Academic Press Private Equity and Venture Capital in Europe_4 ppt

99 public funds to develop the economic system by supporting SMEs. Today, rigid regulatory limitations minimize the role of SBICs. Business Angels are private entrepreneurs who provide capital for a busi- ness start up. The tax profi le of venture capital funds organized as 10-year LPs can deduct capital gains, whereas other revenues and costs are tax sensitive. According to the law, all SBIC revenues are de-taxed. The tax profi le of Business Angels is more complicated and can be summarized by the following: Capital gains are de-taxed in case of reinvestment of money in 60 days in qualifi ed small business stocks (QSBS) or SBIC shares Capital gains are de-taxed for 50% if the holding period of QSBS is higher than 5 years Taxes are paid differently if investors are considered a private rather than a legal entity. For private investors, capital gains and earnings are taxed at 5% or 15% depending on global revenues and state, whereas the capital gains of legal entities are always taxed (in the United States the participation exemption prin- ciple is not applied), and earnings are taxed from 0 to 30% depending on the held quota. Unlike Italy, in the United States there are low incentives for companies, especially for start-up and R & D expenditures. Start ups are provided with a mark down of the company tax rate between 15 and 35% related to the amount of revenues. For R & D costs and investments, exiting rules order a tax credit equal to 20% of the difference between yearly R & D costs and the average R & D costs of the last 3 years. No DIT or thin cap schemes are operating in the United States. 6.5.4 Vehicle taxation: the UK The principles for taxation in the UK are similar to those in the United States, but the actual tax systems are different; for example, the British scheme for pri- vate equity and venture capital deals is more complicated. In the UK, private equity and venture capital deals are run by ■ Venture capital funds ■ Venture capital trusts ■ Business Angels Venture capital funds are pooled investments in companies believed to be too risky by banks or other fi nancial institutions. In the UK the most common vehicle used to create a venture capital fund is the LP. To obtain benefi ts pro- vided by law, the LP must run for 10 years. 6.5 Fiscal framework for equity investors and vehicles: The EU condition 100 CHAPTER 6 Taxation framework for private equity and fi scal impact A venture capital trust (VCT) is a highly tax effi cient closed-end collective investment scheme designed to provide capital fi nance for small expanding companies and capital gains for investors. First introduced by the Conservative government in the Finance Act in 1995, VCTs have proved to be much less risky than originally anticipated. The Finance Act created VCTs to encourage invest- ment in new UK businesses. VCTs are companies listed on the London Stock Exchange that invest in other companies who are not listed. Business angels in the UK, must act as individuals, so they can only be investors. In both the UK and United States venture capital funds organized as 10-year LPs can deduct capital gains, while other revenues and costs are tax sensitive. For VCTs capital gains are de-taxed if the holding period is longer than 3 years, whereas earnings are always de taxed. There are different tax structures for investors considered as Business Angels, legal entities, or private or corporate investors. Business Angels in the UK can only be private investors, and their investment generates a tax credit of 20% if the holding period is longer than 3 years and the amount of the investment is lower than £ 150,000. Capital gains are de-taxed (and losses are deductible) if the holding period is longer than 3 years. If the investor is a corporate venture there are general restrictions: they are allowed only to be unlisted companies or quoted for a maximum of 30% of their total shares . Corporate ventures generate a tax credit of 20% and capital gains are de-taxed if money is invested in the same investments within 3 years. For private individuals the system is less intricate, because capital gains and earnings are taxed at a level of 10% or 32.5% depending on the amount of rev- enue (under or over £ 29,400). Legal entities are unsuitable vehicles for private equity and venture capital deals, because costs can be higher than other vehi- cles: capital gains are always taxed (in the UK the participation exemption prin- ciple is not applied) and earnings are always taxed. Like the United States and contrary to Italy, there are many incentive schemes for start ups and R & D expenditures in the UK. Fiscal rules allow a mark down of the company tax rate within a range of 0 to 19% of the amount of revenues for a start up, and for R & D costs and investments there is a tax credit of 50% for unlisted companies. In the UK there is a strict thin cap scheme and interest rate costs are not deductible. 6.5.5 Vehicle taxation: reform in the German market After long political debate, the German legislature produced a new set of laws reforming the private equity and venture capital fi nancial framework. 101 This reform is under review by the EU Commission regarding its fi scal aspects and by German fi nancial institutions as far as the implementation feasibility is concerned. Two of the most important items created by the reform are ■ Classifi cation of a company as a venture capital company or equity invest- ment company ■ Tax profi le for incomes related to equity investments The new tax framework will change the actual subjects and vehicles oper- ating in the private equity and venture capital industry apart from their fi scal profi les. Vehicles that will be available in Germany include: ■ Venture capital companies ■ Equity investment companies Venture capital companies are recognized by BaFin 5 only if they meet these requirements: ■ They must manage acquisition, holding, administration, and divestiture of venture capital participations ■ Their headquarters must be in Germany; ■ Minimum capital must be at least €1 million ■ Management must be made up of at least of two managers ■ Investments must be in “ target companies, ” i.e., in companies with particu- lar characteristics Equity investment companies are classifi ed by the competent Supreme Federal State Authority and not by BaFin. 6 In Germany, equity investment is a very broad term that includes participations in domestic and foreign companies, all mezzanine fi nancing, and all investment that may be related to equity. The German law distinguishes between an open equity investment company and an integrated equity investment company. The integrated equity investment company still qualifi es as a subsidiary after the expiration of a 5-year start-up period during which investors can hold a participation of more than 40% of the capital or voting rights. However, the company may only invest in companies managed by at least one person who directly holds at least 10% of its voting rights. All equity investment companies may hold participations for a period of 15 years. 6.5 Fiscal framework for equity investors and vehicles: The EU condition 5 The German fi nancial authority. 6 This aspect is one of the most criticized fi scal reforms. 102 CHAPTER 6 Taxation framework for private equity and fi scal impact The taxation profi le of venture capital companies depends on its classifi cation: asset manager or commercial company. If it is classifi ed as an asset manager, the company is completely “ transparent ” for income tax purposes so all income is not taxed. If the classifi cation of asset manager does not apply, all tax advantages are lost and corporation tax must be paid. However, capital gains, under certain conditions, may result in tax exemption. For equity investment companies there is no special treatment and general taxation rules are applied. Since 2009, for all operators, tax exempt carried interest is reduced from 50 to 40%. PART 2 The Process and the Management to Invest This page intentionally left blank 105 Private Equity and Venture Capital in Europe: Markets, Techniques, and Deals Copyright © 20xx by Elsevier, Inc. All rights reserved.2010 The management of equity investment 7 7.1 EQUITY INVESTMENT AS A PROCESS: ORGANIZATION AND MANAGEMENT Equity investment satisfi es two different needs: (1) companies collect funds because their entrepreneurs do not have suffi cient fi nancial resources to sup- port and increase the development of their businesses and (2) these fi nancial resources are held by investors who fi nance high-risk high-reward projects. Equity investment can be developed through vehicles that allow institutional venture capital activity. These funds are split up between different companies that are potential sources of high economic return. Different vehicles for investment activity include: 1. Partnership — Shareholders are responsible for the management of the private equity fund and they respond directly with their personal assets; in some cases, the management of the fund can be delegated to external professionals (management company), but the total funds reserved for shareholders and the fund are equal, and the fund does not represent an autonomous legal entity. This partnership has a life of about ten years that can be extended for two more years depending on the shareholders. 2. Limited partnership (LP) — Similar to a general partnership, there are two clearly defi ned categories of shareholders. The limited partners are insti- tutional and individual investors who provide capital. They have limited responsibility in the fund’s management and investment decisions, which only extends to the capital they contribute. The general partners, apart from transferring capital, are responsible for organizing the fundraising, managing CHAPTER 106 CHAPTER 7 The management of equity investment the funds raised, and the reimbursement of the quotas to the subscribers at the expiry of the fund. Their responsibility is extended to their personal assets. Almost all partnerships allow a single partner to close the partner- ship in case of a death or withdrawal of the general partners and/or fund bankruptcy. Usually the LPs include some private agreement allowing the limited partners to dissolve the partnership and replace the general partner if the limited partners represent more than 50% of the fund and the general partners are damaging the fund. 3. Corporation — A company where the shareholders are the investors. The main disadvantage, compared with the previous organizational forms, is that the corporation is subject to taxation on capital gains realized (and not distributed), whereas the partnership and the LP have full “ fi scal trans- parency. ” The law does not allow specifi c parties to operate through part- nership or LP in a corporation. 4. Closed-end fund — An autonomous legal entity independent from both the subscribers and the company that manages the resources. The sub- scribers, however, cannot interfere in the management or investment activities of the management company. The management of the fund can also be supported by one or more advisory companies. Regardless of the legal structure, a set of common characteristics distinguish venture capital funds from other types of fi nancial intermediaries: 1. Limited life — This fund has a predefi ned expiry date at which the redemp- tion of the quotas subscribed are returned to the investors. This minimizes the risks to venture capitalists and investors during the timing and meth- ods of redistributing the invested funds. Returning the subscribed quotas to investors is a powerful incentive to optimize the effi ciency of manage- ment company investment policies. If the results are worse than expected, it will seriously compromise the fund’s ability to raise money in the future. 2. Flexibility — A management company can launch several funds simultane- ously, each one characterized by a distinctive duration, capital, and invest- ment philosophy; therefore, it is possible to satisfy a variety of investor categories, each with a specifi c risk/return/liquidity profi le, widening the depth of the risk capital market. This fl exibility allows the manager to dele- gate (to advisor companies) some of their institutional activity (fundrais- ing, identifi cation of the target companies, investment selection and/or monitoring, analysis of the exit opportunities). Therefore the company is always able to supply the clientele with highly specialized and sophisti- cated products without possessing wide and specialized expertise. 107 3. Remuneration mechanisms — Parties appointed to the fund management receive a fi xed management fee, generally between 2 and 3% of the total capital raised. The management company also participates in the fi nal result of the fund, through the carried interest mechanism, allowing it to receive a certain percentage (usually 20%) of the total capital gains real- ized in the exit phase. Hence, venture capitalists are more responsible in the investment selection and management activities because this affects an important part of their own remuneration. Venture capital funds constituted through LPs provide two distinct invest- ment categories, general partners and limited partners, with a different level of involvement and responsibility in the management of the capital raised. This separation is typical in closed-end funds, but it does not occur between the reserves of the venture capital fund and the fund managers; the general partners allow the management team to act autonomously in the selection of the best investment opportunities, accelerating the decision-making process relative to the preparation and conclusion of the investments. To avoid the risk of opportunistic general partners, they are explicitly pro- hibited from trading operations on their own behalf (self-dealing), which could allow them to receive benefi ts unavailable to the limited partners. In contrast to the closed-end funds, subscribers can exit the investment before the end of the fund’s life, i.e., the limited partners can ask at any time for reimbursement of the subscribed quota. It is thus possible that liquidity risks might arise within the LP jeopardizing the stability of the fi nancial resources given to the companies fi nanced. An LP is not a company with share capital so it is not eligible, in the coun- tries whose legal regulations provide for such a company structure, to be admit- ted for quotation on offi cial stock markets. The quotas of a closed-fund, on the other hand, can be traded on a regulatory market, and in case of quotation, it is possible to subdivide the quotas to permit greater marketability of their certifi - cates and increase the liquidity profi le. In the countries where it is possible to constitute an LP, the largest part of its success is related to favorable fi scal schemes. This is different from the schemes applicable to other intermediaries operating in the venture capital market, e.g., the closed-end fund. 7.2 THE FOUR PILLARS OF EQUITY INVESTMENT Vehicles dedicated to equity investment have a specifi c value chain with phases and organizational functions that can be classifi ed worldwide. For each phase 7.2 The four pillars of equity investment 108 CHAPTER 7 The management of equity investment there is a different contribution from management and the advisory board and the Board of Directors. The typical phases of equity investment are fundraising, investing, managing and monitoring, and exit. 7.2.1 Fundraising Fundraising is the promotion of a new equity investment vehicle within the busi- ness community; the purpose is to fi nd money and create a commitment. The main motivation, considered by investors during the selection of the funds, is based on obtaining returns higher than those offered by the fi nancial market. Private equity investors normally want a premium of about 5% compared with the gain. This extra performance covers the extra risk connected with the minor liquidity of the fund and the higher risk connected with private companies. Also taken into account is the track record of the investment managers based on their competencies, their reputation, and their previous performances. Investment managers should demon- strate that past deals have been successful because of a series of good capital allo- cations not just one successful deal. Investors use IRR as a measure of success. The money multiple (the number of how many times the fund has been able to multi- ply the initial endowment of capital) is also used because it is infl uenced less by distortions over the duration of the investment. Investors also evaluate the terms and rules included in the corporate governance structure of the fund. The fund subscribers consider not just the IRR realized by the investment, but also the performance of the fund netted by the costs, the fees, and carried interests paid. It is important to defi ne carried interest: it is a part of the earn- ings generated by the fund and given back to the management team at the end of the fund. It is defi ned as 20% of the fund performance and can be calculated in two different ways: 1. The fund as a whole — The carried interest is based on the total perfor- mance and result of the fund and is paid only when the investors receive their total capital before subscribers. 2. Deal by deal — The investment manager receives a part of the profi t obtained from the investment, but they have to avoid the eventual losses provoked by management activity. Mixed solutions are also frequently applied allowing the investment manag- ers to receive the carried interest deal by deal but only at the end of the fund after reimbursing the risk capital to the subscribers. Fundraising is for all funds, especially ones without a track record, because many investors are reluctant to invest in an unproven team even if the partners [...]... equity management team is involved in the governance of the venture- backed companies financed There are different practical types of investments: investment in a private equity fund, in a private equity fund of funds, or the direct investment in equity or the construction of a private equity fund and the involvement of the private equity fund in the firm-financed shareholders under the control of a single... Legal & Governance Reporting Promoting & Recruiting People Fiscal Selling management Fundraising Investing Managing & Monitoring Exiting FIGURE 7.2 The skills along the private equity investment process Legal and fiscal skills are important during the deal structuring, closing, and exiting because they are the stages when the private equity fund has to define and respect specific legal and tax requirements... Competitive investment including start-up financing, growth or expansion financing, and the public equity Recovery investment realized through debt restructuring, turnaround financing and leverage buyout financing, and vulture capital Investors of risk capital must focus on the origination activity, which consists of a steady flow of investment opportunity This is the key factor in starting the investment... privacy of the investment deal, to be fully engaged in the negotiation process, and to ignore the rumors and deal inside the financial market and with other equity investors When planning exit strategies in this phase investment managers should define covenants, the timing of divestment, contractual IRR expected, and identification of subscribers 7.2.3 Managing and monitoring Managing and monitoring selected... during the core phases of investing and managing funds owned by private equity They are important for solving or reducing agency problems between subscribers and managers of the fund and also to guarantee a higher level of transparency Promoting and selling skills are critical at the founding and at the closing of the fund, because they help realize the desired economic return at the exit Recruiting and. .. Fundraising There are certain steps in the fundraising process that lead to a successful result: Creation of the business idea Venture capital organizations Selling job Debt raising Calling plan Key covenants Types of investments 8.1 CREATION OF THE BUSINESS IDEA The creation of a business idea starts by explaining the idea to the business community and catch the attention of potential investors The business... remains contained compared to the largest venture capital private companies with average investments from $100,000 to $500,000 Academic foundations and institutions may invest in venture capital through the acquisition of holdings in closed-end funds, but their contributions are limited because of risk levels 8.3 SELLING JOB It is critical to identify the category of investors potentially interested in. .. equity investments follow a logical financial strategy, whereas the last two follow an industrial strategy and the third one (direct investment in equity) has both a financial and industrial logic The venture capitalist investments, depending on the specific phases of the life cycle of the target firm, can be classified as three main clusters of equity investment: Pre-competitive investment (seed financing)... fascinated by the explicit trust in the investment manager’s dealing skills 7.3 THE RELEVANCE OF EXPERTISE AND SKILLS WITHIN THE PROCESS The expertise and attitude needed in the investment process (see Figure 7.1) is different depending on the specific stage The specific skills necessary during the venture capital activity (Figure 7.2) include: Company valuation skills are relevant during the investing and. .. because the capital is stable for a medium- to long-term horizon and there is highrisk In the UK and US markets fundraising for closed-end funds comes from pension funds, both public and private, whereas in Europe the largest investment 8.3 Selling job 123 comes from the banking system and other institutional investors Closed-end fundraising occurs during the initial formation phase through financial intermediaries . types of investments: investment in a private equity fund, in a private equity fund of funds, or the direct investment in equity or the construction of a private equity fund and the involvement. oper- ating in the private equity and venture capital industry apart from their fi scal profi les. Vehicles that will be available in Germany include: ■ Venture capital companies ■ Equity investment. phases of equity investment are fundraising, investing, managing and monitoring, and exit. 7.2.1 Fundraising Fundraising is the promotion of a new equity investment vehicle within the busi- ness