Private Equity and Venture Capital in Europe_6 docx

In the UK, private equity and venture capital deals are run by 6.5 Fiscal framework for equity investors and vehicles: The EU condition... 100 CHAPTER 6 Taxation framework for private eq

Capital gains are de-taxed in case of reinvestment of money in 60 days in qualifi ed small business stocks (QSBS) or SBIC shares

Capital gains are de-taxed for 50% if the holding period of QSBS is higher than 5 years

Taxes are paid differently if investors are considered a private rather than a legal entity For private investors, capital gains and earnings are taxed at 5% or 15% depending on global revenues and state, whereas the capital gains of legal entities are always taxed (in the United States the participation exemption prin-ciple is not applied), and earnings are taxed from 0 to 30% depending on the held quota

Unlike Italy, in the United States there are low incentives for companies, especially for start-up and R & D expenditures Start ups are provided with a mark down of the company tax rate between 15 and 35% related to the amount of revenues For R & D costs and investments, exiting rules order a tax credit equal

to 20% of the difference between yearly R & D costs and the average R & D costs

of the last 3 years

No DIT or thin cap schemes are operating in the United States

6.5.4 Vehicle taxation: the UK

The principles for taxation in the UK are similar to those in the United States, but the actual tax systems are different; for example, the British scheme for pri-vate equity and venture capital deals is more complicated In the UK, private equity and venture capital deals are run by

6.5 Fiscal framework for equity investors and vehicles: The EU condition

100 CHAPTER 6 Taxation framework for private equity and fi scal impact

A venture capital trust (VCT) is a highly tax effi cient closed-end collective investment scheme designed to provide capital fi nance for small expanding companies and capital gains for investors First introduced by the Conservative government in the Finance Act in 1995, VCTs have proved to be much less risky than originally anticipated The Finance Act created VCTs to encourage invest-ment in new UK businesses VCTs are companies listed on the London Stock Exchange that invest in other companies who are not listed

Business angels in the UK, must act as individuals, so they can only be investors

In both the UK and United States venture capital funds organized as 10-year LPs can deduct capital gains, while other revenues and costs are tax sensitive For VCTs capital gains are de-taxed if the holding period is longer than 3 years, whereas earnings are always de taxed

There are different tax structures for investors considered as Business Angels, legal entities, or private or corporate investors Business Angels in the UK can only be private investors, and their investment generates a tax credit of 20% if the holding period is longer than 3 years and the amount of the investment is lower than £ 150,000 Capital gains are de-taxed (and losses are deductible) if the holding period is longer than 3 years

If the investor is a corporate venture there are general restrictions: they are allowed only to be unlisted companies or quoted for a maximum of 30% of their total shares Corporate ventures generate a tax credit of 20% and capital gains are de-taxed if money is invested in the same investments within 3 years

For private individuals the system is less intricate, because capital gains and earnings are taxed at a level of 10% or 32.5% depending on the amount of rev-enue (under or over £ 29,400) Legal entities are unsuitable vehicles for private equity and venture capital deals, because costs can be higher than other vehi-cles: capital gains are always taxed (in the UK the participation exemption prin-ciple is not applied) and earnings are always taxed

Like the United States and contrary to Italy, there are many incentive schemes for start ups and R & D expenditures in the UK Fiscal rules allow a mark down

of the company tax rate within a range of 0 to 19% of the amount of revenues for a start up, and for R & D costs and investments there is a tax credit of 50% for unlisted companies

In the UK there is a strict thin cap scheme and interest rate costs are not deductible

6.5.5 Vehicle taxation: reform in the German market

After long political debate, the German legislature produced a new set of laws reforming the private equity and venture capital fi nancial framework

This reform is under review by the EU Commission regarding its fi scal aspects and by German fi nancial institutions as far as the implementation feasibility is concerned

Two of the most important items created by the reform are

■ Classifi cation of a company as a venture capital company or equity ment company

■ Tax profi le for incomes related to equity investments

The new tax framework will change the actual subjects and vehicles ating in the private equity and venture capital industry apart from their fi scal profi les

Vehicles that will be available in Germany include:

■ Venture capital companies

■ Equity investment companies

Venture capital companies are recognized by BaFin 5 only if they meet these requirements:

The German law distinguishes between an open equity investment company and an integrated equity investment company The integrated equity investment company still qualifi es as a subsidiary after the expiration of a 5-year start-up period during which investors can hold a participation of more than 40% of the capital or voting rights However, the company may only invest in companies managed by at least one person who directly holds at least 10% of its voting rights All equity investment companies may hold participations for a period of

15 years

6.5 Fiscal framework for equity investors and vehicles: The EU condition

5 The German fi nancial authority.

6 This aspect is one of the most criticized fi scal reforms.

102 CHAPTER 6 Taxation framework for private equity and fi scal impact

The taxation profi le of venture capital companies depends on its classifi cation: asset manager or commercial company If it is classifi ed as an asset manager, the company is completely “ transparent ” for income tax purposes so all income is not taxed If the classifi cation of asset manager does not apply, all tax advantages are lost and corporation tax must be paid However, capital gains, under certain conditions, may result in tax exemption

For equity investment companies there is no special treatment and general taxation rules are applied

Since 2009, for all operators, tax exempt carried interest is reduced from

50 to 40%

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Equity investment can be developed through vehicles that allow institutional venture capital activity These funds are split up between different companies that are potential sources of high economic return

Different vehicles for investment activity include:

1 Partnership — Shareholders are responsible for the management of the

private equity fund and they respond directly with their personal assets;

in some cases, the management of the fund can be delegated to external professionals (management company), but the total funds reserved for shareholders and the fund are equal, and the fund does not represent an autonomous legal entity This partnership has a life of about ten years that can be extended for two more years depending on the shareholders

2 Limited partnership (LP) — Similar to a general partnership, there are two

clearly defi ned categories of shareholders The limited partners are tutional and individual investors who provide capital They have limited responsibility in the fund’s management and investment decisions, which only extends to the capital they contribute The general partners, apart from transferring capital, are responsible for organizing the fundraising, managing

insti-CHAPTER

106 CHAPTER 7 The management of equity investment

the funds raised, and the reimbursement of the quotas to the subscribers

at the expiry of the fund Their responsibility is extended to their personal assets Almost all partnerships allow a single partner to close the partner-ship in case of a death or withdrawal of the general partners and/or fund bankruptcy Usually the LPs include some private agreement allowing the limited partners to dissolve the partnership and replace the general partner

if the limited partners represent more than 50% of the fund and the general partners are damaging the fund

3 Corporation — A company where the shareholders are the investors The

main disadvantage, compared with the previous organizational forms, is that the corporation is subject to taxation on capital gains realized (and not distributed), whereas the partnership and the LP have full “ fi scal trans-parency ” The law does not allow specifi c parties to operate through part-nership or LP in a corporation

4 Closed-end fund — An autonomous legal entity independent from both

the subscribers and the company that manages the resources The scribers, however, cannot interfere in the management or investment activities of the management company The management of the fund can also be supported by one or more advisory companies

Regardless of the legal structure, a set of common characteristics distinguish venture capital funds from other types of fi nancial intermediaries:

1 Limited life — This fund has a predefi ned expiry date at which the

redemp-tion of the quotas subscribed are returned to the investors This minimizes the risks to venture capitalists and investors during the timing and meth-ods of redistributing the invested funds Returning the subscribed quotas

to investors is a powerful incentive to optimize the effi ciency of ment company investment policies If the results are worse than expected,

manage-it will seriously compromise the fund’s abilmanage-ity to raise money in the future

2 Flexibility — A management company can launch several funds

simultane-ously, each one characterized by a distinctive duration, capital, and ment philosophy; therefore, it is possible to satisfy a variety of investor categories, each with a specifi c risk/return/liquidity profi le, widening the depth of the risk capital market This fl exibility allows the manager to dele-gate (to advisor companies) some of their institutional activity (fundrais-ing, identifi cation of the target companies, investment selection and/or monitoring, analysis of the exit opportunities) Therefore the company is always able to supply the clientele with highly specialized and sophisti-cated products without possessing wide and specialized expertise

3 Remuneration mechanisms — Parties appointed to the fund management

receive a fi xed management fee, generally between 2 and 3% of the total capital raised The management company also participates in the fi nal result of the fund, through the carried interest mechanism, allowing it to receive a certain percentage (usually 20%) of the total capital gains real-ized in the exit phase Hence, venture capitalists are more responsible in the investment selection and management activities because this affects

an important part of their own remuneration

Venture capital funds constituted through LPs provide two distinct ment categories, general partners and limited partners, with a different level of involvement and responsibility in the management of the capital raised This separation is typical in closed-end funds, but it does not occur between the reserves of the venture capital fund and the fund managers; the general partners allow the management team to act autonomously in the selection of the best investment opportunities, accelerating the decision-making process relative to the preparation and conclusion of the investments

To avoid the risk of opportunistic general partners, they are explicitly hibited from trading operations on their own behalf (self-dealing), which could allow them to receive benefi ts unavailable to the limited partners

In contrast to the closed-end funds, subscribers can exit the investment before the end of the fund’s life, i.e., the limited partners can ask at any time for reimbursement of the subscribed quota It is thus possible that liquidity risks might arise within the LP jeopardizing the stability of the fi nancial resources given to the companies fi nanced

An LP is not a company with share capital so it is not eligible, in the tries whose legal regulations provide for such a company structure, to be admit-ted for quotation on offi cial stock markets The quotas of a closed-fund, on the other hand, can be traded on a regulatory market, and in case of quotation, it is possible to subdivide the quotas to permit greater marketability of their certifi -cates and increase the liquidity profi le

In the countries where it is possible to constitute an LP, the largest part of its success is related to favorable fi scal schemes This is different from the schemes applicable to other intermediaries operating in the venture capital market,e.g., the closed-end fund

7.2 THE FOUR PILLARS OF EQUITY INVESTMENT

Vehicles dedicated to equity investment have a specifi c value chain with phases and organizational functions that can be classifi ed worldwide For each phase

7.2 The four pillars of equity investment

108 CHAPTER 7 The management of equity investment

there is a different contribution from management and the advisory board and the Board of Directors The typical phases of equity investment are fundraising, investing, managing and monitoring, and exit

7.2.1 Fundraising

Fundraising is the promotion of a new equity investment vehicle within the ness community; the purpose is to fi nd money and create a commitment The main motivation, considered by investors during the selection of the funds, is based on obtaining returns higher than those offered by the fi nancial market Private equity investors normally want a premium of about 5% compared with the gain This extra performance covers the extra risk connected with the minor liquidity of the fund and the higher risk connected with private companies Also taken into account is the track record of the investment managers based on their competencies, their reputation, and their previous performances Investment managers should demon-strate that past deals have been successful because of a series of good capital allo-cations not just one successful deal Investors use IRR as a measure of success The money multiple (the number of how many times the fund has been able to multi-ply the initial endowment of capital) is also used because it is infl uenced less by distortions over the duration of the investment Investors also evaluate the terms and rules included in the corporate governance structure of the fund

The fund subscribers consider not just the IRR realized by the investment, but also the performance of the fund netted by the costs, the fees, and carried interests paid It is important to defi ne carried interest: it is a part of the earn-ings generated by the fund and given back to the management team at the end

of the fund It is defi ned as 20% of the fund performance and can be calculated

in two different ways:

1 The fund as a whole — The carried interest is based on the total

perfor-mance and result of the fund and is paid only when the investors receive their total capital before subscribers

obtained from the investment, but they have to avoid the eventual losses provoked by management activity

Mixed solutions are also frequently applied allowing the investment ers to receive the carried interest deal by deal but only at the end of the fund after reimbursing the risk capital to the subscribers

Fundraising is for all funds, especially ones without a track record, because many investors are reluctant to invest in an unproven team even if the partners

have successful individual track records There are many ways new private equity funds can solve this problem The fi rst solution is to identify and involve inves-tors who are not only focused on fi nancial returns but look for some strategic benefi t from the fund In this case the investors are willing to accept a lower return in front of the indirect benefi t provided by the investment The second strategy is to arrange a partnership with an existing institution such as an invest-ment bank or another private equity fund providing a joint management of the funds raised The main benefi t of this strategy is improved credibility but, at the same time, there are some real costs; for example, investors should suspect that the institutional partner will affect the quality of the investment strategy Another solution is to hire a lead investor This is an institutional investor who leads the investment strategy His is often called a special limited partner because

he subs cribes a relevant amount of capital and usually provides the fi nancial resources needed by the fund to cover the costs of marketing (seed funding)

Fundraising activity is directly infl uenced and determined both by the supply

of private equity (the relative desire of institutional investors to allocate capital

in the sector), and the demand for private equity (the number of entrepreneurs with a good idea who want to be fi nanced) Many analyses of fundraising activ-ity have been performed, and one theory suggests that this activity is impacted,

in inverse proportion, by the change in tax rates that should foment or lower fund demand Other theories argue that fundraising activity depends on the public equity market status: during robust phases the market allows new fi rms

to issue shares and entrepreneurs to achieve liquidity and monetize the value of their companies

There are many sources of capital and the following are six of the most mon investor types:

1 Family and friends are the most common source of seed money and

proba-bly the easiest way to raise funds, but are also the most likely to cause lems If the business fails, the fi nancial troubles of the parties involved may

prob-be dwarfed by the emotional consequences Nonetheless, many of America’s successful companies have been created from this type of fi nancing

instead of professional investors There are big risks when playing such

an important role in the development of major innovative fi rms

3 Private pools of funds are partnerships between different shareholders

who decide to invest part of their own assets

4 Corporate funds are funds and fi nancial resources managed by venture

cap-ital with the intention of fi nancing companies in the development stage

7.2 The four pillars of equity investment

110 CHAPTER 7 The management of equity investment

5 Mutual investment funds are fi nancial vehicles that provide capital by

issu-ing and placissu-ing participation quota with investors

6 Bank fi nancial intermediaries, in particular merchant banks, are entities most

oriented to long-term investments and are prepared to sustain risk levels

7.2.2 Investing

To reach his fi nancial and competitive goals, a private equity investor creates value through the scouting and screening of available investments The type of investment is chosen through the use of debt, because the private equity man-agement team is involved in the governance of the venture-backed companies

The venture capitalist investments, depending on the specifi c phases of the life cycle of the target fi rm, can be classifi ed as three main clusters of equity investment:

Pre-competitive investment (seed fi nancing)

Competitive investment including start-up fi nancing, growth or expansion

fi nancing, and the public equity

Recovery investment realized through debt restructuring, turnaround fi ing and leverage buyout fi nancing, and vulture capital

Investors of risk capital must focus on the origination activity, which consists

of a steady fl ow of investment opportunity This is the key factor in starting the investment process The origination phase includes selection of an investment opportunity realized through appropriate professional resources and informa-tion This phase requires a lot of time due to the extremely selective nature of the investment decision through risk capital, especially if early stage expansion

or the buyout of a small to medium family fi rm with a high level of innovation

is selected The selection is based on the industry and the position inside the industry of the target fi rm, the validity and reliability of the business plan, the entry price, the quality and skills of the entrepreneur and/or management of the target fi rm, and the exit strategy