R&D Tax Incentive Scheme;
Personal Direct Investment Incentives
The Venture Capital Program
Matrix of Programs
Optimised Incentive: Self-Managed VC Funds

In previous weeks in this series we have reviewed the different investment incentive programs offered by the Australian Federal Government. The strengths and weaknesses of those programs and how they compare with each other for investor incentives.

It is not a simple comparison, not the proverbial apples & apples, because each program’s objective is different. While the VC program’s ESVCLP structure offers the greatest potential investor incentive of tax exemptions plus an upfront tax offset, the program’s objective is not to give investors greater benefit for investing into Australian SME’s but to stimulate the growth of venture capital industry by giving them the ability to facilitate these tax exemptions for their investors.

The only direct investor incentive program is the Angel Investment Tax Incentive Scheme, which is severly restricted. What I did not state about the AITI scheme is that it does the very thing the government keeps saying it doesn’t want to do because it has mostly gotten it completely wrong, it tries to pick the winners by deeming which industries should receive investment and which industries should not.

Another irony of this is that whereas the AITI scheme clearly has a preference for backing software development the VC program tries to nudge investment away from this same overheated investment area.

Having had considerable experience with the deepest levels of understanding of the VC program legislation as the principal of the only fund manager to have challenged the joint regulators of the program through the courts, I feel some confidence in stating that the programs intentions, as stated are honourable, do not exclude and are not overly restrictive of the use of the program for a more direct investor benefit.

The legislations parameters for permissible investments are quite broad applying the widest collective definition of early-stage investment and then only limiting investment within this scope away from those industries overinvested, i.e. real estate, financial services.

Unfortunately, as has repeatedly occurred elsewhere, regulators have overlaid restrictions much narrower than the legislation and that reflect their own conservative views and that of their interest groups. Yes, such restrictions might be false and can be undone through legal challenge, but at what financial and time costs?

What is the Objective Anyway?

If the objective of tax incentivised investment schemes could be broadly said to be to “incentivise a greater level of equity investment into Australian SMEs for the long-term economic development of Australia” and we know that the Federal Government has historically and repeatedly been wrong more often than right when it comes to “picking winning” investments (this appears not to be unique to any national government, but consistent globally), then the concerted effort to avoid such folly by legislators opting to adopt a policy of setting broad scope parameters restricting only away from over-invested sectors as done in the VC program legislation seems to be a great place to begin.

What a shame narrow minded and conservatively biased public servants forming industry regulators have self-delegated themselves wiser than our elected legislative representatives.

The problem with the historic implementation of the otherwise revolutionary VC program, particularly the ESVCLP program, is that it has only ever been implemented with the overlay of the historic venture capital management model. There are a number of structural aspects of the traditional venture capital management model that create biases rendering the model beneficial only in limited scenarios. I will explore these structural deficiencies in another article.

Regulatory bodies lack imagination and seldom appreciate, then alone embrace innovative thinking although that is precisely what results in economic growth.

In the regulation of the VC programs the regulatory bodies have stifled attempted innovation in the structure of venture capital management in preference for the existing known but structurally limited model. One regulator was an oximoron as previously named Innovation Australia, while the second goliath, the Australan Taxation Office, is legendary for its blunt and heavy handed tactics often with little regard for the law because its punishment for breaching such laws have been slight.

Optimal Outcome

Achieving the stated broad objectives of the collective incentive programs, which are already enshrined in well established legislation, can be better achieved by regulatory bodies allowing innovation, enforcing legislation, not impeding its use, and otherwise getting out of the way.

I am not condemning the venture capital industry. This industry has long played a very important role in the development of new sectors, but it is like adding a bucket of water to a bathtub. On its own it will barely cover the bottom surface. Added to the bath full of water it is quickly absorbed and dissappears into the mass. If it is dyed a certain colour it may taint the water, but do nothing to change the chemical composition.

Australian SME equity finance is estimated to be $5B per annum, while debt finance is $100B per annum, therefore about a 5:95 ratio.

Venture Capital investment has certainly improved over the twelve years since the introduction of the VC program, or has it actually?

According the government’s venture capital dashboard it has been steadily improving over those 12 years. But what they are really measuring is the uptake and use of this VC program. Prior to this program what were the VC investment numbers? Surely some or much of the recorded growth trend might be explained as a transition from non-program investments into program measured investment vehicles. Also, the numbers have a significant element of compounding within them so they will almost inevitably trend up year on year. Another concern with the data is that it includes the VCLP program which is really a private equity investment vehicle rather SME venture capital, and its much larger numbers reflect this.

Getting back to my point, if the average annual venture capital investment $250M, that is great but it is only 5% of the annual SME equity investment.

Before rushing to point out that 5% is still significant even if it is a bucket in a bathtub let’s consider that perhaps the bathtub is far less than half full at $5B per annum. That is like trying to have a bath on cold winters day but sitting naked in the tub the water is only touching your hips and covering your ankles. If you try to lay down to get warm all that happens is you get wet enough that it makes you even colder.

What is the Right Split?

Who decreed that the correct apportioning between SME debt and equity finance should be 95:5?

I don’t believe it can ever be full parity at 50:50 for structural reasons but I also don’t believe those structural limitations render a correct balance as being anything as disproportionate as 95:5.

I believe, given the technology capabilities we now have, it is possible for the split to be 70:30 and that Australian SMEs will be greatly advantaged over their international competition if it is, and that will give the Australian economy competitive advantage.

So I am going to make it my mission, and that of the Lellco business, to strive for 70:30.

I am going to explore this matter at length in another article, but assuming the analogy is correct the SME equity bathtub should be closer to $35B per annum, rather than the current $5B. The current $250M p.a. of venture capital investment becomes 0.7% of the annual SME equity investment pool.

Origin of Investment

Of the current estimated $5B p.a. of SME equity investment it is estimated the majority of the residual 95% of non-venture capital investment comes from the Australian public and businesses. A small percentage will come from off-shore direct corporate investment, but is unlikely to come from profesional investors who are more likely to utilise the benefits of the VC program.

Interestingly as much as 50% of venture capital investment (including the VCLP program) is non-domestic investment.

I am stil looking for details but it seems to early in the Angel Investment Tax Incentive Scheme’s life to get data on its performance, however, I remain sceptical that the scheme will have a large uptake because of its structural limitations. This is relevant because as I pointed in my series on “Tax Incentivised Investment Programs” it is the only government incentive scheme designed to apply directly to the investor, while the venture capital program is designed to further develop the venture capital industry.

Of course, it can be argued that with complete tax exemption on investment returns the venture capital program is very much about incentivising investors to increase investment. Indirectly, this is true. I think a counter-argument is that the legislators felt that it was only by giving the venture capital industry the power of controlling tax exempt investment vehicles could they reasonably expand the industry itself. An argument that is weakened by the fact that of the two components of the VC program, ESVCLP having complete tax exemption, and VCLP effectively only having extra tax advantage to managers, not the investors, but in 2022 ESVCLPs have a little over $4B in total committed capital and a median fund size of only $20.14M, while VCLPs have closer to $20B total committed capital and median $58.7M fund size. Remember 50% of all this is non-dometic investment.

Filling the Bath

It is a reasonable assumption, given current facts, that an expansion of Australian SME equity funding is likely to originate predominantly from Australian investors; i.e. they can fill the bath. As stated above I will explore the impediments to filling this bath in a different discussion at a later date.

Assuming the impediments can be removed, adjusted for and managed adequately it will still require at least an initial incentive program to shift investor attitudes.

This is already available with current incentive programs, if our ‘public servants’ cease to inappropriately superimpose their conservative attitudes formed by history and vested-interests.