosure to investors, other than an offer to existing shareholders or employees of the company (or any of its subsidiaries).

Finally, the holder of an Australian Financial Services License (AFSL) would potentially breach the terms of its licence by engaging in CSEF using a web-based platform and documentation – since an AFSL only allows the holder to provide advice to 'sophisticated investors', and prohibits it from raising funds from 'retail investors or either listed or private clients'.  The consequences of such a breach could include a fine or even cancellation of the licence.  
 
Whilst the full details of a proposed regulatory framework have not yet been released, the Federal Government's December 2014 discussion paper listed some of the key components of any potential CSEF scheme as:

  • limitation of the regime to small enterprises that have not already raised funds under existing funding arrangements
  • restrictions on advertising CSEF issues
  • limitation of the regime to a single class of fully paid ordinary shares
  • CSEF issuers will only be permitted to raise up to $2 million in any 12-month period (similar to the current funding ceiling disclosure exemption under s 708(1) of the Act)
  • reduced disclosure requirements for CSEF issuers
  • implementation of individual investor-caps, such as $2,500 per investor per 12 month period for each CSEF issuer, with a maximum of $10,000 in total CSEF investment by an investor per 12 month period
  • equity instruments to be issued through a licenced intermediary, who must undertake some level of due diligence and provide generic risk warnings to investors.
 

The advantages of implementing such a CSEF regime in Australia include:

  • lowering of the barriers to investment and broadening the characteristics of participating investors
  • increasing the available options for creating economic value and encouraging growth
  • allowing the Australian economy to compete with other international markets that currently permit CSEF
  • preventing a loss of Australian talent to foreign markets
  • giving greater visibility to a growing talent pool of Australian entrepreneurs and tech specialists and promoting a culture of innovation
  • likely to be best suited to slow-to-medium growth start-up companies, perhaps even with a domestic, or at most a South East Asian focus because it would offer alternative pathways to investment for companies that would otherwise be competing for investors who have a broader global focus
  • along with the other reforms discussed below, providing stronger encouragement for start-ups.

However, there are also a number of disadvantages to the proposed scheme:

  • significant logistical and compliance difficulties for raising a relatively small amount of capital from such a large number of investors
  • the need to draft a suitable, all-encompassing shareholder's agreement
  • the extent of due diligence required before the CSEF offer is released, and the level of disclosure required. In particular, the extent of detail in relation to financials such as forecast EBITDA and revenue projections
  • logistical difficulties in responding to requests for further details from individual investors
  • potential conflicts between investors, including conflicts of interest
  • risk that the market will find the scheme too complicated or unreliable. To maximise participation, investors will need to feel confident about the process, the platform, and most importantly, the legitimacy of each CSEF issuer.

While there is bipartisan support from both sides of politics for the development of a CSEF framework, there is little indication as to which particular regulatory framework will be adopted.  It is vital that the framework chosen be appropriate and commercially-minded in order to maximise investor participation and the effect of CSEF on investment in Australian start-ups.  

Employee Share Schemes

The Budget announcements also included reference to legislation currently before parliament which, with effect from 1 July 2015, will shift the taxing point of rights to acquire shares, including options.

Currently such rights are taxed at the time of vesting. This means the taxing point for the recipient comes prior to the receipt of any economic benefit in relation to the rights.  As such, there is a considerable disincentive for employees to participate in such schemes.

This is of particular importance to start-ups, as they lack sufficient funds to incentivise employees with high salaries.  Providing employees with options to acquire an equity interest can therefore provide a more cost efficient and ultimately more effective incentive.

The announced change is a shift in the taxing point of such rights from the date of vesting, to the date on which the rights are exercised.  This means that it will now coincide with the receipt of the economic benefit, and will restore the effectiveness of employee share schemes and their attractiveness to employees.

However, there are also certain restrictions in relation to announced changes which companies and employees must be aware of.

For companies, it should be noted that the changes do not apply to listed companies or unlisted companies which have been incorporated for more than 10 years.

For employees, it is also important to remember that cessation of employment remains a taxing point in relation to such rights.

Tax Deductions for Professional Service Costs

As discussed in this other recent article, the 2015 Budget announcement also included provision to allow businesses to deduct start-up costs such as professional, legal and accounting services immediately from the 2015/16 income year, rather than having to capitalise and deduct such costs over a five-year period.

This creates an incentive for start-ups to obtain quality professional advice early on, particularly in relation to establishing the appropriate vehicle for the start-up, securing funding, regulating stakeholder engagement and protecting intellectual property.
 
Obtaining appropriate advice on commencing a start-up, rather than waiting until sometime down the track, greatly increases the chances of success.  

Significant Investment Visa Changes

Recent changes to the Significant Investor Visa (SIV) program are also likely to be welcomed by the venture capital and start-up community.

To obtain an SIV, an individual is required to invest a minimum of $5 million in complying investments for a period of not less than 4 years.
 
In an effort to increase Australia's innovative potential, the changes to the SIV program re-direct proportions of the $5 million investment as follows:

  • at least $500,000 is to be invested in venture capital funds that are registered with AusIndustry; and
  • at least $1.5 million is to be invested in managed funds that invest in emerging ASX-listed companies or unlisted Australian companies that have a market capitalisation of less than $500 million. No more than 20% of such managed fund's net assets can be in unlisted Australian companies. However, we note that this component does not contain further restrictions such as requiring the company to be an 'innovative enterprise'.

The remainder 'balancing investment' of up to $3 million is to be allocated (via a managed fund) to other complying investments, such as shares, real property (subject to a 10% limit on residential property), eligible corporate bonds or notes, and deferred annuities.  Government bonds have now been removed from the list of 'approved' investments, and derivatives are only permitted to be used for risk management purposes.

Time will tell whether or not these amendments to the SIV program will be effective in driving heavier investment in venture capital and emerging companies in Australia, but they represent a positive change for the Australian start-up environment.

Conclusion

Taken together, the above reforms provide further support and encouragement for the establishment and operation of new businesses in Australia.  Swaab Attorneys has extensive experience in advising start-up businesses and is well placed to assist in navigating the relevant schemes, compliance requirements and tax benefits and implementing appropriate steps to provide a strong foundation for any start-up business.

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This article is not legal advice and the views and comments are of a general nature only. This article is not to be relied upon in substitution for detailed legal advice.

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