Australia VC: Policy permutations

Peer-to-peer (P2P) lending platform Moneyplace has ambitions to replicate in Australia what Lending Club has achieved in the US. Founded by a team of senior bankers 15 months ago, the business has yet to be officially launched because it is in the process of applying for licenses from local regulators.

"We hope to have our licensing result in the next couple of months, and then we should be able to launch in April or May. But we actually don't know. The regulatory environment in Australia is very rigid," says Stuart Stoyan, founder and CEO of Moneyplace.

While he accepts that some level of government oversight is necessary in the P2P lending space, Stoyan - who is also a member of the Productivity Commission's roundtable that is studying support systems for start-ups - rejects the notion that online lending platforms should be forced to abide by the same laws as traditional banks, for example. A graduated approach is preferable to foster the development of new businesses.

Entrepreneurs and venture capitalists can readily identify where government policy drives forward or holds back innovation and what this means for the start-up ecosystem.

A significant hole in this ecosystem appears close to being plugged following an announcement last October that the tax code so that paying employees in stock options under the employee share scheme (ESS) is an incentive rather than a financial burden. For anyone seeking capture the size of the gap between Australia and Silicon Valley in terms of nurturing technology start-ups, this was a huge red flag.

"We need significant reform of the legislation around the ESS, so we can improve employee participation in company ownership and fresh initiatives to stimulate investment in venture capital, given the trillions of dollars that are locked up in our superannuation funds," says Anne-Marie Birkill, general partner and executive director at OneVentures. "The government should play a significant role in creating an environment that encourages such investment because of the potential returns to the economy in terms of tax revenue and employment."

Valuable options?

ESS is used to attract talent to companies that might not yet have the revenues to offer significant wages. The system is familiar to entrepreneurs in many countries. In the US, for example, the stock options awarded in lieu of cash are only taxed when shares are sold or the options exercised.

Australia had a similar approach until 2009 when the then Labor administration unveiled measures intended to save A$200 million over four years by preventing executives earning more than A$180,000 per year from minimizing their tax exposure. Start-ups got caught in the crossfire. As options were reclassified as income, which meant they were taxed at the employee's marginal rate, many ESS adopted by small businesses collapsed almost overnight.

Nick Abrahams, a partner at law firm Norton Rose Fulbright, likens the current tax system to charging every person who buys a lottery ticket just in case they win. Paying upfront tax for the shares is unfair on start-ups because their success rate is relatively low; after several years of paying tax on options, the holder could one day find they were suddenly worthless.

The issue is serious enough to make founders consider relocating to jurisdictions where tax treatment is more favorable. "Especially when those founders are creating a company that addresses opportunities in a global market, they won't choose to be in Australia. They will go to the US or other countries where the technology infrastructure and tax regime are better," Moneyplace's Stoyan says.

In order to stem this brain drain, the government plans to re-introduce tax breaks for ESS, effective July 1. Under the new proposals, eligible start-ups would be able to offer shares or options to employees at discounted rates without having to pay tax upfront. Eligibility depends on having an aggregate turnover of less than A$50 million, being unlisted and having less than 10 years of operational history.

The government will extend the maximum time for tax deferral from seven to 15 years, allowing start-ups more time to succeed. And options will be subject to capital gains tax rather than the higher income tax - a key benefit of the proposed changes, Abrahams says.

Not only will it become easier for technology start-ups to retain talent, but from a longer-term perspective, these reforms are expected to help create a new generation of successful entrepreneurs. They are likely to follow the example already being set by a handful of others and plow a portion of their wealth back into the technology sector.

"The change is good for the whole start-up ecosystem because it helps spread the wealth from just one or two founders to a wider group," says Rick Baker, managing director at Blackbird Ventures. "In Silicon Valley the liberal use of ESS sustains contributions to that ecosystem. If we don't have a good ESS in Australia and just concentrate the wealth generation among a small numbers of people, the ecosystem has less chance to grow and blossom."

Different needs

The research and development tax incentive program has also played a critical role in keeping skilled employees in Australia. If a business is able to prove that R&D is used as an investment for future growth, it may qualify for a 45% refundable tax credit.

"Every single start-up that I know uses the R&D tax credit to get an extra 3-4 months to runway, sometimes more. The policy is really, really important to the start-up community. Not only does it give that extra runway, but it also creates a relatively inexpensive place for local founders to hire software engineers and keep their product development team in Australia," says Baker.

Last week, the program arguably lost some of its edge when the government announced a cap of A$100 million on the amount of R&D expenditure that companies can claim as a tax offset. For expenditure above that threshold, companies can claim an offset at the company tax rate, which is higher. Brigitte Smith, founder and managing director at life-science focused GBS Ventures, says that even with the cap, the vast majority of firms she invests in will be unaffected because they are early stage.

"The R&D tax incentive is the most important program to life science companies because they aren't generating any revenue yet," Smith says. "By contrast, ESS isn't as important to them as it is to other sectors. It's more about how policies can facilitate more funding into the start-ups because life science companies are very capital intensive. There isn't enough VC funding available in Australia right now."

Nevertheless, life sciences was one of few perceived winners in the 2014-2015 "austerity budget" that saw the government cut several start-up support programs.

On one hand, the A$20 billion Medical Research Future Fund (MRFF) was announced with a remit to bridge the gap in between Australia's medical research capabilities and its ability to convert them into commercial benefits. The fund was supposed to start functioning last month but the fine detail is still being negotiated. On the other, Commercialization Australia, a grants program for start-ups, and the Innovation Investment Fund (IIF), which sponsors VC funds, were both discontinued.

Founded in 1997, the IIF is a co-investment scheme whereby the government licenses fund managers and provides capital for investment which must be matched at an agreed ratio by private sector LP commitments. It has served as a cornerstone LP for a number of first-time managers. OneVentures, which is currently looking to raise A$100 million for its second VC fund, previously raised capital from the IFF. The GP reached an A$60 million first close in October.

"The discontinuation of the IIF program is unfortunate because post-global financial crisis we are in an environment where institutional investors are by and large not investing in venture capital," says Birkill. "The program provided critical leverage to unlock private sector capital, which in particular helped first-time managers to get new funds up. Australia's VC industry is relatively small and immature compared to other countries so programs that stimulate investment are important for growing the industry."

Foreign legion

Venture capital fundraising has struggled ever since the global financial crisis. According to the Australian Private Equity & Venture Capital Association (AVCAL), VC firms raised A$158 million and A$100 million in 2010 and 2011, respectively. In 2012, the total soared to $240 million but a year later it was back at A$152 million and then reached A$120 million in 2014. With superannuation funds lacking an appetite for domestic venture capital, new firms start to look elsewhere for support, notably US VC players and high net worth individuals (HNWIs).

The government recognized the role the latter can play when it unveiled proposed reforms to the Significant Investor Visa (SIV) program last week. Through the program, individuals can qualify for permanent residency in Australia after four years, pending local investment of at least A$5 million. At least 20% of this sum will now have to be deployed in domestic venture capital funds. Official figures show that nearly 1,500 applications have been approved since SIV's launch in 2012, with Chinese investors making up 90% of successful applicants.

AVCAL endorsed the move, saying it will lead to a bigger pool of funding for local entrepreneurs, although it is uncertain how readily investors will commit to the asset class above the mandated 20% - venture capital continues to be categorized as relatively high-risk. Looking at the environment through a wider lens, however, there is evidence of increasing interest in start-ups. A total of 93 nascent businesses received A$516 million from local and global investors last year, the most since 2005 in dollar terms.

Even though it has yet to enter operation, P2P platform Moneyplace is looking to bring a funding round forward to March on the back of strong soft demand from investors. The funding was originally planned for the second half of the year.

"Australia's fundraising environment has really come into its own over the past few years," says Stoyan. "It is not as mature as markets like the US or Israel, but if I point to our own experience, Moneyplace has been inundated with inquiries from a wide range of investors, including VCs, institutions, family offices and HNWIs. We're seeing significant interest from some serious investors."

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• Topics
• Australasia
• Venture
• Regulation
• Australia
• Blackbird Ventures
• GBS Venture Partners
• Growth capital
• Venture
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• TMT
• healthcare
• regulation