Venture capital: A sensible investment?

By Ing Lamprecht

Despite sizeable potential returns and tax benefits associated with specific venture capital investments, individuals (and even institutional) investors seem to be somewhat reluctant to put their money into this asset class.Erika van der Merwe, chief executive officer of the South African Venture Capital and Private Equity Association (SAVCA), says there is a degree of frustration amongst venture capital members, that there is no institutional investment in this asset class.

“Pension funds, for instance, do not allocate capital to venture capital – they consider it too high risk,” she notes.

Even in the case of private equity (the broader asset class of which venture capital is a small part), pension funds are still reluctant and uncertain about this asset class, Van der Merwe says.

“We think it is just a matter of education and getting our pension fund trustees more comfortable with the asset class because regulation allows them to allocate up to 10% of their portfolios to private equity which includes venture capital.”

Van der Merwe explains that venture capital fund managers are to a large extent reliant on “angel investors” – wealthy individuals who have often made their money through large organisations that they have set up and build over a period of time. Although these investors understand the entrepreneurial spirit and want to give back to society, they are often below the radar and don’t want to be identified.

Who should invest in venture capital?

Van der Merwe says this type of investor is fairly sophisticated and understands the risks associated with venture capital. “So the rewards are potentially very attractive, but there are risks.”

This particular investor understands the risks involved and would only allocate a small portion of his or her total diversified portfolio in this asset class. Van der Merwe says although she is not a financial advisor, her gut feel is that the allocation should not be more than 5%.

Section 12J

Although the South African Revenue Service (SARS) has already introduced tax incentives under section 12J of the Income Tax Act a couple of years ago, the establishment of venture capital companies under this section has been slow.

According to data from the SARS website, only three companies have been granted venture capital company (VCC) status under section 12J.

Olivewood Resources Limited was granted VCC status in October 2009. At the time the company indicated that it would focus primarily on investing in coal and renewable energy and that it would “be at the forefront of developing smaller mining companies”. Efforts by Moneyweb to make contact with the company were unsuccessful. Contact numbers listed on its website are not in service anymore.

Emiscore Limited, another company that was granted VCC status (in February last year), is in the process of being sold to another company. It has not been operational up until now.

Grovest Venture Capital Company Limited was granted VCC status in March this year.

The fact that only a few companies have been awarded VCC status could be related to the challenges in setting up such a company.

“If you listen to a company like Grovest and if you see what it took and what it cost them in effort and time to get this registration… and it is not just the section 12J registration, but I think also the FSB licencing… it is difficult,” says Van der Merwe.

“It is the right thing and it is good because this is a particular asset class where you need to be sure that you’ve got sophisticated investors who know what they are doing, so this is all about protecting the investing public. So it is good to have regulation, but the question is whether the regulation and the incentives that we have, if they’re attractive enough to actually bring in the investors that we so desperately need,” she says.

Jeff Miller, director of Grovest, says the company plans to raise R100 million from investors in the next few months. The funds will be invested in a blend of high quality small and medium sized private companies with significant growth potential, especially in the technology and mobile industries.

Miller says the two main reasons why SMEs fail, is the lack of capital and guidance. He believes Grovest can avoid these pitfalls by ensuring that the companies they invest in are properly funded and by using company’s expertise to the SME’s advantage.

The minimum investment in the fund is R100 000 and the objective is to achieve returns of three to five times money in a five to seven year time frame, equating to an internal rate of return of between 25% and 37%, he notes.

Miller says the tax benefits associated with this particular investment will significantly lower the risk of investing.

Tax benefit

Section 12J offers up to 40% tax relief on the investment. Miller explains that an individual who pays maximum tax at the threshold (40%) would be able to deduct the full amount (100% of his investment) from his or her taxable income.

This means that an individual whose taxable income is R500 000 and who invests R100 000 would only pay tax on R400 000, he notes.

“Once you received the proceeds back, the first 40% that you’ve got as a tax deduction would be treated as a recoupment and the balance would be subject to capital gains (tax).”

In the above-mentioned example, if the fund returns R300 000 to the investor after a couple of years, the first R100 000 would thus be considered a recoupment and the other R200 000 would be subject to capital gains tax.

“If we returned any dividends, the dividends would be tax-free in the hands of the individual.”