The difficulties involved in setting up and managing Section 12J Venture Capital Companies

The difficulties involved in setting up and managing Section 12J Venture Capital Companies

“Section 12J Venture Capital Companies” (Section 12J VCC) seem to be a bit of a buzz phrase doing the rounds in the South African entrepreneurial world at the moment. We have had several requests from new and existing clients to set one up, mainly because of the attractiveness of these structures to investors.

A Section 12J VCC is a company formed in terms of section 12J of the Income Tax Act, 1962 (ITA) – it is essentially a pooling mechanism created by the South African Revenue Service (SARS) to encourage largely high net worth individuals to invest in start ups. The incentive to invest in a Section 12J VCC comes from the fact that investors get a full tax rebate on the funds invested into the Section 12J VCC. So, if a person in the highest tax bracket (presently 45%) invests R 1 million, they will get a tax rebate of R 450,000, meaning that the net investment is R 550,000.

The Section 12J VCC itself is relatively simple to set up, but the real complexity and difficulty comes with the management of it. The legislators have included several anti-avoidance provisions in section 12J of the ITA, which have made it particularly difficult, and in our experience prohibitive, for anyone to manage and run a Section 12J VCC. In fact, at the moment, there are only fifty six Section 12J VCCs approved by SARS and according to the information that we have gathered, and less than half of those are actually trading. It is interesting to note that the legislation allowing these funds was put in place in 2009 – that equates to, on average, seven of these companies formed (not necessarily even operating) every year since inception.

So why is it so difficult to get a Section 12J VCC off the ground? Below we have highlighted some of the major difficulties that some of our clients have had:

  1. No investor into the Section 12J VCC may be a “connected person” in respect of the Section 12J VCC, which essentially means that a natural person cannot own 20% or more of the shares in the Section 12J VCC (directly or indirectly) and a company can own up to 50%, in limited circumstances, of the Section 12J VCC (directly or indirectly), but no more.
  2. No more than 20% of the capital raised through the issue of shares may be invested into any one investee company.
  3. An investee company cannot be a “controlled group company”, meaning that a Section 12J VCC cannot own 70% or more of the equity shares in an investee company.
  4. To be recognised by SARS, the Section 12J VCC must be registered in accordance with section 7 of the Financial Advisory and Intermediary Services Act, 2002 (FAIS), meaning that the company must have a “key individual” in its employment and the Financial Services Board must issue it with a certificate.

There are many more nuances to a Section 12J VCC that we have not highlighted here as they are too lengthy to get into, but they also make for significant barriers to entry.

Regarding point one above – the issue of being a “connected person” – this provision was clearly put in place to avoid situations where a single investor uses this platform to invest in a company where he ordinarily would have done so in any event, but he simply sets up a Section 12J VCC to reap the tax benefit on an investment that he was always going to make.

What we have seen is that there are legitimate arm’s length transactions where investee companies are told that the investor will only invest in them if they are able to use the section 12J of the ITA structure and because of the anti-avoidance restrictions, investee companies are losing out on a potential investment as it is often not possible for this to be done.

Regarding points two and three above, Section 12J VCCs are often restricted in the manner that they can invest when they see a good potential investee company, as they cannot invest more than 20% of their raised capital into the investee company. This means that investee companies can, and do, miss out on obtaining more funding or any funding altogether.

It can also prevent arm’s length investors from investing into one investee company, as they cannot use the Section 12J VCC vehicle to invest into a qualifying investee company because they cannot own more than 70% of the investee company and they cannot use more than 20% of the funds raised in the Section 12J VCC to invest in the investee company. The investor also cannot hold 20% or more of the equity shares in the Section 12J VCC.

The final point is possibly the most difficult, FAIS approval is difficult to obtain as you must have a person who fits the criteria to be a “key individual” in terms of FAIS, which requires experience in the industry and further study. With the fast pace of the business environment, it is often too much of a hurdle to cross to find a party with the correct industry experience to write the exam and become qualified as a key individual.

If you have a legal team that thinks laterally about it, there are ways to manoeuvre within the compliance framework, but even then, there are limitations to the extent that it can be done.

Section 12J VCCs look very attractive from the outside, but when you scratch below the surface, there is a structure that is complex and difficult to manage and balance, which is probably the reason that they have not taken off in South Africa yet. That is not to say that forming a Section 12J VCC cannot be done, as we have assisted in setting up several of them, but it is worth considering it a little bit deeper to see whether this is going to be the best structure for you.

Potential oversights of entrepreneurs – protection of intellectual property

Potential oversights of entrepreneurs – protection of intellectual property

Running a business is a tough ask of anyone – between maintaining cash flows, keeping customers happy, managing your employees and looking for potential investors (or dealing with current investors), there is a lot that can fall through the cracks. One of the things that is very easy to forget about, especially with the more modern, technology-heavy businesses, is the protection of your intellectual property (IP).

In the technology sphere, copyright law governs the development of computer software, which is much of what the entrepreneur of today is dealing with. As an entrepreneur, you may come up with a great idea that is going to be the next “Google”. So you call your business partner up and spend countless hours in the office and cups of coffee developing this new idea, whilst running your business at the same time. You come to the end of this, completely overworked, and you have produced the holy grail of products that is going to revolutionise the industry, and you own it, right…? Well, when considering this a little further, that may not be the case.

If your business is a company, you may be in for a surprise – it is probably the company that owns the product that you have just developed and not you personally. If that previous comment made you break out into a cold sweat, not to worry. Below are some factors that you should consider when developing a new idea as a director of or shareholder in a company:

• Did you use the company’s property or time to develop the product? As an example, did you use a company laptop and normal working hours to develop your new product?

• Is the product that you developed substantially similar to other products developed by the company or did you use the company’s software code to make your new product? As an example, if your company develops an app that is involved in data collection in agriculture and you develop an app that collects data in retail, it is likely that because of the common data collection thread, the products are substantially similar. It may also be likely that you “borrowed” some of the code from the previous app to make your new app.

If your answer to both or one of the above is “yes”, then your company probably owns the product that you just developed. This also should not be too much of a problem though. If you and your business partner (if you have one) are the only shareholders in the company, then both of you can just agree to transfer the product out of the company. The only difficulty comes in where you have investors looking for an opportunity to get a return on their investment.

It is not uncommon for investors to factor in protection against the company disposing of any property (including IP) without their consent, as they will almost always want a good return on their investment. You could be stuck in a situation where you have to share the fruits of your labour with the other shareholders in your company, which is not ideal.

A good way of avoiding this is, as soon as you are in the process of obtaining your first round of funding from your first investor(s), introduce a “pay-to-play” option into your company’s shareholders’ agreement. This will essentially provide that any new intellectual property that you are thinking about developing will be offered first to the company and then to any investor, provided that if they want a share in it, they must put some capital into the project, which project can, and should, be placed into a new company.

There are many more layers to this issue, but the long and the short of it is that you should always be wary of losing all your hard work due to a simple legal slip up.