Gimme hype, Jo-anna!

Gimme hype, Jo-anna!

*Disclaimer – of course, a legal document needs to start with a disclaimer: our firm has a Slack channel called the #unlawyerzone, where we post adventures that team members get up to that are slightly less serious. This blog post comes from the hidden ether of our #unlawyerzone and should be read in that context. Also, I couldn’t resist butchering the title of that most famous and brilliant song (with apologies to Eddy Grant) to sugar up this rant.

I’ve been working as a commercial attorney for about 10 years and something that we inevitably see a lot of is how most of the business world seems to go into crazy mode whenever a new hyped idea comes along.

Any honest lawyer will admit that hype in the business world is to lawyers’ what blood is to sharks (with apologies to sharks). Hype does create work for us, but like that hairstyle you were so proud of in varsity: you may just be investing time and money in something that will be redundant (at best) and scary (at worst) a couple of years down the line.

Remember when the new Companies Act came into effect and you just had to adopt a new MOI for your company by midnight or the world would go up in flames? It was long before I joined our firm, but I’m glad to see that my partner Adrian Dommisse put things into perspective for our clients at the time with a slightly less Armageddonesque view on the situation.

Our firm has always been hesitant on hyped subjects (without being stuck in the past), but we’ve found that even if you don’t run towards the noise whenever there is an air of excitement in the business world, the party inevitably tends to move to your doorstep after a while.

I’m thinking of all the queries from people who wanted to put everything they ever owned into a Section 12J fund and how hyped that was a few years ago. People with no investment experience at all wanted to start Section 12J funds on every corner, until they learned about all the rules and red tape!

When every millennial with an online Python course in the bag started their own crypto fund from their garage, the queries took a different shape (often the misplaced shape of pyramids). Then there was the period when it was almost frowned upon not to refer to your start-up company as “the Uber of this or that…” or “the Spotify of organic vegetables”, but I see that we’re (mostly) past that now.

My goal is not to be the Grinch who stole hype – I have just been reflecting a lot over the years about what the best position is to take when the next best thing arrives. Our approach as a firm is simple: use hype to learn, but only spend your time and exert your energy on ideas or businesses that have substance.

For example, I think some of the hype around Section 12J has died down a bit over the last few years, with mostly only the serious players (who genuinely want to invest in exciting scalable businesses in the way that the Tax Man intended) still plying their trade in this way. Similarly, with the crypto world having come down to earth over the last year or two (read: the quick buck barbarians have left town), we can now focus on the amazing possibilities offered by blockchain technology.

Even though the dust has settled on the hype around topics like these, we are wiser on these topics now than we were before the circus came to town, so we can now use our tricks for real-world solutions. And how fulfilling it is to work with clients who are using blockchain technology to build or invest in real-world businesses that will improve the lives of people and take the friction out of exchanging and growing value.

The regulatory vacuum of equity crowdfunding in South Africa: time bomb or open door?

The concept of crowdfunding has been making ripples in startup funding talks over the last few years, but as with any new phenomenon, it is interesting to consider whether this concept is as new as we think it is. If not, why did it not work before and what is different now? Before we start, for those of us who have been “trekking” in the Andes for the last ten years and don’t know what crowdfunding is, firstly: lucky you; and secondly: crowdfunding is when someone raises money for a project from a large number of people, promising something in return for the funding.

Contrary to word on the street, the concept of crowdfunding is not as new and shiny as we might think. In 1713, Alexander Pope decided to have Homer’s Iliad translated into English, which took translators more than five years and no doubt numerous sleepless nights. To fund all of this, Pope offered 750 people the opportunity to each pledge two gold guineas in return for a mention of the donation in an early edition of the translation. There are numerous other examples of crowdfunding over the last three centuries and the emergence of social media has brought with it endless possibilities when it comes to funding projects, businesses, adventures, charities, bravery or silliness – through crowdfunding.

One form of crowdfunding that has been in the limelight since it was first used by the U.S. based Grow VC Group in 2009, is equity crowdfunding. This is a form of investment crowdfunding (the other being debt crowdfunding), in terms of which an investor would fund a company or project in return for equity (i.e. shares) in the company that owns the project when it takes off. If you’re familiar with angel investment, this is a similar concept, but implemented on a bigger scale and with even less control by investors over investee companies.

This all sounds pretty exciting, especially if you’re good at creating new ideas and getting people excited about them. According to a report by Massolution, global Crowdfunding is expected to exceed venture capital as a funding mechanism for early stage companies in 2016. However, there are a few thorny issues around equity crowdfunding that might just spoil the party – none more so than the regulation of these transactions.

Since 2011, financial regulators in the UK, USA and elsewhere in the world have been trying to find ways to regulate equity crowdfunding without turning out the lights completely. Until recently, crowdfunding was allowed in these countries, as long as benefits other than equity are offered to the public. The essence of the conundrum for regulators when it comes to equity crowdfunding is that there needs to be a balance between the need to protect public investors and the need to promote capital raising activity that could stimulate the economy. This explains why all forms of crowdfunding are illegal in countries like Singapore. In 2013 the U.S. Securities and Exchange Commission (“SEC”) proposed a 500 page set of rules to regulate the offer and sale of securities through crowdfunded private offerings, which are now set forth in Title III of the “Jumpstart Our Business Startups (JOBS) Act”. As the rest of the world usually follows suit, we need to use this as an indication of what lies ahead from a South African perspective and very importantly, consider how these regulations were received worldwide.

The responses to the regulatory framework set in the USA and UK have been varied: some say the regulation is too strict; while others say that the regulation falls short of addressing the level of risk involved when offering equity to the public in this manner. One thing is certain, the regulation is likely to take the joy out of the process for managers of most equity crowdfunding platforms and it seems to have been designed this way. Michael Piwowar, the U.S. SEC Commissioner, told the Market Mogul that there are traps hidden in the new regulations which are expected to burden small investee businesses that don’t keep regulatory compliance as a top priority. However, considering the level of risk of financial fraud that investee companies and investors can be exposed to, extensive disclosure and financial reporting requirements are of paramount importance.

From a South African perspective, there are a few crowdfunding platforms that are starting to make suggestions that they intend to go the equity route. For the moment these initiatives will be clouded by the lack of certainty when it comes to the regulatory framework. What we do know, is that a South African equity crowdfunding platform will be deemed as an “offer of securities to be issued to any section of the public” in terms of section 95 of the South African Companies Act, 2008 (“the Act”). This means that unless the offering of securities falls within one of the exclusions listed in section 96 of the Act (such as “offers to persons whose ordinary business is to deal in securities”), the entity that owns the platform will be required to be a public company. The platform will therefore be regulated by all the disclosure, financial reporting, auditing and general governance requirements regulating public companies in terms of the Act and other financial legislation. Considering the extent of an equity crowdfunding platform’s public presence and risk involved for investors and investee companies alike, this level of regulation is inevitable. Cross-border equity crowdfunding activity will also need to comply with South African exchange control regulations, which may add another hurdle to those aiming to streamline the funding process.

The question is whether the regulation of equity crowdfunding will kill the initiative in its tracks. There is definitely a place for capital raising in this manner in the South African market, but creating a cost-effective platform that addresses the risks involved while still providing a streamlined alternative for capital raising will prove to be no small task.

Introducing the SAFE document as a vehicle to raise capital in early-stage South African companies

Our regular involvement in funding transactions for startups in the South African tech space often requires us to implement US-style investment terms and instruments to ensure that we are as relevant as the market needs us to be. In recent months the SAFE document (being an acronym for ‘Simple Agreement for Future Equity’) was introduced in the US venture capital scene and made its way to South Africa fairly quickly, where it has now become a popular method for early stage financing.

The essential terms of this document are that the investor purchases the right to subscribe for preferred shares in the investee company upon the next round of equity funding in the investee company. The most common method of calculating the number of shares to be subscribed for by a SAFE-holder is by applying an agreed valuation cap to the investee company upon issuing the SAFE document to the investor. By way of example, if US$1 million is invested at a valuation cap of US$3 million and the valuation of the company grows to US$5 million by the time the next round of equity funding is done, the SAFE-holder’s US$1 million investment will buy more shares than that of an equity subscriber also investing US$1 million at a later stage.

An alternative to the valuation cap, is to apply a discount rate to the investee company’s valuation upon the next round of equity funding and issuing preferred shares to the SAFE-holder based on the reduced valuation. This discount rate is specified in the SAFE document issued to the investor and has a similar effect to the valuation cap, but is calculated differently. If a 20% discount rate is applied in the scenario above, that means that the investee company’s actual valuation on the next equity round (US$5 million) is reduced by 20% to calculate the preferred shares to be issued to the SAFE-holder. In this case that would mean that the SAFE-holder subscribes at a valuation of US$4 million.

The SAFE document can also include both a valuation cap and a discount rate, in which case the document will state that the method of calculation which results in the greater number of shares issued to the SAFE-holder will be applied. By way of example, based on the scenario above, if a valuation cap of US$3 million and a discount rate of 20% is provided for in the SAFE document, the valuation cap (and not the discount rate) would be applied, as that will result in more shares for the investor.

If the company’s valuation drops to below the valuation cap by the time the next equity round is implemented, the valuation cap is merely disregarded and the SAFE-holder subscribes for preferred shares at the same valuation as the other subscribers.

One of the reasons why SAFE documents were developed is to limit transaction fees by using a simple standardized document, cutting out significant costs, time and effort usually spent on closing equity funding rounds. This also enables the investee company to close transactions with investors (and get the funds needed in the business) one investor at a time, as each investor negotiates separate terms with the investee company. This can prevent the situation of one stubborn investor holding up a whole funding round.

Other positives are that the investee company can offer different valuation caps to different investors, depending on the timing of the investment or even the reputational or experiential value of the investor. Having flexibility in the valuation offered to different investors may be very useful when negotiating with investors who can contribute more to the business than just their monetary investment.

This may all sound very attractive to investors, especially if you consider that the flexible valuation may be a very effective way to reward the risk of very early stage investment with a higher return. However, the picture becomes slightly less exciting if you consider the SAFE-holder’s position in more detail.

Here are some of the obvious areas of concern from an investor’s perspective:

  • The SAFE-holder only subscribes for preferred shares in the investee company upon the occurrence of specified trigger events. These are usually an initial public offering (‘IPO’), the next round of equity funding, any other change of control or the dissolution of the investee company. In the interim period (unlike holders of convertible debt), the SAFE-holder is not a creditor, as the SAFE -document is not a debt instrument (there is no obligation on the investee company to repay the investor, no interest and no security). This means that the investor will have no recourse or further rights unless a trigger event occurs, which can be very problematic if, for instance, the investee company keeps on raising capital by issuing more SAFE documents to third party investors.
  • Unlike convertible loan notes, the SAFE document does not create an option in the hands of the SAFE-holder, as the subscription will happen automatically upon the occurrence of a trigger event. The only exception to this is where an IPO (the SAFE-holder has the option to subscribe for ordinary shares) or other liquidation event (the SAFE-holder has the option to have its investment returned) occurs. This means that a convertible loan note holder will be in a better position than a SAFE-holder, as the convertible loan note creates a debt with a defined payment obligation and an option for the holder to remain a creditor or subscribe for shares in the investee company.
  • Once the SAFE-holder subscribes for preferred shares in the investee company, its preferred shares will have a liquidation preference (like other preferred shareholders). However, if the SAFE-holder subscribed for shares at a lower valuation than that of the other preferred shareholders, the SAFE-holder’s liquidation preference is calculated on the lower valuation (i.e. on a lower ‘per share’ liquidation preference than that of other preferred shareholders).
  • When signing the SAFE document, the SAFE-holder does not know what the terms of its shareholding with the investee company will be. It knows that they will be materially similar to those of the other preferred shareholders, but that may not always be favourable for the SAFE-holder. If, for instance, other preferred shareholders are related to the founders of the investee company in some way, the rights attached to the preferred shares may be structured with slightly ‘lighter’ protective mechanisms (like vesting of founders’ shares, restraints, preferred distribution rights) compared to terms usually included in early stage funding transactions.

When we advise investors on SAFE documents, we aim to mitigate some of the risks highlighted above, by including certain restrictive measures not included in the standard SAFE document. These may include a restriction on the investee company to only source a limited amount of funding through the issuing of SAFE documents. This will ensure that the investee company does not delay the equity subscription with endless issuing of SAFE documents. In addition to this, we would also suggest to investors that there should be a time limit to the SAFE document, which triggers repayment (in real terms) or equity subscription (at the SAFE-holder’s option) if an equity funding round (or other trigger event) does not occur by a certain date.

Considering the above, it is clear that the SAFE document may hold certain advantages for both the investor and the investee company. However, it remains to be seen whether investors are willing to accept the risks associated with the SAFE document in its standardized form.

Introspection 101 for entrepreneurs: how attractive is your company to prospective investors?

All businesses start in exactly the same way: someone has an idea, then that person (and others) add money, resources, considerable effort and more ideas to refine the idea, create value and hopefully turn R1 into R2.

We were recently requested to address the participants at the 2015 Net Prophet Sparkup! event, as to the most fundamental legal challenges faced by start-up entrepreneurs. As the event is an exciting entry for some into the world of investor-entrepreneur relations, we spent some time discussing the manner in which investors measure the prospects of a start-up company.

We all know that in the real world, all great ideas are not created or developed equally well. Two entrepreneurs might have very similar business ideas, but the one’s name eventually shines brightly in Forbes magazine, while the other ends up among the sequestration notices in the local newspaper (with apologies to Henry Ford, Donald Trump, Walt Disney and the many more who played in both teams).

At Dommisse Attorneys, we have a passion for assisting our entrepreneurial clients in turning their sharp ideas into tangible value. On the other side of things, we also strive to see our investor clients adding real value to investment opportunities…the right opportunities! In light of this, we are in the perfect position to provide entrepreneurs with a very realistic overview of the things that make one company more attractive to investors than the next.

Although this article is certainly not the alpha and omega on this topic, we thought it well to pen down our thoughts on some of the most important legal factors that investors usually consider before taking the leap.

  1. Intellectual property

The number of tech startups that have emerged in recent years highlights the importance of intellectual property (IP) as an asset from investors’ perspectives. Most importantly, investors will want to know what measures have been taken to protect a startup company’s IP. While the company can patent certain aspects of its IP (if the IP is new, a result of an inventive step taken and useful in commerce), there might be more effective ways to protect IP. If the company has IP that is not in the public domain, which the company can keep secret even while using the IP in the market, then it might be more appropriate to protect the IP as a trade secret by imposing certain protective measures. This does not require a formal registration process and might be a very cost-effective strategy to apply. If you want to explore the option of patenting an idea, it is very important that you do not to start using IP in the market before submitting your patent application, as the idea will then lose its novelty and no longer be patentable.

In most cases it will also be important to determine how the company is planning to commercialise its IP, for example, by means of licenses or franchise agreements. It is therefore fundamentally important to have a clear idea of what your company’s essential IP is and how it will be protected, developed and commercialised.

  1. Capital structure

The manner in which the ownership of a company is structured, is often referred to as its “capital structure”. While investors are likely to require you to simply rectify anything they don’t like, it is important to think carefully about the shareholding proportions when issuing shares to founders. This may be extremely difficult early on in the company’s growth cycle. Be careful when issuing shares to some shareholders for cash contributed, while issuing shares to others for services rendered to the company. While both are acceptable, the net effect can be quite surprising if you don’t consider the tax implications (i.e. that shares issued for services rendered are subject to revenue tax) or have an inaccurate view of the company’s valuation. Further to this, a company is not allowed to issue shares upfront for any deferred performance, as things can then become messy when that performance is not measurable and the parties dispute whether performance was completed or not. For this reason shares that are issued in return for any deferred contribution should be held in escrow until performance is completed. Investors do not want to be dragged into future disputes regarding the founders’ shareholding and frankly, this is the crux of a founder’s hope to get monetary returns for hard work, so make sure that the initial subscription process and terms are handled correctly.

  1. Liability

There are a million and one ways in which any company can be held liable for the loss or damages incurred by others. This may be as a result of defective products, injury caused to end users, sub-standard performance, technology glitches, etcetera. While there is no point in lying awake at night panicking about this, we understand that it can be very concerning and there are ways in which to curb a company’s risk from a legal perspective. Investors will be more comfortable investing in a company that knows exactly what its risks are and has found ways in which to carefully protect itself against exposure in this regard.

This may mean simply taking careful aim when determining the company’s “terms and conditions” with customers, but also to implement other measures like holding all the company’s assets in one entity and using a second entity as the “operational company”. This sounds fancy, but can be a very effective way to make sure that the essential business assets are not exposed to potential claims of creditors. Another option, especially for companies with more than one unrelated technology or product offering, is to hold each of these in a separate entity. This is beneficial to ring-fence each entity’s risk, but also gives prospective investors the opportunity to only invest in one technology or product offering. This level of flexibility might be very attractive for investors, especially the clever ones that insist on investing only in products that they understand.

  1. Funding

The company’s funding history is quite important and can be detrimental for chances of sourcing investment in the future. If the company has obtained too much debt funding or funding on risky terms in the past, investors will flag this as a massive risk and for that reason be reluctant to invest in the company regardless of how promising the business looks otherwise. For this reason it is important for founders to not only maintain a healthy debt : equity ratio, but also to make sure they understand the effect and terms of funding obtained.

  1. Continuity

Investors will also want to know that the founders will be prevented from exiting the company prematurely, especially if founders have essential skills required to grow the company to the next level. In terms of the company’s constitutional documents founders are often bound to vesting provisions, which determine that founders’ shares vest in the founders gradually over the first few years of the company’s growth cycle. This means that founders are prevented from selling their shares in the company before the lock-in period expires. In addition to that, founders can often be expected to “earn out” when they sell their shares in the company. This enables the company to replace the exiting founder with a new person in that role and complete the required handover process. The investor therefore knows that a founder’s exit will not derail the company. It is important to implement these protective mechanisms sooner than later in the company’s life cycle. Even if a first round of investors do not require it, the experienced investor most certainly will, but if the new round of investors see that there is already a vesting period implemented, they are unlikely to request that the vesting period be extended.

  1. Key management

Inexperienced entrepreneurs often struggle to differentiate between ownership and management of a company. The ownership is one element, which is covered in the constitutional documents of the company, but it is crucial to also understand the importance of regulating the founders’ roles as directors of the company. Founders and other key employees should have adequate agreements with the company, in terms of which they are restrained from competing with the company when they resign, assign all IP rights (to inventions made while working for the company) to the company and other terms to determine the performance measures to be applied to the person’s services to the company. These agreements should be seen in a positive light, as they clearly define what the company expects from each executive, even before investors come aboard.

In the same light, it is also important to consider incentivizing key employees in the company by, for example, implementing an employee share option pool (ESOP), which is basically a scheme that rewards key employees for their hard work by giving them the option to buy shares in the company. A manner in which to do this is by giving employees the option to subscribe for shares in the company at a fixed strike price, even if the valuation of the company increases. This is a very effective way to inspire employees to apply their best efforts to ensure that the company succeeds. Investors love to see an ESOP in place even before they invest, because that means the key employees are more committed to the cause. Another more obvious reason, is that if a limited amount of shares have already been allotted to an ESOP, the investor will not be diluted when it eventually happens.

While there are many more aspects to consider when getting your company in shape for investors, the ones mentioned above are some of the most crucial ones, at least from a legal perspective.

We are currently working on a Startup Legal Playbook, which we will soon make available on our website as a free document to guide entrepreneurs through the early years with more details on the above, as well as other challenges in this regard. In the meantime, please feel free to contact us should you have any queries, or require our assistance.

The effect of Section 12J of the Income Tax Act on the South African venture capital regime

Section 12J of the Income Tax Act has been the talk of the town in many South African venture capital circles in the last few years, but ironically there has been a lot less action in the market than the government expected when implementing this tax incentive in 2009. This incentive seems very promising on face value, but at the moment there are still less than 10 approved Section 12J venture capital companies in the country. This is an exceptionally low number if we consider how popular a similar venture capital incentive in the United Kingdom has been over the years, which beckons us to take a closer look at the incentive to determine the reason for the market’s reluctance to explore this.

The rationale behind the incentive is quite simply to address the fact that one of the main challenges to the economic growth of small and medium-sized businesses in South Africa, is the inability of these businesses to secure equity finance to fund their growth.

In terms of Section 12J, any South African tax resident that invests in a venture capital company (VCC), approved and registered in terms of Section 12J, can claim income tax deductions in respect of the expenditure actually incurred to acquire shares in such VCCs, subject to certain conditions.

Section 12J VCCs are therefore intended to be a marketing vehicle that will attract retail investors to invest in VCC’s, whereas the VCC makes money by investing in smaller trading companies. These are entities which the VCC’s fund managers deem as having prospects of producing a favourable return on investment. These companies are generally referred to in this context as qualifying investee companies.

However, before a venture capital company can start trading as a Section 12J VCC, it has to apply to SARS to be registered as such, for the purpose of which the company must meet certain preliminary requirements. To meet these requirements, the company must:

  • be a South African tax resident and its tax affairs must be in order;
  • have as its sole object, the management of investments in qualifying investee companies;
  • not control (whether directly or through a related entity) any qualifying investee company in which it holds shares; and
  • be licensed as a financial services provider in terms of section 7 of the Financial Advisory and Intermediary Services Act, 2002.

The major risk for a Section 12J VCC and its investors alike, is that SARS can withdraw the approved VCC status if, during any year of assessment, the company fails to comply with the preliminary approval requirements as listed above. SARS may also withdraw the company’s VCC status, if the preliminary requirements are met but the company fails to satisfy the following additional requirements after the expiry of 36 months from the date of SARS approving the company’s Section 12J VCC status:

  • a minimum of 80% of the expenditure incurred by the VCC to acquire assets must be for shares in qualifying investee companies, and each investee company must, immediately after the issuing of the qualifying shares to the VCC, hold assets with a book value not exceeding R300 million in the case of a junior mining company or R20 million in the case of any other qualifying company; and
  • the expenditure incurred by the VCC to acquire qualifying shares in any one qualifying investee company may not exceed 20% of its total expenditure to acquire qualifying shares, which basically means that the VCC must have at least 5 investee companies in its portfolio.

What happens when a Section 12J VCC loses its status as such? Well, SARS can include in the VCC’s income in the year of assessment during which the status was withdrawn, an amount equal to 125% of expenses incurred to issue shares.

If you consider the fact that venture capital investments are generally regarded as high-risk, relatively illiquid investments, the picture seems even less rosy for investors if the drastic consequences of non-compliance looms as an additional risk to their investments.

However, in the 2014 National Budget Review, the government announced that it will propose one or more of the following amendments to the VCC regime:

  • making tax deductions permanent if investments in the VCC are held for a certain period of time;
  • allowing transferability of tax benefits when investors dispose of their VCC equity investments in VCC’s;
  • increasing the total asset limit for qualifying investee companies from R20 million to R50 million, and that of mining companies from R300 million to R500 million; and
  • waiving capital gains tax on the disposal of assets by the VCC.

These new changes are to be welcomed and have certainly sparked renewed interest in the market, which is still wide open for those that are willing to enter this relatively untapped opportunity. Whether the proposed reforms are substantial enough to give this incentive the required momentum to ignite the South African venture capital industry as intended by the government remains to be seen.

Build your own Blackstone: legal aspects to consider

The global economic meltdown of recent years has turned the financial environment on its head, I don’t expect anyone reading this to disagree with that. However, as the well-spoken Sir Winston Churchill would remind us: “Difficulties mastered are opportunities won,” which stirs us to explore ways in which the current economic climate can be utilised to generate sustainable growth. One such opportunity is private equity, which has become quite a buzzword in the global financial space over the years. Private equity funds like the US based Blackstone Group have sailed very well through the waves of economic turmoil over the last few years.

The copybook private equity deal can be illustrated by the following example of the ideal leveraged buy-out transaction, obtained from David Carey and John E. Morris’s highly recommended book “King of Capital”:

Company X generates R1 million of cash annually and Company A is interested to buy Company X for R10 million. If Company A were to buy Company X using its own cash, it would earn a 10% return on its investment on an annual basis. Not bad, but considering the risk involved this would be a relatively low-yield return. However, Company A can opt to only use R1 million of its own cash and R9 million borrowed from a bank or other funder. As security for the loan from the bank Company A cedes and pledges to the bank the Company X shares to be acquired and pays interest of R600 000 per year using Company X’s proceeds to repay the loan to the bank. After paying the interest, Company X is left with R400 000 generated per year. Company A has then effectively acquired an income bearing asset by investing R1 million of its own money and earning R400 000 returns per year on such investment, constituting an annual return of 40% on its capital investment. Hence the label “leveraged buyout.” The ideal company to acquire, is therefore one that looks likely to produce enough cash to cover the interest on the debt needed to acquire the company.

In this article, we intend to discuss some of the most fundamental legal considerations in structuring a private equity fund between third party South African resident investors (excluding strictly regulated investors such as pension funds, collective investment schemes and other financial institutions as defined in the Financial Services Board Act, 1990, as these will require more rigorous regulatory measures to be complied with) and South African fund managers.

Private companies are usually not preferred as investment vehicles for private equity funds, as it can be quite a daunting task to create a capital structure in a company that is flexible enough to accommodate the goals of a private equity fund. For instance, the shareholders of a company usually contribute capital to a company in proportion to their shareholding, which is not ideal if investors intend to reserve the discretion as to whether they intend to invest in a particular opportunity or not. As discussed below, flexibility in the structure applied is key to ensuring that the fund is positioned to act on the opportunities presented to it by fund managers.

The most common private equity fund structures in South Africa are investment clubs, bewind trusts and limited liability partnerships (also called en commandite partnerships). Further details on these options are as follows:

i)                    Investment clubs

Investment clubs have only in recent years become more popular in South Africa. These may be seen as vehicles by which investment opportunities are presented in a closed environment, rather than being an investment vehicle in its own right. The basic framework in this case, is that fund managers would source suitable investment opportunities for the club, which opportunities may then be invested in by the members of the club at their discretion. The club members may include high-net-worth individuals or other entities, which pay annual membership fees to fund managers. The membership fees are applied to fund the fund managers who quit their day jobs to actively look for investment opportunities. Members do not make any capital commitments toward the club, subject to the rules of the club, unless they opt to participate in a particular opportunity. The rules of the club should record the type of investment vehicle to be used when investments are made by club members, the options are discussed below.

ii)                  Bewind trusts

Those readers that are familiar with the concept of trusts under South African law will understand this quite easily. The trusts used on a day-to-day basis in South African business and estate planning are mostly discretionary trusts. In these trusts, the trustees obtain ownership of trust assets, but only in a fiduciary capacity (which means they own and manage assets for the benefit of the beneficiaries). Bewind trusts are different in the sense that the trustees merely hold and manage assets on behalf of the beneficiaries. Therefore, ownership of trust property remains vested in the beneficiaries and never in the trustees.

These trusts are created by means of trust deeds and are subject to the regulatory control of the Master of the High Court in the same manner as discretionary “family trusts”. From a private equity perspective, the fund managers will be the trustees of such a trust, administrating the trust property (shares and claims in investee companies) for the benefit of the pool of investors, as beneficiaries. In this scenario the trust will have certain rules that apply to provide a discretionary framework for fund managers (trustees) to guide the private equity activity in accordance with the investors’ risk appetite and other financial considerations.

It is of course possible to form an investment club as indicated above, which is presented with investment opportunities by the fund managers. The investing club members are then plugged into the trust structure once they decide to act on a particular investment opportunity. Such club members will then become the beneficiary of the trust, created to pursue the particular opportunity. The benefit of this structure is that the beneficiaries may be ring-fenced to be exposed to certain investment opportunities only. As indicated above, “club members” need not commit any capital unless they want to act on a specific investment opportunity.

iii)                Limited liability partnerships

Limited liability partnerships are more common in the private equity world and are created like any other partnership, except for the requirement that the parties must expressly agree to form such partnership. The fund managers (called general partners in this context) manage the funds of the partnership and are the public face of the partnership. The investors are called en commandite or “silent” partners, contributing capital to the partnership to enable the general partners to invest in opportunities in terms of the partnership agreement. The silent partners’ limited liability lies therein that their liability to creditors is limited to their investment in the partnership and nothing more. The general partners’ liability to creditors is, however, not limited in this manner. The silent partners are therefore mostly on the background and share in the profit or loss of the trust in proportion to their respective capital contributions to the partnership.

The type of vehicle chosen depends on numerous factors, including the track record of the fund managers, investors’ appetite for risk and as always, the relevant tax considerations. Eventually the parties should ensure that a structure is implemented that protects investors optimally, whilst still enjoying enough flexibility to enable investors to get involved in suitable investment opportunities in their discretion.

“Opportunity comes like a snail, and once it has passed you it changes into a fleet rabbit and is gone.” ~ Arthur Brisbane