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Funding For Start-Ups & Early Stage Businesses
- Publication – FA News
- By – Carien Engelbrecht, Director of Aurik
- Date – 26 November 2009
With unemployment running at 24.5%, there is currently much concern regarding the growing social, economic and financial impact of joblessness. When quizzed on solutions, almost everyone mouths platitudes regarding the value and importance of building and boosting entrepreneurship as a way of either creating jobs or developing alternative viable lifestyles. The importance of entrepreneurship as a way of creating employment is supported by research which has found that small and medium-sized firms account for approximately 41.7 percent of all employment in the private sector (Hans Falenka et al., Competition in South African Banking. Task Group Report for the National Treasury and the South African Reserve Bank (Pretoria: South African Reserve Bank, April 2004).
Every second week, we are told of new interventions to rescue key industries and unlock access to business finance. Regrettably, many of these interventions are short on detail and even slower to implement. But perhaps the most serious problem with these proposals is the extent to which they demonstrate a limited understanding of the real-life funding and support requirements of start-up and early-stage businesses.
If we are to grow entrepreneurship, we need, in the words of Chairman Mao, to “let a hundred flowers bloom”. It is obvious that as a business evolves, its financing needs develop and change in parallel. We accordingly have to create an environment in which the right type of funding is made available in the right amounts at the right time in the life of a business.
As a general rule, commercial debt funding is only relevant once a business has moved out of the highest-risk phases and has developed a sustainable and somewhat predictable cashflow. Prior to this point, commercial bank debt funding for a start-up or early stage business is difficult at best and irresponsible at worst. The discussions between government and the banking sector to promote commercial lending, whilst of importance to many established enterprises, is accordingly of little relevance to start-up or early-stage businesses.
But if debt funding is inappropriate, then what are the alternatives? The answer to this conundrum lies in the availability and provision of more risky equity finance. This may either take the form of venture capital or may be provided by so-called “angel” investors. In the United States, venture capital funding accounts for roughly 4% of all seed financing for start-up companies. The venture capital industry in South Africa may best be described as “nascent” as professionally managed funds specializing in venture capital-type investments are few and far between.
It is interesting to note that despite its glamorous image, venture capital is in fact not the most important source of start-up capital in the US. Instead, this accolade goes to angel investors who are estimated to provide 27 times more seed funding to early stage businesses than venture capital funds each year. In 2007 alone, angel investors invested more than $26 billion in 57 000 start up businesses.
So what is angel funding and who are these angel investors? An angel investor is typically an individual or network of individuals who provide capital to start-up businesses, usually in exchange for convertible debt or equity ownership. Angel investors are critical if we are to fill the gap between the financing typically provided by family and friends and venture capital funds.
Angel investors exist everywhere and are not an American phenomenon. In practice, it is estimated that up to 80% of Chinese businesses are funded by Angel investors and many countries are taking steps to actively encourage angel investors as part of a broader package of economic stimulus. Unfortunately, in South Africa, there is no angel industry to speak of. And yet, without this funding source, many new businesses will inevitably be starved of capital at a crucial stage in their growth cycle and will be doomed to failure. It is a little like planting seeds but only remembering to water them after the second month of drought, and then complain that the seeds are somehow defective when they either fail to grow or grow in a stunted form!
The importance of tax policy
The lack of effective venture capital and angel funding vehicles in South Africa may be at least partially attributed to the South African tax policy which does not incentivize these forms of investment.
In many countries, extensive tax support is provided to both the venture capital and angel funding industry. In the UK the Enterprise Investment Scheme (EIS) incentivizes corporate venturing by providing small investors who invest up to GBP150 000 per year, with up-front income tax relief, a capital gains tax exemption on the disposal of shares, deferred taxes on profits (if these are reinvested) and tax relief for capital losses. Similar provisions apply in many EU countries and in the US, where tax credits for venture capital and angel funds are common and in Brazil and Singapore where venture capital funds are exempt from capital gains tax. Most of these fiscal support mechanisms are broad-based, some are sector specific and many are location-driven.
The South African fiscus has made a limited foray into supporting the establishment of formal venture capital funds through the enactment of S12 J of the Income Tax Act. Tax relief is accordingly directed at investors who purchase new shares in registered venture capital companies. Cursory discussions with venture capital players however suggests that the impact of the tax relief has been modest at best and that it has certainly not had the desired effect of promoting widespread venture capital investment in early stage businesses. Of perhaps greater concern is the problem that there is currently no tax relief whatsoever for angel investors or angel investor networks who fund start-up or early stage businesses. This means that this form of funding will probably remain unavailable within the South African environment, with ongoing negative implications for entrepreneurial development.
Whilst we fully support current government initiatives and the renewed focus on start up and early stage businesses, we believe that the current approach of government falls short. In particular, we believe that without appropriate supportive interventions that match the business lifecycle, all our attempts to grow and develop an entrepreneurial culture in South Africa will inevitably fail, undoing existing investments by government in entrepreneurial development and training.
A crucial step forward would accordingly be for government to evaluate and restructure the existing tax treatment for venture capital funds and to establish tax-based incentives for angel investors (whether individual and corporate). This would go a long way towards plugging the real funding gaps that plague start-up and early stage businesses.
As a general rule, commercial debt funding is only relevant once a business has moved out of the highest-risk phases and has developed a sustainable and somewhat predictable cashflow. Prior to this point, commercial bank debt funding for a start-up or early stage business is difficult at best and irresponsible at worst. The discussions between government and the banking sector to promote commercial lending, whilst of importance to many established enterprises, is accordingly of little relevance to start-up or early-stage businesses.
But if debt funding is inappropriate, then what are the alternatives? The answer to this conundrum lies in the availability and provision of more risky equity finance. This may either take the form of venture capital or may be provided by so-called “angel” investors. In the United States, venture capital funding accounts for roughly 4% of all seed financing for start-up companies. The venture capital industry in South Africa may best be described as “nascent” as professionally managed funds specializing in venture capital-type investments are few and far between.
It is interesting to note that despite its glamorous image, venture capital is in fact not the most important source of start-up capital in the US. Instead, this accolade goes to angel investors who are estimated to provide 27 times more seed funding to early stage businesses than venture capital funds each year. In 2007 alone, angel investors invested more than $26 billion in 57 000 start up businesses.
So what is angel funding and who are these angel investors? An angel investor is typically an individual or network of individuals who provide capital to start-up businesses, usually in exchange for convertible debt or equity ownership. Angel investors are critical if we are to fill the gap between the financing typically provided by family and friends and venture capital funds.
Angel investors exist everywhere and are not an American phenomenon. In practice, it is estimated that up to 80% of Chinese businesses are funded by Angel investors and many countries are taking steps to actively encourage angel investors as part of a broader package of economic stimulus. Unfortunately, in South Africa, there is no angel industry to speak of. And yet, without this funding source, many new businesses will inevitably be starved of capital at a crucial stage in their growth cycle and will be doomed to failure. It is a little like planting seeds but only remembering to water them after the second month of drought, and then complain that the seeds are somehow defective when they either fail to grow or grow in a stunted form!
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