What startups overlook when raising money - and what savvy investors look for

Back in 2016 the federal government introduced tax incentives for early stage investors, a program which provides investors with a 20% tax offset on Australian startup investments (effectively cash back at tax time). In order for the investment to qualify, the startup needs to be considered an “early stage innovation company” (ESIC). The program is roughly based on the UK’s Enterprise Investment Scheme.

A startup can self-assess its status by following the ATO guidance - or engage a startup accountant to help them through it. Companies which have been through an accelerator program, spent money on research and development or patents and/or raised capital can usually qualify as an ESIC, the more boxes you tick the more likely you are to qualify. In my experience most startups can find a way of qualifying until they fail the 'early-stage test', which typically happens when the startup is too old (three or six years old depending on spending patterns) or turning over too much ($200,000 per year).

Investors love a discount

Why might you choose to assess yourself as an ESIC? Because savvy investors like it.

As both an angel investor and a penny-pinching accountant, it's right up my street! You get 20% of your investment back at tax time, as an offset against the amount of tax you would otherwise need to pay, and as an extra kicker, any capital gains on the investment are tax-free.

I've always considered this an under-appreciated program. There's an argument that an angel investor invests or not based on their assessment of the startup's prospects, and a 20% discount isn't going to factor into that decision. I disagree. Investment decisions are allocations of a finite pie. Most investors have limited funds to deploy, and if they nurture deal flow as they should, they end up with more viable opportunities than they can afford to invest in. A 20% kicker can become a differentiator between two opportunities. As an investor, not all my investments are in Australia, and of the local ones not all qualify as an ESIC - nonetheless over the years I've claimed cash back on nine of them. That freed up enough cash to almost fund another two investments - and so increased my probability of a successful exit by 20%.

Always selling

When raising money, always promote the fact that you are an ESIC (assuming you are an ESIC), at least with Australian investors - overseas investors can’t claim it*. Don’t worry about ‘cheapening’ the investment opportunity you are offering. Sure, you’re trying to present yourself as a future unicorn and build a certain fear-of-missing-out with the prospective investors, and so you’re not going to lead with a ‘discount’ in your pitch deck. But at least mention it as a footnote, investors are mostly rational when it comes to financial decisions.

*They may be able to claim it, but because it's an offset it's of little use to them if they don't have any taxable income in Australia

Crowdfunding

The incentives are also available when investing through Australian crowdfunding platforms. While I appreciate a lot of entrepreneurs are too busy building great things to be across something as non-essential as a tax incentive, I am always amazed that the platforms don’t do a better job of promoting the incentives in campaigns involving an ESIC. After all it’s their job to systematise the marketing of investment opportunities.

In the early years of the program I was talking to a crowdfunding platform operator about promoting the ESIC status of startups raising money. For the operator it was an after-thought, something the startup would figure out after the round had closed. For me this missed the promotional opportunity of the incentive.

Still today, the level of awareness is just not there. Earlier this year I backed a company on another platform, that’s been operating in the space for over a decade, and when I enquired if the startup I was backing was an ESIC, the answer came back that they didn’t think so. When I suggested the platform should check with the startup to be sure, the answer came back a day later saying actually they were – and so that’s 20% cash back to every investor!

Pitfalls

There are a couple of pitfalls to be aware of.

Only thing in life that’s certain – not tax

In the early days some accountants were keen to help you apply for an ATO private ruling on your status as an ESIC. A private ruling is what’s known as ‘binding advice’, in other words the investor can rely on it without fear of the ATO later auditing them and finding they've incorrectly claimed the benefit.

More recently I haven’t seen as many accountants encourage clients down this path, and I’d certainly recommend against it in most cases. It takes time (a few months) and money (the accountant can charge up to $15,000). Both of which are usually in short supply to startups trying to raise money. It’s always possible an investor may ask you to get a ruling, as they may value the perceived certainty that the document provides them when claiming their tax credit - but I’d recommend pushing back. Your time and money is better spent on your business.

Technically, the binding advice isn’t a 100% guarantee for the investor anyway: it is the ATO’s opinion based on the facts presented by the startup at the time of the request – those facts may have been incorrect or incomplete, and things may change for the startup between the point at which the application is prepared and the point at which the subscription agreement is signed. A few months is a long time in the life of a startup!

You’re better off saving time and money and self-assessing. As a compromise, offer the investor to have your friendly accountant prepare a letter supporting the self-assessment, I’ve done this for clients a few times, at least this gives the investor an independent third-party opinion they can put on file (and present to their own tax accountant as a supporting paper when preparing their claim for the incentive payment as part of their tax return).

Watch for converting investments

Increasingly startups are relying on more founder-friendly investment instruments like SAFE notes and convertible notes. I’ll cover what these are in a future post, but they basically allow the startup to delay the point at which shares are issued to the investor, until a later date when the note converts to equity.

It’s important to understand the interaction between these instruments and the ESIC investor incentives. The startup has to qualify as an ESIC at the point at which the shares are issued, so clarifying your ESIC status ahead of raising money through a con note or SAFE note is kind of pointless. Conversely, as an investor don’t forget to check the ESIC status of the company down the track when the conversion happens, as that is when you can still claim the incentive.

A deadline for an exit – but watch those losses

A final consideration for investors is that the capital gain exemption only lasts for ten years* – so expect your savvy investors to be pressuring you for an exit as that deadline approaches. Only kidding – we’ll be pressuring you for an exit regardless!

*The capital gain exemption doesn’t altogether disappear, instead you benefit from a re-basing of the cost base of the shares to their market value at the ten year point.

An often over-looked aspect of the incentive is that, on the flipside of the capital gain exemption, there’s also a capital loss exemption. So for those startups that don’t quite succeed (the majority), the investor loses the silver lining of being able to deduct the capital loss from their other gains.

In conclusion, both investors and entrepreneurs in Australia should familiarise themselves with the tax incentives scheme around ESICs. At CFOcus we have expertise in this area so feel free to reach out!